Unconstrained fixed income views: November 2024
Fiscal policy is back. Again.
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After years of dormancy, fiscal policy has been a key driver of markets over the half-decade since the start of the Covid pandemic. The US election result has opened up the prospect of more fiscal easing and China has begun making tentative steps to address its sharp industrial slowdown with fiscal policy, to support monetary easing, although an expectant market has been underwhelmed by measures so far.
The UK government talked tough going into the Budget at the end of October, and then delivered unexpected stimulus. Meanwhile, the eurozone is plotting a different course with budgetary tightening pencilled for next year. But even there, the upcoming German election offers the prospect of a structural change in fiscal policy with a more expansionist tone.
These events do two things for our outlook on markets. First, the potential for more fiscal easing in the US, on top of an already strong economy, raises the risk of a no-landing outcome in our scenario framework. And secondly, the disparity between the fiscal paths across various markets creates opportunities for us to identify value in bonds, currencies and asset allocation.
Growing risk of a no-landing outcome
Source: Schroders Global Unconstrained Fixed Income team, 17 November 2024. For illustrative purposes only. "Soft landing" refers to a scenario where economic growth slows and inflation pressures eases; “hard landing” refers to a sharp fall in economic activity and additional rate cuts are deemed necessary; “no landing” refers to a scenario in which inflation remains sticky and interest rates may be required to be kept higher for longer.
How soon is now?
Though not officially in power for another two months, President-elect Trump seems determined to hit the ground running with his second administration. It is uncertain exactly which policies will be prioritised, but markets will continue to shift expectations as the details are clarified. We would expect to see the following:
- In the short term, measures of confidence and 'animal spirits’ will increase, as business sentiment responds to the prospect of an easier regulatory environment going forward.
- While the range of fiscal policy options remains wide, the overall effect is likely to provide a small boost to the economy compared to what we expected before the elections. There is also a chance that we could see much more aggressive fiscal easing than would have been possible under a divided Congress. The actual impact on the economy will most likely be felt from 2026 onwards, but the fiscal plans for 2025 are already mostly set. In our view, the budget deficit is expected to improve as a stronger economy increases tax revenues, along with spending limits put in place by the outgoing Biden administration. However, investors may start adjusting their expectations ahead of these changes.
- Stricter immigration policies are likely to reduce the boost to the labour supply that has been a key feature of delivering a soft-landing outcome so far. At this stage, uncertainty around this issue is particularly high: will we see a decline in the labour supply as a proportion of population due to deportations, or simply slower increases? At a minimum, the scale of job growth possible without tightening the labour market is likely to fall much nearer to 100,000 per month, which is similar to what we saw pre-pandemic. If policies become even more restrictive, that number could fall significantly lower.
- A more hawkish global trade policy looks certain. Whether this is universal or more targeted remains to be seen but coming on the back of an already weak global manufacturing cycle this adds a further headwind. Business confidence in those areas most likely to be impacted—such as Europe—will be hit even as the actual policy details remain uncertain: if you’re going to worry, why wait?
Play with fire
What is the impact of this on the US outlook?
First things first: US growth going into the election has been great. Growth averaged an annualised 2.5% in the first three quarters of this year, and lead indicators point to continued health in the key drivers of domestic services and consumption. The labour market, which had shown some signs of fragility in the summer, looks evenly balanced after data revisions and with continued low layoffs – although the breadth of job growth (the extent to which the whole economy is participating rather than just certain sectors) and the quits rate (the percentage of workers choosing to quit their jobs) are downside risks we continue to monitor.
Inflation in September and October has been above levels that would be consistent with the US Federal Reserve’s (Fed) target, but domestic drivers such as wage pressures continue to move in the right direction. Economies are rarely in true equilibrium, but on the eve of the recent Presidential election, the US economy was about as close as you can get.
The growth impact of potential new policies is ambiguous and will depend on their scale, timing and sequencing: deregulation and easier fiscal policy would be supportive, but a negative labour supply shock caused by stricter immigration controls and potential deportations could be stagflationary. Tariffs would have differing implications by sector, but typically they mostly work as a tax on global growth.
On the inflation side, however, the potential new policy measures point in the same direction: higher. This doesn’t mean we expect inflation to run wild; we don’t. But the Fed’s challenge in keeping inflation low and stable over the medium-term has just become harder, and it is therefore little surprise that building in "optionality" seems to be a common theme of their recent communications. The chance of the Fed pausing their rate cutting cycle earlier than they expected is now greater, and for this reason we have upgraded our probability of a no-landing outcome.
Dear Prudence
It is an irony lost on absolutely nobody that while the US needs further fiscal expansion the least, it is now the most likely to deliver it. Meanwhile, areas and countries much more in need of the cyclical demand and structural reform that fiscal policy can offer are, at this stage, the most reluctant to use it.
Europe is likely to be strongly impacted by a worsening trade environment and an associated impact on business uncertainty, adding to an already weak industrial outlook. We have been concerned about growth in the eurozone for the last few months; the potential for trade friction simply adds to this.
Given this backdrop, we believe more policy support is needed. The less that fiscal policy contributes, the more the European Central Bank (ECB) will need to offer on the monetary front. Although the fall of the German coalition means impending elections, which open the door to a more stimulative fiscal policy, for now the eurozone has pencilled in mild fiscal tightening as we head into 2025—much of which comes from France. We fear that eurozone policymaking may be too reactive and not bold enough at this stage given the scale of the challenge.
The UK Budget, meanwhile, offers the prospect of modest fiscal easing over the next couple of years, despite talk in the build-up being dominated by the need for tax rises and fiscal restraint. While this move to greater fiscal spending complicates the job of the Bank of England in bringing inflation back to target, the weakness of gilts since the Budget has been notable and we believe they now provide attractive opportunities, especially as they have decoupled from economic data.
Finally on fiscal policy, China. The Chinese economy has been weakening for several quarters, and we consider it a major driver of the softness we have already seen in the global manufacturing cycle, even before a potential trade war worsens the situation further.
After moves in September to suggest greater policy support was imminent, the latest round of fiscal easing measures has been underwhelming, given the scale of the problem and the inefficacy of monetary policy. We continue to watch closely for signs of a more forceful “bazooka” from the Chinese authorities, which still has the potential to cause a paradigm shift were it to occur.
Where are the opportunities?
Strategically we believe the inflationary impact of the US election raises the risk of a no-landing outcome. This would normally suggest an underweight to the US, but looking on a more tactical basis US economic surprises are elevated, sentiment and positioning towards bonds have become negative, and valuations have cheapened significantly. In our view, therefore, engaging with an underweight to US bonds, either outright or cross-market, is not justified at current levels. We believe patience is merited.
Our favoured locations for long duration remain the eurozone, and UK gilts. In the former, the macro outlook is weak, and the threat of tariffs will only worsen it. The latter have cheapened significantly since the UK Budget as many investors have reduced previously overweight positions.
We see currency as an alternative way of expressing the different dynamics between the US and the rest of the world. The impact of already weak European growth, the likelihood of a worsening global trade environment, and the need for the ECB to offset this shock with more stimulus, are all consistent with the euro weakening further against the US dollar.
In asset allocation terms, we have further reduced our outlook for credit due to very tight valuations, which we don’t believe offer sufficient margin of yield cushion against any unexpected deterioration. This is especially true in the US, but eurozone credit has also been downgraded on our scorecard. So have covered bonds—to neutral—and quasi-sovereigns, though in the latter case we retain a small overweight score.
Agency mortgage-backed securities offers the main outstanding valuation opportunities across our universe and is therefore alone in having been upgraded since last month. It remains our highest-conviction asset allocation choice.
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