Unconstrained fixed income views: December 2024
‘Tis the season to be jolly, but not everywhere…
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Over the month we’ve made no changes to our scenario probabilities, believing the macro outlook has not materially altered its course in the last few weeks.
Principally, and while a “soft landing” of steady growth and controlled inflation remains our base case at a 60% probability, the risks are skewed in the more hawkish, higher interest rate, direction with a “no landing” probability of 30%. A stalling of the disinflation process in the US, the release of pent-up demand in the form of business spending now that the US election is out of the way, and some policy-driven inflation risks all help justify this probability. For now, we see the “hard landing” risks as well contained, at just a 10% probability.
Our scenario probabilities remained unchanged over the month
Source: Schroders Global Unconstrained Fixed Income team, December 2024. For illustrative purposes only. "Soft landing" refers to a scenario where economic growth slows and inflation pressures ease; “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.
Animal spirits show early signs of emerging in the US
We wrote last month that with the election result behind us, the US economy was likely to enter a period where uncertainty declines, sentiment rebounds and—ultimately—we would see economic survey data turning more positive. To some extent this is what has played out in recent weeks, and we suspect the trend will continue: that is, there will be further positive data points as businesses continue to adjust to a new pro-business and de-regulatory agenda.
One area where we believe there is plenty of scope for further upward momentum, for example, is in the US manufacturing cycle. A combination of loose financial conditions, easing credit standards, and supportive governmental policy all signal that US manufacturing should emerge from its nearly two-year-long recession.
So, companies in the US can enjoy a cheery festive season and head into 2025 with greater confidence. But while the manufacturing cycle tends to be global in nature, we have less confidence in seeing much of a rebound outside of the US, given that the ominous threat of the US imposing tariffs on imports will weigh on major capital expenditure decisions.
Instead, business sentiment has been souring on the other side of the Atlantic, with firms in the UK and on mainland Europe demonstrating limited ability to grow. The October Budget is no doubt weighing on UK sentiment, with the likely impact of depressing private sector hiring in the near term. The Eurozone also continues to contend with a combination of cyclical and structural challenges. The expectation of future tariffs could certainly limit any improvements in the European manufacturing sector in the coming months. Perhaps a further increasing concern now is the European service sector, which appears to be losing momentum. This will help focus the minds of the European Central Bank (ECB) as they consider how the path of interest rates should develop, following their 25bp cut this month.
All that said, given the depressed current state of global manufacturing, it is frankly difficult to see European manufacturing sentiment getting much worse, absent the emergence of an actual recession. At least with this backdrop any global rebound in manufacturing is likely to remain limited, keeping a lid on commodity prices gains and helping inflationary pressures stay contained.
Stalling, not falling…
On inflation, if we zoom out to look over the last couple of months, the big picture shows that US disinflation has largely stalled. This is clear from several key underlying metrics: core CPI has now printed at or above 0.3% on a month-on-month basis for four consecutive months, and core services, excluding shelter, look to have stabilised in the region of 4.3% year-on-year. If we fail to see further disinflationary progress in these areas, it argues for a much shallower cutting cycle from the Federal Reserve (Fed) as we move through 2025.
This is all before we consider the Trump administration’s largely pro-inflationary agenda. The market seems to have taken a relatively benign view of this so far, apart from a short-term boost to expected inflation driven by anxiety over global trade tariffs. But on a longer view we are more concerned. If it looks like Trump will keep to his word on immigration restrictions and deportations, the risk of a tightening in the labour market increases, especially given a backdrop of strong US demand.
Indeed, there have already been some tentative signs that the labour market is tightening again, having cooled gradually in recent quarters. Alongside a slight rebound in the quits rate and a near-term pick-up in payroll growth, we also observe that US corporate profit growth continues to be positive, historically a constructive sign for the health of the broader labour market. It is true that the unemployment rate has risen a little this cycle, thanks largely to positive supply dynamics, but this impact should be limited as long as corporate profit growth keeps increasing.
All this means is that essentially the downside risks to the US economy from a weaker labour market appear to be diminishing, which will ease any remaining recession concerns at the Fed. This again implies a gentler cutting cycle and supports the low hard-landing probability in our scenario framework.
Where are the opportunities?
Agency mortgage-backed securities (MBS) offer the main outstanding valuation opportunities across our universe, and are therefore alone in having been upgraded since last month. It remains our highest-conviction asset allocation choice.
In recent communications we have argued that our significant no-landing probability warrants a more negative stance on US duration but that, tactically, sentiment and valuations have suggested patience when actually taking these positions. More recently, yields have come off their post-election highs which means valuation levels have become slightly more attractive in terms of taking short duration positions in the US. We look for further dips in yields to provide more opportunities to implement these.
From a cross-market standpoint, as last month, we favour Europe and the UK over the US. Granted, the UK does still have a lingering inflation challenge, but the Budget has opened up some downside risks to the private sector employment outlook, and growth is not comparable to that in the US. The European outlook remains challenged, with continued scope for disinflation, and potential job losses on the horizon.
Given the difference in outlook between the Europe and the US, we also retain our positive US dollar currency view, although we are conscious that being long US dollar is a well-held market position, meaning in the short-term there may be limited scope for the US dollar to appreciate further.
Our views on the European periphery remain slightly negative, with rich valuations offering little compensation for future risks, even if a catalyst for repricing appears lacking at present.
In asset allocation, with corporate credit spreads remaining extremely tight, we continue to dislike US investment grade, preferring euro IG on a relative basis. High yield spreads in both markets also look unattractive (although again we have a slight preference for Europe). More positively, we retain our preference for agency MBS, since we expect rate volatility to be relatively contained. Over the month we have also become more constructive on covered bonds, helped by improved valuations and a constructive supply outlook into 2025.
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