The world holds its breath

The following blog is an extract from our latest Active Fixed Income Outlook.

At the time of writing, markets are enjoying a powerful mix of US monetary policy easing and now Chinese policy stimulus. Their reaction to these crucial events is helping us build a picture of the potential shape of the next economic cycle.

As the US Federal Reserve (Fed) finally switches its focus from inflation to employment, markets have been quick to price in a bout of aggressive policy easing.

The case for owning duration now is that it offers good insurance value as long as the ‘disinflation’ story remains intact. If investors find it hard to get concerned about the risks of resumed high inflation, the correlation between risk-free and risky assets should be negative (in other words, helpful). As a result, we have continued to run unconstrained fixed income funds long on duration and long in credit.

We don’t believe there’s any mean reversion in nominal yields – just because they went down doesn’t mean they’ll go up, and vice versa. We aren’t buying into the narrative that they’ll magically go back up just because they’ve gone down a lot.

We also don’t buy into the idea that the pace of cuts that's been priced in cannot be delivered in reality. In fact, we’re not focusing much on the pace of cuts at all. We’re much more interested in the level rates will be at when the cuts stop – where will the neutral point turn out to be? And until rates markets start pricing below the range of plausible estimates from ‘sensible’ economists, we continue to think there’s room to rally.

At the same time, a deteriorating geopolitical backdrop can provide further support for rates (and by extension, fixed income). So too can any further signs that the US economy is seeing uncertainty in the outcome of the Presidential election impacting growth. Delayed decision-making from companies could lead to reduced capital formation, even if the consumer remains robust. Increased risk aversion among investors could also become a factor.

At the start of the year, many highlighted the number and significance of the elections we would see this year. Some two thirds of the world's population will have gone to the polls by the end of 2024. To us, the most striking observation is that austerity has not been on the ballot in any of them.

If we see further evidence that fiscal policy will remain policymakers’ primary economic growth stimulant in the next cycle, then the landscape will look very different to what many market participants have experienced before.

The latest cost estimates for Kamala Harris’s policies come to around $1.8 trillion added to the 10-year deficit. Donald Trump’s will add $5.8 trillion. When could markets say enough is enough? Either way, it all helps paint a picture of a shorter, more volatile cycle than we have seen since the late 1980s. We think there is a plausible path to rising interest rates far earlier than currently expected. Overall, the possibilities that exist within fixed income markets in an environment like this are fascinating. As ever, our mantra is that we cannot predict – only prepare.

The above blog is an extract from our latest Active Fixed Income Outlook.