Greg Venizelos, Credit and Fixed Income Strategist at St. James’s Place, comments on the economic backdrop shaping markets in the first half of the year, and what investors can expect as inflation, growth and duration risks continue to define the outlook for H2.
The key themes in fixed income in H1 have been the resilience of spread risk, the vulnerability of duration risk, the disruption of the diversification role of bonds in a portfolio, and portfolio protection from inflation risk. Earlier in the year, spread risk was unsettled by the woes of private loans to software companies that face AI disruption risk. That was mostly a US centric story, and US spread underinformed Europe spreads as a result. The onset of the Iran conflict created energy-driven inflation fears with Europe and the UK more exposed to such risks.
Although largely a US-centric story, the associated spread widening extended to Europe. Both spread responses have since faded, and spreads are now tighter year to date. By contrast, government bond yields have been volatile and rising since the start of the year, a situation exacerbated by the Iran situation. The latest inflation shock has raised the spectre of interest rate hikes by central banks and further fiscal concerns given the already very elevated levels of government debt. Duration risk has suffered as a result.
Along the same vein bond returns have been negative even during stock market corrections, undermining the defensive nature of bonds in a portfolio context. Year to date and in GBP hedged terms, Global HY has returned 2.1%, Global inflation-linked 1.7%, Global IG 0.9% and Global govies 0%.
The onset of stagflation conditions, namely subpar growth and above par inflation is a risk that could unsettle risk premia driving spreads wider. It is a risk that we remain cognisant of as the full impact of the Iran situation may be yet to be felt. The presence of high inflation during anaemic growth is an unsavoury cocktail, as central banks are constrained from cutting interest rates to stimulate growth. Ongoing heavy supply of corporate bonds, and by the AI giants in particular, could add to the negative mix if the macro backdrop was to deteriorate.
On the other hand, corporate balance sheets remain in good health on average, which could prove a supportive factor for spreads if we were to go into an economic downturn. Duration risk on the other hand is likely to remain volatile as inflation and fiscal concerns persist but govie bonds defensive nature could come into play were we to face serious recession risks.
“There are very few if any glaring extremes in terms of valuations within the fixed income space. We maintain a high conviction neutral on HY credit and a reasonably high conviction neutral on duration risk. We once again consider an underweight in IG credit as spreads have tightened back towards 70bp in US IG.
