Key Points
- The current market cycle is characterized by low visibility and high uncertainty, with a significant financial-market correction underway.
- With growth risks dominating the agenda for investors, we expect bonds will play a positive role in portfolios.
- We believe that our approach of actively managing duration and credit risk, along with uncovering opportunities in credit and emerging markets, will be key in navigating the market backdrop.
There are two key factors at play that are driving bond markets. First, the current market cycle is characterized by low visibility and high uncertainty, with the probability of a global recession increasing. Second, there is a financial-market correction underway, particularly in equities and, to some extent, credit, with substantial downside risks remaining. The correction appears to be significant, particularly in areas with high concentration and valuations, such as artificial intelligence and related industries.
Therefore, we have these two elements to consider: a potentially weaker real economy, and softer financial markets. Overall, this environment should favor bonds.
Challenging Backdrop for Bonds
Nevertheless, bonds have not moved as much as expected. We think that this is because we are in a different regime, with two competing themes. This regime, which began following the Covid pandemic, has been characterized by inflationary pressures that are more structural in nature, accompanied by greater government intervention, as outlined by our big government theme. In addition, fiscal deficits remain high, and given the market correction that began in January, risks in markets have increased – underscoring the trends identified by our financialization theme.
This presents a backdrop that is challenging for bond investors; the increased supply of bonds, combined with fiscal concerns and inflationary pressures, has led to a difficult setup. Market participants have shown concern about the fiscal viability of some sovereigns, including the US, France and even the UK, leaving very little room to maneuver. Yields at the long end of the UK gilt market, for example, are still relatively high by historical standards.
What Does This Mean for the Role of Bonds in Portfolios?
We believe that bonds still play an important role, and that our approach of entering this year defensively was sensible. Given the backdrop, we think that active management of both duration and credit risk can be beneficial for investors this year, and this is how we are navigating the current market cycle. With growth risks dominating the agenda for investors, preceded by the correction in financial markets, we expect bonds will play a positive role in portfolios.
With growth risks dominating the agenda for investors, preceded by the correction in financial markets, we expect bonds will play a positive role in portfolios.
Opportunities
Given our defensive positioning so far this year, we think there are current opportunities to buy credit at cheap levels, particularly at high yields of 9% or over. We also think that emerging markets remain attractive on a structural basis.
In terms of currencies, we think that the US dollar appears overvalued, and while the speed of the dollar’s decline has been surprising, there is still some way to go. European currencies look to be in a better position, and with the challenges facing the US dollar, we expect that this will result in emerging-market currencies generally performing well. As we become more bearish on the dollar, we are likely to increase exposures to emerging-market currencies.
Overall, the current market cycle presents challenges and opportunities for fixed-income investors. By actively managing duration and credit risk and increasing exposure to credit and emerging-market currencies over the year, we believe a patient approach will be key to navigating this market backdrop.
Authors
Ella Hoxha
Head of Fixed Income
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