Quarterly Outlook
Equity outlook: The high cost of global fragmentation for US portfolios
Charu Chanana
Chief Investment Strategist
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Central banks are on the verge of committing a policy mistake. It isn't time to increase duration, yet
Althea Spinozzi
Head of Fixed Income Strategy
Summary: Powell and Lagarde’s concerns about sticky inflation reverberate through markets. They will hike interest rates further until inflationary risks are at bay. With data showing signs of a decelerating economy, the market is considering the possibility of a policy mistake. Central banks are running the risk of tightening the economy too much, provoking a recession. On the other hand, stagflation is a tail risk that cannot be ignored any longer. We believe the euro bloc is running towards a higher risk of stagflation than the U.S.. Within this framework, we prefer to keep duration at a minimum. As the macroeconomic backdrop becomes clearer and central banks' tightening bias ends, we will see more scope to take longer duration. However, we don’t expect that to happen before the last quarter of the year.
The way forward: a policy mistake is likely
Central bankers continue their fight against inflation. The Federal Reserve flags a potential further half-point in rate hikes this year, while the ECB says another 25bp rate hike in July is "very likely." However, there is something central bankers are not saying: the hiking cycle is about to end, and the implications are big for markets. It means that although interest rates are kept at a high level, there is a high probability for front-term yields to drop as markets position for the beginning of a rate-cutting cycle. The longer part of the yield curve might remain pinned down but is likely to fall amid growth woes.
That's why central bankers are doing everything possible to keep hawkish. If the market positions for upcoming rate cuts, lower rates will defy the aggressive policies they have implemented. Dropping yields will loosen financing conditions, risking creating a fertile ground for inflation.
Yet, the opposite side of the medal doesn't look good, either. A deep recession might ensue if central banks continue with their aggressive monetary policies.
Central bankers have painted a positive picture: they are about to reach a sweet spot that guarantees the defeat of inflation while supporting economic growth. However, obstacles remain for such an outcome to materialize.
In the U.S., the real Fed funds rate turned positive for the first time since 2019, signaling that financial conditions are tighter. Yet, in Europe, the real ECB deposit rate remains profoundly negative in the bottom range it traded from 2010 until 2020 amid ECB's expansionary monetary policies.. Thus, the probability of spiraling inflation is higher in Europe than in the U.S., putting the euro bloc at a higher risk of stagflation.
Stagflation or soft landing: short duration is preferable
The good news for income-seeking investors is that the bond market currently offers good income opportunities.
Duration is cheap at the front end of the yield curve. Two-year U.S. Treasuries offer more than 90 basis points over 10-year U.S. Treasuries. Moreover, short-term yields are the first to drop in the event of interest rate cuts. The bias for shorter maturities is clear. However, in the case of stagflation, the long part of the yield curve might drop sharply, bringing plenty of upside to bonds with long duration. Yet the risk of holding such bonds is high, especially now that the future is uncertain.
Holding short-term bonds has its risks too. If you are holding short-duration bonds as a stagflation scenario develops, there is the risk that central banks might continue to hike rates and the value of your short-term bonds falls. That would be fine if you hold the bond until maturity and you are content with the yield you have locked in, yet you would suffer from opportunity risk. For example, you might be locked in a bond at a 4.5% yield for two years, but rates go to 6% in that timeframe. Yet, you will get your capital back at maturity, and you could ultimately reinvest at higher yields.
Income opportunities are even more striking in the corporate space. On average, investment grade U.S. corporates with maturity between two and five years offer 364 basis points over U.S. Treasuries. In comparison, U.S. investment grade corporates with maturity above thirty years offer only 300 basis points over U.S. Treasuries. In the U.S. high-yield space, corporate bonds with a maturity between two and five years offer almost 540 basis points over U.S. Treasuries, while junk bonds with a maturity between ten to thirty years offer only 450 basis points.
In Europe, investment-grade corporations with two to five years of maturity offer 127 basis points over German sovereigns. High-grade corporates with maturity between ten and thirty years offer 131 bps over Bunds, only 4 basis points over shorter maturities. In the European high-yield corporate bonds, those with a maturity of up to two years offer 550 basis points over German sovereigns, while those with a maturity between five to ten years offer only 474 basis points on average.
Reducing interest rate risk while maximizing returns is critical in an evolving macroeconomic environment. That's why short-term securities offer an ideal risk-reward trade-off.
What instruments can I consider to get exposure to short-term bonds?
In the case of U.S. Treasuries, European Government bonds, and U.S. and European corporate bonds, you can trade the cash instrument by searching for bonds in the Saxo platform screener. The same can be done for ETFs; however we highlight some for inspirational purposes: SPDR Bloomberg 1-3 Month T-Bill UCITS ETF (Acc) (ZPR1), Amundi U.S. Treasury 1-3 UCITS USD ETF (U13C: exams), Invesco U.S. Treasury Bond 1-3 Year USCITS (T3RE: Exeter), SPDR Bloomberg 1-3 Year Euro Government Bond UCITS ETF (Dist) (SYB3), Xtrackers II Germany Goc Bond 1-3 Years (D5BC: Exeter).
In the corporate space: Amundi EUR Corporate Bond 1-5Y ESG UCITS ETF (EBBB:xpar), SPDR® Bloomberg 1-3 Year Euro Government Bond UCITS ETF (Dist) (SYB3:xetr), iShares 1-5 Year Investment Grade Corporate Bond ETF (IGSB:xnas), SPDR Bloomberg 0-3 Year U.S. Corporate Bond UCITS ETF (Dist) (SYBF:xetr).
When looking at corporate bonds, we have searched for bonds with short duration, sizable coupons, and good yields. Below are the bonds that we find most interesting.
Beware, fixed income products carry duration, interest rate, and default risks. This research is not meant to be advice.
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