So far this year, the macro backdrop for fixed income markets has been ever changeable, reflecting the uncertainty and volatility that investors have had to navigate. The market narrative has been a roller coaster, jumping from one concern to the next, month after month. As we reach the halfway point of the year, it is crucial to understand the factors that are shaping these markets and how they affect fixed income investment decisions.
To shed light on these issues, we enlist the expertise of Colin Finlayson, fixed income portfolio manager for Aegon Asset Management’s strategic global bond strategies. With an insider’s view, Colin analyzes three key factors that are driving fixed income markets today: inflation, economic growth and the interest rate policies of the major central banks. His analysis will give us a better understanding of the underlying dynamics and how these may influence fixed income investment strategies in the coming months.
Starting with inflation, what have you seen so far this year and what are your expectations for the second half of the year?
Inflation has probably been the most important news so far this year, especially in the United States. We have seen the steady decline in inflation become a bit slower and stickier. And this has raised some concern about the degree of interest rate cuts the Fed will be able to implement this year. The Fed’s preferred measure, the underlying PCE deflator, has been moving gradually lower. But the question is whether it is moving enough for the market.
Across the Atlantic, the story is quite different. Inflation has been surprising to the downside fairly steadily in Europe, and the UK is seeing inflation return to the Bank of England’s target, having recently hit 11.1%. This continued decline in inflations is help give some confidence to fixed income markets and is offering support to the outlook for government bonds and therefore broader bond market yields.I wanted to ask you about growth… What is your outlook for growth and how does it affect fixed income investors?
There has been an ongoing debate about whether we are going to see more of a soft landing for economic growth or more of a no-landing scenario where growth starts to reaccelerate. In Europe and the U.K., we have clearly been on a soft landing trajectory as growth has been at more recession-like levels, unemployment has started to rise and the impact of higher interest rates is starting to be seen in household demand and spending.
In the United States, however, growth has been somewhat more robust. The US has benefited from greater resilience in the labor market, but also from earlier fiscal spending, which has been percolating through the system. During the first few months of this year, it looked like there were going to be steady upside surprises in US GDP. But in fact, first quarter growth was weaker than expected and was revised down again in its most recent reading. So in the US, which looked set to deliver more upside surprises, growth is starting to moderate, which is reflected in business surveys, such as the ISM, which are starting to soften. The idea of a soft landing is starting to become more apparent in the US and, again, this is a backdrop that would be more beneficial for bond markets than a no landing scenario, which was feared earlier this year.
I wanted to ask you about growth… What is your outlook for growth and how does it affect fixed income investors?
As far as official interest rates are concerned, central banks are now considering only two paths: hold them or cut them. The European Central Bank (ECB) has already lowered rates along with the Bank of Canada, the Riksbank and the Swiss National Bank, and we believe other central banks will follow suit. With monetary policy at tightening levels, there is no need to keep rates at these elevated levels for an extended period of time. We believe that the Bank of England will be the next major central bank to cut rates and that the US Federal Reserve will follow.
From a fixed income investor’s point of view, the fact that we are talking about rate cuts rather than rate hikes is the most important factor. With growth slowing and inflation returning to target, we expect interest rates to come down at a gradual pace in the coming period. And this will help support fixed-income markets over the next 12 to 24 months.
How do these factors influence the management of Aegon Asset Management’s fixed-income portfolios?
The macroeconomic backdrop is constantly changing, and we try to cut through the noise to construct portfolios with a long-term view of where we believe there is value in fixed income markets. Strategic global bond portfolios are designed to be flexible and unconstrained and can use their flexibility to take advantage of anomalies that arise as data evolves and market value changes. Given our outlook for inflation, growth and interest rates, we believe portfolios with a more flexible approach are well positioned to benefit from changing market conditions over the next 12-24 months.
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