Are bonds back for H2?

Macro indicators have influenced markets all year, broadly keeping them in a holding pattern on cruise control towards a soft-landing scenario. But dynamics changed gear in early August, as weak US payrolls came as a shock to global investors, sparking uncertainty over whether this is the start of a shift in trajectory towards recession or just a blip in the data.

Fixed income markets have had their own, longer-running, recession-related quirk. The US yield curve, which is typically viewed as a precursor to recession, has been inverted for the past 18 months or so. The inversion receded in some parts of the curve over the summer as expectations of a first rate cut by the Federal Reserve gathered pace. The short end has outperformed as a result. For the long end of the curve to start outperforming, we’d need to see clear recessionary signals that build on the hints proffered by the US payrolls data.

While we wait for greater directional certainty, we can look across the fixed income landscape to see what it might deliver in the second half of the year.

H2 could indeed be positive for bonds ─ we see opportunities across the market but believe an important performance driver will be having clear distinctions between geographies. The US, Europe and the UK each have economic nuances that demand differentiated regional views.

In Europe, longer duration makes a lot of sense as interest rate cuts are in motion, and we should see one or two more before the year is out. While inflation is at target, Europe’s economic environment remains challenged, with Germany losing hold of its position as the EU powerhouse and struggling to deliver growth. As such, EUR high yield looks less appealing than earlier in 2024, but we continue to see potential in investment grade bonds, albeit less cyclical exposure.

The story is a little different across the channel in the UK, as sterling high yield bonds offer more attractive coupons against a recently stablised political backdrop. With the Labour government just starting to bed in, we don’t expect to see any real movement in the UK’s fiscal situation for at least six months, so having some sterling exposure for the remainder of the year makes sense to us. Names we currently favour include some of the budget supermarkets, which are benefiting from inflation and rates-stretched consumers switching to lower-cost foods. We also like bonds in the leisure sector.

In the US, the lack of certainty around rates and the trajectory of inflation makes us more cautious on duration, but in contrast to Europe, the overall robustness of the economy should be positive for high yield. While a Goldilocks outcome seems unrealistic, a rate cut in September and another in December should create a supportive backdrop for high yield bonds – we’re particularly interested in higher coupon bonds in solid businesses with positive outlooks. The drivers here are more idiosyncratic. Conversely, after a good run, the ‘crossover’ names that sit at the top of the high yield category on the boundary of investment grade now offer low coupons and little capital appreciation, so that’s a trade we’re leaving behind in H2.

As a continuously moving feast, the US election is a pundit’s dream, with court cases and new candidates creating twists in the tale. A Trump win seems likely as I write, which should be positive for equities and therefore supportive for credit. Seeing Harris in the Oval Office would be less obviously market-friendly for some sectors such as oil & gas, but could equally bring opportunities in environmental and sustainability-linked bonds. But let’s wait and see for a little longer on that topic. 

Overall, markets may well trade in a range until rates, recession or politics create enough of a story to act as a trigger point. Coupon income is a theme that should persist through the year, while a regional view with a higher-quality stance in Europe is what we think will drive outperformance across H2.  Flexible, go-anywhere strategies that can allocate dynamically across sectors and geographies should be well placed to capitalise on the differentials becoming more apparent across fixed income markets.