With Trump set to take office in January, potentially boosted by a Republican sweep, the messaging across the investment press has been resoundingly positive for equities and on the gloomy side for bonds. But fixed income certainly isn’t going into hibernation for the next four years.
With a few months to go until we see if ‘in-office’ Trump is true to his campaign-trail rhetoric, it’s key that we think about the US and Europe as two distinct bond markets, and that the sub-asset classes within each market are given careful consideration. At any point in time when there’s uncertainty, taking a nuanced, region-specific approach is usually best.
In terms of the US, Trump’s messaging to-date has led with fiscal stimulus via tax cuts and imposing tariffs to protect domestic businesses. This should prove supportive of consumer spending, US growth and risk-on sentiment in financial markets. It’s also likely to be inflationary, creating a near-perfect environment for equity market performance. But we’d also expect to see winners on the fixed income side, namely in US high yield.
Spreads are currently tight in the US high yield market, but there’s room for them to tighten further in response to the improving growth outlook, which should drive better corporate numbers, lower default rates and support favourable supply/demand dynamics. And even if spreads weren’t to tighten, investors would still enjoy generous coupons free from impending recession concerns. We have been positive on US high yield for a while now, and Trump’s victory only goes to further support the investment case for the sub-asset class.
Taking a broader view on corporate debt, the Trump environment could also create some winners in the US investment grade, although this sub-sector is more interest-rate sensitive than high yield, depending on where you are on the maturity curve. Nevertheless, we expect to see some spread tightening driving positive performance across corporate debt.
The main potential negative for US bonds is going to be the Treasury market, particularly given any renewed focus on the fiscal deficit that may likely deteriorate further under a Trump presidency.
Given Trump’s policies are expected to trend towards inflationary, the number of rate cuts priced by the market is reducing. Just six weeks ago, a 50bps reduction was baked in for November, yet it proved to be only 25bps. The odds on a cut in December have fallen to 50/50. Again, the Federal Reserve has continued to indicate a path to lower rates, but much will depend upon data, the trajectory of which has now become even less certain.
In Europe, the collapse of Germany’s coalition government has added to the idiosyncratic risk profile that France was already fueling, and the prospect of US tariffs poses another headwind to economic growth. This makes us more cautious on European high yield, particularly as the sub-sector has a lot of automotive and consumer-related exposure. Instead, we prefer an ‘up in quality’ view in Europe while we wait to see how the economic environment is going to develop; better quality EUR assets make sense to us in a market where we’re seeing growing economic headwinds.
The European Central Bank will have a role to play here, with the likelihood of continued rate cuts to offset the economic deterioration that is continuing to unfold. In an environment of lower inflation, we may well see a decoupling from the US and potentially better performance for European government bonds.
