Update Bonds: Driving the portfolio
Financial security prices reflect investors’ expectations about future developments. For example, if most investors expect the US economy to go into recession next year, then the Fed is expected to cut interest rates over time; current US Treasury yields will reflect this and move lower.
Investors must thus be careful not to invest only based on backward-looking economic data. An alternative is using forward-looking indicators. Plenty are available, but unfortunately they come with a high degree of uncertainty.
Are we driving our investment decisions by looking into the rear-view mirror, or through a very foggy windshield? The answer is neither. Balancing out the signals from these different types of data is why investing is sometimes said to be more of an art than a science. Uncertainty will always be around, and the way to deal with this is by thinking about future economic developments, and financial market moves, in terms of scenarios.
We came into the year with a base case for a US soft landing, surrounded by a recession scenario on the one hand and a ‘no landing’ scenario, with growth remaining strong, on the other. Following the disappointing US employment report early this month, a soft landing remains our base case. But we have increased the probability of a recession scenario playing out. High-quality bonds with a long duration (interest rate sensitivity) are likely to do well in both our base case (where disinflation allows central banks to cut rates) and recession scenarios. Corporate bonds, which have been trading at expensive spread levels in most segments, should continue to do well in our base case. But since corporate bonds carry credit risk, they may not fare so well if a recession scenario were to materialise (company defaults tend to increase during recessions). Consequently, our preference is for taking duration risk over credit risk.
Notable economic data this week included the Bureau of Labour Statistics’ revised jobs report (revising down the number of workers on payroll for the period April 2023 - March 2024 by 818,000, implying the labour market is coming from a less resilient position than thought before). In Europe, various PMIs (Purchasing Managers Indices), released this week, painted a mixed picture for business activity in the eurozone. The revised US job report and European PMIs can fit with both our base case and recession scenarios, and less so with a no landing scenario. Next events and economic data to look out for are Fed Chair Jerome Powell’s speech at the Jackson Hole symposium Friday afternoon, as well as next week’s US consumer confidence data and inflation reports in both Europe (CPI) and the US (PCE).