Markets have long been pricing in rate cuts, but sticky inflation, geopolitical risks and resilient growth are putting that outlook to the test. With cash yields still attractive, credit spreads tight, and bonds’ diversification role under scrutiny, a critical question emerges: how should portfolios be positioned now?
Watch our digital event replay to hear our fixed income experts discuss the forces reshaping global bond markets and what they mean for portfolio construction today.
Key topics:
- Why fixed income is back in focus and where opportunities are emerging.
- Higher for longer: implications for rates, duration and government bonds.
- Navigating tight credit markets with a selective, risk-aware approach.
- Do bonds still diversify? What slowing growth could mean for portfolios.
Edited transcript
Lukasz de Pourbaix (LDP): One of the key things at the back of the mind for a lot of people at the moment is inflation. If we roll back a couple of months, people were anticipating rate cuts, particularly in the US, but with the rise of geopolitical risk, inflation is certainly back on the cards, which is challenging that view. How are you viewing inflation and the prospect of rate cuts in the current environment?
Ario Emami Nejad (AEM): With the onset of the conflict, everything has changed. Because of the conflict, we now have much higher oil prices and also commodity prices everywhere in the world, which means that the inflation trajectory in the US and also globally is not the same as before. So, you know, we are not expected to go back to 2% or below anytime soon.
In fact, we are likely to see a period of above target inflation added. On top of that, the data that has come from US and also as well is showing signs that the labour market in the US has shown sign of stabilisation. Naturally when you put this new view into the market, we are seeing cuts being priced out and at the same time hikes being priced in.
The other thing that we have to talk about is that in the US, we are going to have a new Fed Chair and that is going to be a big unknown - will he be as dovish as people expect or not? So far, he's keeping his cars close to his chest. and giving the message that he's going to be reacting to the data rather than to reacting to what the administration wants to do.
Is the market wrong to be pricing some sort of a hikes into the future? We don't think so. But at the same time, we don't think we are in an environment similar to 2022 when we went down a path of sustained hiking cycle. We might get a couple of hikes here and there, but I think that's the extent that we are likely to see it.
LDP: If we explore that across regions, obviously much of the focus has been on the US. If you look at other regions such as the UK or Europe, is that a similar environment?
AEM: Yes and no. I think the shock that we are seeing is a global shock and it's affecting all parts of the world to a certain extent. However, the US central bank's reaction function is going to be quite different.
Starting with the US for example: yes, inflation is going to go up for a certain amount of time and the job market has too, but at the same time, we are still facing a Fed that really doesn’t want to hike. Whereas before people were betting on the Fed definitely cutting, I think not hiking is a new cutting as far as the US is concerned because the central bank is really not keen to be hiking at the current juncture.
If we move into Europe, central banks are more focused on the data and less concerned with the labour market or growth, as that aligns with their mandate. We think it’s quite likely the ECB will deliver at least two rate hikes, starting from the June meeting, which is in line with what markets are pricing.
The key risk is that if the conflict persists and energy prices remain elevated, the ECB could hike more aggressively. The ECB has consistently prioritised inflation above other considerations. If the conflict drags on, we could see more than two hikes in 2026. We think the Bank of England, on the other hand, does not want to hike given the risks facing the UK economy. However, if energy prices stay high for an extended period, it may be forced to do so.
LDP: Investors are asking what a “higher for longer” environment means for duration. How are you approaching this from a portfolio perspective?
AEM: The key point to emphasise is that whilst we are in a higher for longer environment currently, they will not remain high indefinitely. Investors are understandably influenced by the experience of 2022, but that was a very different environment. In 2022, rates started from very low levels, forcing central banks to respond aggressively to inflation.
Today, rates are already elevated, and the current inflation shock is unlikely to be as severe. While one or two additional hikes are possible, our inclination is to fade excessive rate hike pricing. So yes, are we going to go down an environment that we see one or two hikes by central banks across the world, it's a possibility, but our inclination is to try to fade that excessive hike pricing.
Looking at the US "almost too high" has been priced in. Can market bring the time timing of that hikes a little bit closer? Absolutely, dependant on the new Fed Chair. However, are we going to go and see much more than two hikes in the US? We feel that's a little bit unlikely.
What this really calls for is a very active approach to duration management because the facts on the ground can change at any moment and the central banks that were looking to hike might decide they shouldn't.
Perhaps things will turn on the unemployment front and maybe they have to cut, so an active duration management approach is necessary. We have to be nimble but think our base case should be that a lot of hikes have already been priced in and any further pricing of the hikes from here mean we should try to look for fading those moves across different jurisdictions.
LDP: A lot of the discussion and narrative has been about supply side shocks and supply driven demand and that's really on the back of a lot of the geopolitical risks - obviously, the issues we've seen in oil markets and inflationary pressures there. One of the things that's less discussed is the demand side of things and a possible slow down there. If you think through the lens of the US consumer, how are you thinking about the supply side and in particular the US consumer?
AEM: The US is very interesting economy to like to analyse at the moment because on the surface is doing quite well. If you look at the top line levels, economic indicators show no sign of worry but and at the same time, when you look at the equity market, it's hitting all-time highs every day. The are Al trade is something that everyone is on board with.
There are a few signs that we have to be worried about. For example, when we look at the US consumer, the spending that we see in the US economy is bifurcated. The higher income cohort is doing most of the spending, whereas the lower income cohort has not been spending or pulling its weight for a long period of time. Part of that is reflected of the fact that the buffers that were built up during the COVID period and onwards have been depleted.
What is probably helping the higher income cohort at this junction is again, the stock market, because a lot of the wealth is invested in stock market and it's going up every day. So obviously, if you are a high net worth individual and your net worth is growing higher daily, you feel like you can spend all you want.
But this brings some sort of a reflexivity into the market as well because the moment there will be some sort of a correctional stock market, all that positivity that was driving the consumption can suddenly stop. Then the higher income cohort can basically converge to where the lower income cohort is at the moment.
When you compare it to earlier in the year, we are still in this environment of low hiring, low firing in the job market. This is a very unsteady equilibrium. It can only take one shark into the market for unemployment, suddenly take a time for the worse.
There are many shocks that we can think about. For example, Al will have an impact on the job market. The timing of that is uncertain and the size of that is uncertain, but if there is some sort of a development that causes the process to increase that snowball.
Another example is private credit. Everyone is worried about what is happening in the private credit market. There's a lot of levered money being invested that might not see the returns that they were looking for. Should there be some sort of a retrenchment in the private credit market.
There are some signs to be worried about and that's why you know we when we are thinking about our portfolio positioning, we are not trying to be too optimistic in terms of how much higher yields can go because there are lots of risks lurking in the background and it is our jobs to factor in those risks.
LDP: If we did see a demand driven slowdown, how would you envisage the portfolio to be positioned for that scenario?
AEM: I think from a top-level perspective, our funds would actually benefit from this sort of an environment because we have got a very nimble and active approach to portfolio management. We don't try to invest in illiquid or lowly rated bonds that will get stuck at the worst possible time.
Too, we are able to shift our positioning on the duration side very quickly. For example, if we think about the US market at the moment, most of our exposures to US interest rates is in the belly of the curve, somewhere between the five-to-10-year part of the curve.
Should we go into an environment with serious slowdown in the market, we have to shift that at the front of a curve because if interest rates in the US are close to 4% or above, there is a lot of room for the Fed to cut and we have to benefit from that.
This active approach being positioned correctly across the curve would be what we'll be looking for to try to generate alpha, should we go through an environment that well see some sort of a demand driven slowdown in the UK, in the US economy or the global economy.
LDP: If we shift to credit part of the market, one of the interesting things is credit spreads are very tight, defaults are low. How are you playing that part of the market at the moment and where are you seeing the opportunities?
AEM: The credit market has had a fantastic few years. But when you look at where the spreads are today compared to history, whether you want to look at it at since 2004, 2005, 2006, or since the onset of the global financial crisis, spreads are at very, very tight levels if not at all-time tight levels.
Some could argue that this has happened for good reason especially in the investment grade world, which is the higher quality part of the credit market. Big companies have got bigger and as a result safer.
For example, if you think about Microsoft, it is 10 times, if not 100 times a safer company than it was 10 to 20 years ago. Should the Microsoft spreads today be tighter than back then? Probably. So, there is some good reasons for why corporate credit spreads are reaching all time tights.
At the same time, there are lots of risks in the market that we need to be aware of. There is a lot of room for caution as well, which is being reflected in our portfolios. Our funds are quite defensive, and we try to be nimble and try to make alpha for our clients as much as we can.
This is not an environment to be lulled by the sense of low volatility and all the positivity in the market. This is the time for us to be cautious.
LDP: Within credit markets, you are being very selective at the moment. What are the areas that you're leaning into and what are you actively avoiding?
AEM: The parts that we are actively avoiding is lower rated corporate credit and also supported ones because we don't think that we are being compensated for taking more credit risk even though the backdrop seems to be quite benign.
At the end of the day, we are in an environment where there is a lot of Al capex related issuance in the bond market. This started from the second half of last year and it’s only going to grow from here. This is either direct issuance from big tech companies in the US like Google and Amazon for example. or it is going to be capex related to the build out of the data centres that we are going to see in the US.
These are the trends that are going to continue for many years. It's not just the one situation and this poses both risk and reward. When we look at the market today, a lot of high-quality bonds that are coming to the market to finance these data centres could provide attractive investment opportunities for us, not all of them, but definitely some of them.
One thing to keep in mind is that because the scope of issuance is going to continue for many quarters or years, this is naturally going to put pressure on the rest of the market. While the rest of the market is very expensive, as we see more debt issuance by these tech names, the rest of the market has adjusted upwards in spreads to compensate for the new deluge of issuance that we are seeing. We are focusing on the new deals, high quality names, mostly in tech.
US banks are another sector that we think is quite safe to invest in. If we are in an environment where interest rates are going to stay a little bit higher for longer, I think that definitely provides some avenue for us for invest in because big US banks have safe balance sheets and you can get good attractive carry and by investing in those names.
LDP: One of the historical roles of bonds in a total portfolio has been to act as a diversifier to equities. We have seen correlations between equities and bonds move around a little bit and certainly, in periods where inflation has been rising, we've seen that correlation go up. How would you position the role of bonds with a diversified portfolio?
AEM: We still think that bonds are going to act as a diversifier in an overall portfolio. We understand investors negativity about this subject based on the experience that they had in 2022. But again, we have to emphasise the role that in 2022, the starting level for interest rates was so much lower that obviously, a lot of pain had to be in some ways imparted on the markets by the central banks to try to rein in inflation.
We are not looking at the same inflationary spike as we did in 2022. In fact, today, the starting level is so high in some ways that you can argue that in a risk reward still favours having bonds as a risk of hedge for the portfolios. We don't think it’s going to go away.
One of the comments that we regularly get is that if we are faced with some sort of a slowdown, governments are going to start spending big fiscal stimulus as a way to stabilise the market. In some ways, this comment is absolutely correct. Governments everywhere have learnt that. When you face a deep internal or external shock, you have to use your balance sheet or do some debt issuance to buffer the broader economy from those shocks.
We still think, given the starting level of the yields and given how much the central banks can cut if they are faced with a shock, bonds would still act as a diversifier, even though the bar for that kind of shock to come into effect is a little bit higher. The front end of the curve would probably be a better diversifier than at the longer level curve.
You can argue from a contrarian point of view, should we go into some sort of external shock environment, I wouldn't be surprised even if the back end of the curve does equally as well as the front end. Bonds are still a diversifier, especially in this environment where every investor in the world is so euphoric.
If everyone is in risky assets in equities, you definitely need some sort of a diversification within your overall portfolio.
LDP: What are some of the key messages you would leave for advisors with respect to global bonds within portfolios and the importance of active management in this environment.
AEM: I have three key takeaways to share. Firstly, the yields that we are seeing right now are actually quite high. The starting point is quite attractive. There is a lot of hikes already being priced in across the developed market and the risk reward is favourable.
Because of the high income and the high yields that we have, not only is that a source of income for our investors, but also buffers us from any sort of volatility that we might see in the market, in the rates market based on the data that comes in. So, it is a good upside downside, but also the income is going to act as a good buffer, should be proven wrong in the short term.
Secondly, it goes back to the higher for longer environment. This is not going to last forever. This calls for an active style of management. There's going to be a lot of volatility in the market over the next few quarters. The conflict is not resolved.
We don't know what Al means for the global economy. We don't know how the private credit sector is going to get resolved. There are lots of risks in the market and whilst everyone thinks that the central banks are going to only hike from here onwards, that mentality can quickly shift and our style of management is definitely suited for this sort of environment. We can be nimble and we can be tactical and we aim to benefit from this volatility that we are very likely to see over the next few quarters.
Finally, I think people really underestimate the role that bonds still provide in their overall portfolio. I think, should we go through a downturn, central banks can cut a lot and they're going to do so extremely quickly, much quicker than what people are probably used to. This diversification was still kicking at a time where equities were at all-time highs, valuations are stretched and everyone is extremely euphoric. The bond diversification is still there. It's just that people don't want to be.
