In just a few weeks, the global macroeconomic and geopolitical landscape has shifted markedly, leaving fixed income investors scrambling for opportunities.
While investors were focusing on a potential AI-induced disinflation in the days before the Iran war started, the conflict upended the inflation outlook as oil prices surged. Within a span of few weeks, expectations of central bank rate cuts have dissipated as investors focus on the deep uncertainty in global energy markets stemming from the war. Traffic through the Strait of Hormuz, a key waterway for transporting oil and other refined products, has virtually come to a standstill since the US and Israel started their attacks on Feb. 28.
Bonds, particularly in the front-end, have borne the brunt of the oil shock and steeper curve positions have been squeezed out. Equities have held up quite well as they are long-term assets that have the ability to withstand inflation if the underlying assets are backed by growth. Volatility has been the order of the day.
Unpredictable geopolitical and policy environment
It’s still not clear whether the uneasy ceasefire between the warring parties will lead to any long-lasting peace deal, with Iran terming US demands over its nuclear programme as “maximalist”.
Even if the war ends, the heavy damage suffered by many energy facilities could keep oil prices elevated for a longer period. In addition, many ships and tankers that transport oil and other products from the Gulf are stranded and it might take a few weeks for the backlog to clear.
The war is the antithesis of Donald Trump’s “America first” policy. Much of his first year of presidency was consumed by the new tariff regime unveiled on “Liberation Day”, under which Trump imposed sweeping country specific as well as sector specific tariffs using emergency powers. After the Supreme Court struck down the tariffs, the U.S. has used other laws to keep base tariffs at higher levels, and uncertainty continues despite sealing trade deals with various countries.
The US policy and geopolitical interventions are producing swings in global growth and inflation and trying to predict the directionality of these important macroeconomic drivers, as many long-only investors do, could be a futile game. And concerns over the impact of AI on the broader economy will resurface.
We believe it’s important not to overreact to these developments and focus on the macro regime that has been consistent over the past 15 months.
Rotation out of US assets
As America’s unpredictable policies undermine its growth and asset performance, investors are diversifying away from US assets, with elevated valuations in risk markets, high debt levels and erosion of credibility also proving to be important considerations. US policies are also producing swings in global growth and inflation. It’s important to recognise this macro regime and the structural shift in investors’ approach, marked by lower frontend US real rates, a steeper US curve, a weaker dollar, and continued outperformance in global assets, instead of focusing on the volatility induced by frequent policy changes and pronouncements.
It’s important to diversify as much as possible within this regime and ensure hedges are effective with active trading when asymmetry presents itself, including the use of short positions within this portfolio set up.
The volatile scenario, compounded by the war, begs the question: how does one build a portfolio while keeping in view the spike in inflation and the possibility of a recession as a result of the war and the unpredictability of US policy?
The Global Macro Solutions team believes the opportunities lie in targeting value assets that will benefit from this ordering of global flows over the long term. Trading volatility and the narrowing of potential outcomes could potentially help in identifying cheaper assets for long-term investments.
Relative value
We believe targeting absolute alpha rather than following a benchmark, making full use of derivatives for flexibility and hedging, and a liquid portfolio for manoeuvrability are important to build a successful portfolio. Diversifying within the macro regime that’s being guided by long-term structural forces is also important, along with adapting for growth and inflation swings by controlling volatility with hedges.
In this context, focusing on relative value rather than directional beta positions primarily would be a better approach. For example, we like emerging market rates due to their superior balance sheets, as this removes the directional inflation and growth risk embedded in all rates markets.
More than 60 days have passed since the Iran war began even though many investors initially didn’t expect the conflict to drag on for so long. Overall, heightened geopolitical tensions, persistent inflation risks, and shifting policy dynamics demand a more flexible and nuanced approach to fixed income investing.
Rather than relying on traditional benchmarks or directional bets, prioritising diversification, relative value opportunities, and active risk management would stand investors in good stead. An emphasis on liquidity, the ability to quickly adapt to any environment, and the use of hedging strategies can help navigate ongoing volatility. Ultimately, success in this environment will depend on recognising the underlying structural factors and positioning portfolios accordingly to generate consistent alpha.
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