It’s not often that one finds oneself on the cusp of a major macro regime change. Fixed income investors, we believe, are in the grip of such a shift now.
The fixed income environment may be undergoing a structural rebalancing, reversing some of the conditions that favoured corporate credit over sovereign bonds for much of the past two decades.
The post-global financial crisis period was characterised by globalisation, weak spending, low nominal growth and low inflation. Bond yields remained low, supported by quantitative easing, while underlying government fiscal vulnerabilities were effectively masked by this environment.
Nominal Growth is trending higher
The inflation shock witnessed in the post-Covid world exposed those vulnerabilities. The pandemic exposed supply chain weaknesses and laid bare the limits of globalisation. Higher interest rates combined with weak growth increased concerns about sovereign creditworthiness. This prompted investors to demand greater compensation for holding government debt.
Deglobalisation is the new paradigm
The macro environment has evolved since then. Trump’s “America first” policy and the disruption caused by his trade war could mean spending becomes more broadly distributed across economies. The increasingly uncertain geopolitical environment and transformative technological changes are forcing governments to boost expenditure to safeguard their sovereignty. If the post GFC world took globalisation for granted, “deglobalisation” is the watchword now.
At the same time, the combination of AI-driven productivity and full employment, we believe, would help mitigate concerns around ageing populations and shrinking labour supply. Governments could benefit from stronger nominal growth and healthier tax receipts, reducing concerns over fiscal sustainability. This would create a more favourable environment for sovereign bonds.
Nominal growth, we believe, is likely to remain relatively firm across the global economy, supported by structural changes in geopolitics. As countries seek greater strategic autonomy, increased spending on defence and efforts to secure supply chains should support economic activity, particularly outside the US.
At the same time, labour markets remain healthy and inflation continues to run above central bank targets, sustaining nominal growth. This combination of resilient real activity and persistent price pressures suggests that global growth should remain solid. That may prompt several central banks to raise interest rates further, although, we expect, the tightening cycle is expected to be relatively short.
Higher real rates a risk for corporates
Corporate bonds have benefited significantly in the period following GFC as interest rates and inflation stayed low and high public debt and deficit reduced the allure of sovereign bonds. Many corporates used the post-GFC environment to rapidly deleverage and improve their balance sheets, boosting their favourability among investors. The avoidance of recession too encouraged capital flows towards credit.
That relative advantage could now reverse. Strong nominal growth remains positive for companies, but higher real rates could potentially raise default risks. Corporate credit is also starting from expensive levels, while AI creates uncertainty over which business models will remain viable.
Credit Risk is Underpriced, Sovereign Risk is Overpriced
US high yield OAS vs 10-year Treasury term premium, 2019-2026
Corporates, particularly technology companies, are also beginning to leverage up again. The argument is therefore not that corporate credit faces a severe downturn, but that it needs to adjust to an environment in which it is no longer the destination for such a large share of capital.
There is also a potential shift in relative leverage. Governments could increasingly look better as nominal growth improves, while some companies, particularly large technology businesses undertaking substantial investment, are increasing leverage and bringing additional bond supply to the market.
Relative value
The structural change is therefore one of relative value and risk. Sovereign bonds are already offering higher yields, while sovereign credit risk could decline as nominal growth strengthens. Corporate bonds, meanwhile, face higher rates, default risk and uncertainty over technological disruption. After a prolonged period in which investors favoured corporate credit, capital could increasingly return to government bonds as investors once again place greater value on sovereign yields and duration.
Sovereign issuers also offer a fundamental certainty that individual companies could be found lacking. Several years from now, governments will still exist, whereas it is less clear which individual companies will survive technological disruption.
Overall, our structural view on the fixed income markets may be radically different from the consensus. But we seek validation from price action of other assets to reinforce our conviction. The pullback in gold prices, Bitcoin and uneventful long term inflation forwards are important pointers that, we believe, back our view on broad-based global growth and argue against the so-called debasement trade. The rise in front-end real yields too is an expression of confidence in a pickup in nominal growth. Higher real yields are also hurting the Swiss franc, not helping it as in recent history, as sovereign risks improve. With equities and credit markets already fully priced or overpriced, we believe the emerging scenario could offer opportunities to diversify into sovereign bonds.
The value of active minds: independent thinking
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