Finding balance amid shifting economic winds

As we enter the final quarter of 2024, the global fixed income landscape stands at a crucial juncture. In the past year, central banks across major economies have worked hard to combat inflationary pressures with a series of interest rate hikes. Despite the aggressive tightening in financial conditions, global growth has shown signs of slowing but not derailing. Investors are now looking for signals of where inflation, interest rates, and economic activity might head next. As inflationary pressures moderate and labour market conditions soften, the prospect of a "soft landing" becomes a central theme for the US Federal Reserve (Fed) and other central banks.

While a smooth deceleration of the economy is our base case, potential headwinds, including a US recession or a resurgence of inflation following the 2024 US presidential election, are key factors that could shift the trajectory.

Inflation and labour markets: Signs of a soft landing

Inflation, once a stubborn adversary for central banks in 2022 and 2023, has begun to show signs of retreating towards more sustainable levels. Headline Consumer Price Index (CPI) inflation in developed markets has moderated significantly from its highs, helped by softer consumer spending, lower energy prices, and a gradual rebalancing of supply and demand in sectors previously constrained during the pandemic.

From a valuation perspective, bond markets have already begun to reflect this improvement. Yields on longer-dated bonds have come down from their peaks as inflation expectations adjust downwards, though they remain elevated compared to pre-pandemic levels. Meanwhile, credit spreads have narrowed further, reflecting increased confidence in the ability of companies to manage their debt obligations as financial conditions improve.

The labour market, a key driver of inflationary pressures through wage growth, is also showing signs of normalisation. Unemployment remains low by historical standards, but job openings have declined from their peaks, and wage growth is cooling, particularly in service industries that had seen the strongest increases. In the US, non-farm payroll growth, a key measure of labour market activity, has softened in recent months, but remains stable around longer-term averages rather than turning negative, which historically has occurred during recessions.

Soft landing, not a recession

A soft landing remains our base case scenario for the US economy. Several factors indicate that this outcome is increasingly likely:

1. Inflation expectations: Previously stubborn inflation has now fallen below central bank target levels. Only rental prices, which are widely known to be a lagging indicator of inflation, are yet to fall completely, but are showing encouraging signs. Going forward, we expect inflation to remain subdued, which gives central banks more wiggle room to lower interest rates further should the economic picture worsen.

2. Monetary policy response: Central banks, led by the Fed, are now shifting from rate hikes to rate cuts. After reaching peak policy rates earlier in 2024, the Fed and several other major central banks have begun gradually lowering rates in response to moderating inflation and signs of economic slowdown. The pace of cuts is expected to be measured, with the Fed's September dot plot projecting a further rate reduction of 150 basis points over the next 12 months. The initial easing has provided immediate relief to bond markets, pushing yields lower and steepening the yield curve.

3. Labour market resilience: Despite softening wage growth, the labour market remains fundamentally strong. The US unemployment rate hovers near multi-decade lows, and jobless claims remain stable, allaying fears of an imminent recession. Job growth, while slower than in previous years, is consistent with a stabilising economy rather than one in sharp decline.

Bond market dynamics according to our FQT Framework (Fundamentals, Quantitative and Technicals)

At the corporate level, fundamentals remain relatively robust, particularly in sectors less exposed to cyclical downturns. Corporate earnings, while moderating in line with slower economic growth, continue to be supported by strong balance sheets, especially among investment-grade issuers. This has bolstered corporate bond valuations, with high-quality spreads tightening back to multi-year lows as earnings outlooks stabilise.

From a technical perspective, supply and demand dynamics in bond markets also support a positive outlook for fixed income in Q4 2024. Issuance, particularly in the corporate sector, has been heavy for most of 2024. This strong supply has been met with increasing demand from investors, particularly as real yields remain attractive relative to equities and other asset classes. Robust technical support in corporate credit markets, along with fundamentals, are some of the primary reasons spreads have stayed tight, and remain part of the reason why we expect them to remain contained going forward.

On the valuation front, bond yields, though lower than at the start of the year, continue to offer attractive risk-adjusted returns. Investment-grade corporate bonds are trading at historically attractive levels, with spreads tightening to pre-pandemic norms but still offering meaningful carry for investors seeking income. In high-yield markets, spreads have compressed somewhat, but careful sector selection remains crucial, as some companies may still face refinancing risks in the years ahead.

Finally, government bonds are also coming back into favour. Like credit, yields are attractive compared to long-term averages and correlations to equities have finally turned negative. This means that in a world where central banks are balancing on a tightrope between a soft and hard landing, government debt now offers a diversified source of returns should a recession unfold.

Risks on the horizon: Recession and reinflation

While the base case for Q4 2024 is a soft landing, investors must remain vigilant about potential risks that could upend the current outlook. Two key risks stand out: the possibility of a delayed recession and the threat of reinflation, particularly following the US presidential election.

Despite the optimistic signs, the risk of recession cannot be entirely ruled out. A deeper-than-expected slowdown in consumer spending or business investment could still push the economy into contraction, especially if inflation proves more persistent than anticipated. While bond yields are reflecting a soft landing, a sudden downturn in corporate earnings or consumer sentiment could widen credit spreads once again, putting pressure on both investment-grade and high-yield bonds.

Additionally, geopolitical risks such as renewed tensions in energy markets or trade disputes could cause global supply shocks, reversing some of the progress made in containing inflation. In such a scenario, central banks might need to pause or even reverse rate cuts, which could flatten or even invert the yield curve again, leading to higher volatility in fixed income markets.

Another significant risk is the potential for reinflation following the US election. The 2024 election cycle brings uncertainty regarding fiscal policy and potential government spending initiatives that could reignite inflationary pressures. A sweep for either party could bring further fiscal spending or, in the Republican’s case, further tariffs. This could lead to a second wave of inflation, forcing the Fed to react with renewed rate hikes, creating volatility in fixed income markets.

Portfolio implications: Favouring duration and credit carry

In light of this outlook, fixed income investors should remain tactically positioned to take advantage of the soft landing scenario while managing downside risks. Given the current macroeconomic environment, several key strategies are emerging for portfolio construction in Q4 2024.

With inflation moderating and central banks already in the early stages of easing, duration becomes increasingly attractive for bond investors. A steepening yield curve—where short-term interest rates fall while long-term rates remain stable or rise—presents opportunities for investors to position themselves favourably through curve strategies.

As inflation continues to moderate and central banks cut rates, this approach should benefit from an additional 30–50 basis points of curve steepening in the months ahead. They also offer an additional risk hedge should global economies tip into a recession, as in this scenario we could expect the curve to steepen to an even greater degree as central banks are forced to cut more aggressively.

In the credit markets, the soft landing scenario also suggests opportunities for investors to benefit from credit carry. With default risks expected to remain low in a stabilising economic environment, corporate bonds, particularly those in investment-grade and higher-quality segments of the high-yield market, are likely to provide attractive risk-adjusted returns. Credit spreads, which widened during the inflationary peak, have begun to stabilise, offering the potential for spread tightening as the economy finds its footing.

However, it will be crucial for investors to be selective. Sectors most exposed to rising rates and refinancing risks, such as highly leveraged companies or those in cyclical industries, may still face challenges. Conversely, sectors with strong balance sheets and more stable cash flows are better positioned to weather the current environment.

Conclusion

As we look towards the final quarter of 2024, the outlook for global fixed income markets is cautiously optimistic. Inflation and labour market trends point to a soft landing for the US economy, supporting a more stable environment for bond investors. While risks such as a potential recession or post-election reinflation remain, our base case suggests that investors should consider favouring duration through steepeners and positioning for attractive carry opportunities in credit markets.

By maintaining a balanced and flexible approach, investors can navigate the evolving landscape and capitalise on opportunities in global fixed income as the economy transitions into a new phase of stability.