Some – but not all – market prices seem to suggest that little has happened so far this year and that April’s market activity might have just been a brief glitch in the matrix. We disagree with this assessment – for now. Even as more recent news flow on the trade policy front surprised to the positive, the saga continues, and more likely than not, capital market dynamics will not just revert to their old narrative.
More broadly, however, the Trump administration’s goal to rebalance the US economy still has a lot of potential for further disruptions, which should be reflected in portfolio positioning. The underlying cyclical economic outlook has clearly deteriorated, as uncertainty is still set to prevail in the decision-making of corporates, as well as consumers. The positive tone on the US/China trade discussion is not going to remove all these worries. We still need to see the weaker ‘soft’ data translate into actual ‘hard’ data readings. More important for us, in our view, capital market dynamics will not just revert to the old narrative so easily, even if the current cross-sectional price data would partly signal that. Underneath it all, more likely than not, some relationships and patterns have changed, and asset prices will remain more sensitive to headline risks from here on.
Duration: Not getting too excited just yet
Looking more closely at the turbulent month of April reveals some interesting information. Ultimately, the weaker growth outlook, as is reflected in the International Monetary Fund (IMF) revisions shown in the chart below, should call for lower yields, but we have not seen that. In fact, the curve has even steepened, and it is quite telling to look at the very long end, such as the 30-year US Treasury yield, which has edged up even higher again, flirting with the multi-year highs printed back in October 2023.
This perfectly reflects the element that has probably not been undone yet and that will also unlikely disappear too easily, in our view, namely the build-up of a term premium in longer-end yields. It basically means that the equilibrium longer-term yield for US government debt is likely higher now, and this might prevail for some time, at least as long as we do not go back too quickly into periods of quantitative easing, i.e. central banks buying up big amounts of government debt. (We seem far away from that, but these days, we would not dare to rule out too much). So what can be done about it? The belly of the curve (i.e. maturities of 3–7 years) probably still has the best offering, balancing reinvestment risks and duration risks. With regard to the former, Fed Chair Powell clearly said at his latest press conference that they are in a wait-and-see mode; yet there is still room for policy rate cuts later this year, which should lead to more global monetary easing, which has slowed a bit as of late.
Focus is shifting towards corporate credit markets
To start with, the corporate bond segments have already recovered a meaningful part of their March and early-April losses. Moreover, and more importantly, primary markets have functioned mostly well, i.e. corporates have been able to access the market. This is the key signal obtained in April. As such, a healthy corporate exposure is still warranted. Having said this, spreads have tightened materially, and we would use the recent spread tightening to cut the highest-beta credit exposure that is left in portfolios. As already outlined several times in the past, the US high-yield market contains structurally better credit quality than in the past, and the highest-quality bucket within the segment (BB rated companies) should still be able to withstand a further cooling of the economy – especially at current yield levels – as it offers a meaningful buffer. The higher the starting yield, the more needs to happen before negative total returns are generated. In other words, more generally, it is difficult to end up with a 2022 shock scenario for bond investments.
What does this mean for investors?
Market prices suggest a return to normal, but policy uncertainty remains. While now is not the time for big strategy changes, reducing exposure to the highest credit risks is wise. Emerging market debt shows resilience, and high-yield markets offer value predominantly in the high-quality spectrum.
A weaker cyclical outlook calls for lower USD yields, while the rebuilt term premium will not just disappear and is likely to persist in the medium term. Consequently, the yield curve is steeper again, and finding the optimal duration exposure is tricky, with balanced exposure still the best way to go. Emerging market (EM) debt has shown remarkable resilience and is not challenged by the usual ‘double whammy’ combination of slowing global demand and USD strength. The EM corporate segment remains our focal point, with a preference towards the higher-rated credits. Lastly, some diversification benefits can be found in more niche markets, such as the CHF bond market, if the currency offers some temporary setbacks.