UBP House View - October 2024

The global economy is becoming more fragmented, creating a complex landscape for investors and policymakers. Geopolitical events, such as the US elections, the Ukraine-Russia war, and heightened tensions in the Middle East, are amplifying market uncertainties. In response, we have raised our conviction on gold from 3/5 to 4/5.

Key Takeaways

Editorial

Fragmentation of global economy set to persist

As the US and the UK demonstrate economic resilience, countries like Germany and China are revealing underlying vulnerabilities. We are witnessing an increasingly fragmented global economy, with some countries expected to struggle with a slowdown over the next twelve months, while others face persistent inflationary pressures. This has created a complex landscape for investors and policymakers, as illustrated by central banks’ desynchronisation.

On the one hand, central banks such as the Federal Reserve, the European Central Bank, the Bank of England, the Swiss National Bank, the Bank of Canada, and the People’s Bank of China have begun cutting interest rates. This pivot signals the end of their battle against inflation for reigniting growth. In stark contrast, the Bank of Japan is tightening its monetary policy to curb persistent inflationary pressures. In Norway, Norges Bank is holding its main rate steady, while the Reserve Bank of Australia is maintaining a restrictive stance.

In addition to its new easing measures, China issued a declaration of intent in September, signalling a complete shift in the direction of its political and economic rhetoric from communism to capitalism. However, we are sceptical about its capacity to effectively implement the required measures to revive the country’s flagging economy. A larger stimulus seems necessary to avoid deflation and fully address the challenges resulting from the real estate crisis.

With mounting uncertainty from geopolitical events – ranging from the US elections to the Ukraine-Russia conflict and escalating tensions in the Middle East –, we anticipate further market fluctuations. This environment is compatible with our risk exposure, as we transitioned eighteen months ago from a directional market to one now characterised by dispersion and volatility.

Strategy

Though the Fed delivering a 0.5% rate cut in September was a surprise, its guidance for rate cuts over 2025 that nearly matched the already dovish market expectations offered an additional surprise for markets. However, with that pair of surprises, the Fed has begun to answer a key question for bond investors, namely that of where Fed policy rates stabilise, i.e. where is the “neutral” interest rate in the first post-pandemic cycle?

According to the Federal Open Market Committee’s September Summary of Economic Projections, the Fed expects the US economy to avoid recession in 2025/26 and the Fed’s policy-setting rate to stabilise near 3% (from 5% currently) in 2026 and beyond. Historically, the relationship between bond yields – from 2-year Treasury yields out to 30-year Treasury yields – has been stable across the cycle; taking into account this “neutral” interest rate anchor makes this post-pandemic clarity invaluable for investors.

If the Fed proves correct, at 3%, 2-year Treasury yields are fairly valued at close to 3.5%, with the risk of a fall to 2.8% or below in a recession. With 2-year yields currently at 4%, short-dated US yields are now pricing in economic acceleration rather than the soft landing we expect in 2025, offering front-end US yield curve opportunities for investors.

In contrast, 5-year Treasury yields are pricing in the soft-landing environment expected in our scenario. An economy which not only skirts recession, but instead reaccelerates should the Fed’s 3% “neutral” rate prove overly optimistic, would see 5-year Treasury yields hit nearly 5%, up from 4% currently.

Benchmark US Treasury yields present an unattractive risk-reward profile for bond investors, with fair value for 10-year yields in 2025 nearly 50 bps higher at close to 4.5% (consistent with our 2024 forecast); admittedly, in a recession, 10-year yields could fall towards 3%. However, a stronger-than-expected 2025 US economy, which an expected 3% Q3 GDP growth and recent strong labour market figures hint at, could once again see yields challenging 5%, thus presenting a key risk for bond investors.

We suggest that the Fed’s proposed rate-cutting path in 2025 and its longer-term 3% “neutral” rate may be overly optimistic, instead of opting for a range of 3.5–4.0%. Investors could find that the low, moderate and long-dated yields of 2024 are closer to the floor for yields should the economy avoid recession in 2025, as UBP forecasts.

Long-duration investment grade bond investors have undoubtedly benefitted from the unanticipated fall in Treasury yields over the summer. However, year-to-date, by pairing short-duration high-yield bonds with low-risk short-term Treasuries, with this sort of “barbell” strategy, investors would have matched the investment grade returns year-to-date with lower exposure to volatile interest rate movements over the course of the year. We are leaning into this strategy, with the addition of senior loans, which will continue to benefit investors as we head into 2025.