Preparing your portfolio for the biggest event risk this year

US bond yields have been backing up sharply in recent weeks from the September lows. Positive surprises on US economic data, alongside swings in the implied US election outcomes have contributed to bond market volatility. Strong payrolls and retail sales data played a key role over the first two weeks of the month. Recent moves were likely driven more by the prediction markets on the US election, with many investors viewing the ‘Republican sweep’ outcome as the most bearish outcome for US Treasuries. Neither candidate (Trump nor Harris) has any plans to address the growing fiscal deficit, putting upward pressure on bond yields. The winner will most likely add to the future level of federal debt. Troublingly government indebtedness, even before any new policies are introduced, is already projected to rise significantly in the future.

The two main economic policies at play in the election are fiscal and tariffs and their impacts on US macro fundamentals and rates. 

This leads to two key conclusions: (1) given offsetting effects, the size and sequencing of more expansionary fiscal policy and increases in tariffs will be crucial, and (2) wider breakeven inflation is the rates trade that unambiguously benefits under either policy change.

The sequencing of potential policy changes after the election is critical, in our view. Given broad presidential discretion on trade policy, Trump’s expressed intentions and the precedent of his first term, we think tariff changes would likely come first. Broad tariffs imply downside risks to growth through declines in consumption, investment spending, payrolls, and labour income, and upside risks to inflation, i.e. a more stagflationary environment. The meaningful differences between the Fed’s monetary policy today and the pre-election period in 2016, suggests that any rise in Treasury yields would be more contained this time. In contrast to the current market expectation of about 125bp in rate cuts over the next 12 months, markets were pricing about 30bp in hikes back then. Furthermore, in the year after the 2016 election, expectations for the federal funds target rate rose by nearly 125bp. A similar rise in expectations for Fed policy would require market participants to expect the Fed to stop cutting rates immediately and refrain from further cuts through 2025, seemingly a remote possibility even under a "Republican sweep" election scenario.

Given the recent moves across markets and the expectations they are pricing in, markets may now be somewhat offside should Harris win, as they would have to reverse course. 

Elections are a known unknown. Based on opinion polls, this race remains extremely tight, and multiple combinations of presidential and congressional outcomes are very much in play. We must also contend with the prospect that determining the outcome may take time.

Outside of the US election, we are viewing the current U.S. episode as more of a mid-cycle adjustment than a recession. Central banks in numerous countries continue to cut policy rates (e.g., the Bank of Canada’s 50bp cut last week) and there’s likely a sequence of rate cuts still coming in the US and abroad – that should provide additional support. We continue to believe that the path to a US soft landing – key for global growth – remains getting previously impaired sectors of the economy (manufacturing and housing) to turn up, before labour market cracks cause spending on services to slacken too much. A question remains about how low is the fed funds rate going to go (where is the neutral policy rate?). We believe a ~1% real (inflation-adjusted) policy rate should still be a good longer-term target. A nominal number in the 3-3.5% range could be in the neighbourhood of neutral. We continue to expect policy rates to be there by the middle of 2025.

In Australia, we have seen very little progress on inflation moderating which leaves the RBA on the sidelines. 

The official quarterly CPI showed services and trimmed-mean inflation rates (the RBA’s preferred inflation measure) have not slowed as much as headline inflation. We still see the RBA lagging global central banks and not delivering the first rate cut until Q1 25. But this still requires a relatively low CPI print in Q4 24. There is also the need for some easing in the labour market, as recent months have implied further tightening of the labour market. Despite faster and more direct policy channel via variable rate mortgages, very strong fiscal activity is supporting growth, and businesses are borrowing and investing, not activities seen before large scale layoffs. This may set up Australia to undertake later and shallower cuts than peers, underpinning sustained yield support for Aussie assets over the near and medium term.

Positioning

Against the backdrop of a soft landing scenario and the strong momentum of the US economy, credit spreads have continued to perform with most markets moving close to valuation tights. An environment of improving earnings and margins with very little sign of credit stress (peak in default rates) supports credit valuations.

But with looming volatility around the US election we had added in some hedges to protect performance. Firstly, we moved shorter duration in the back end of the US curve given the upside risk to yields from the US fiscal dynamics and the growing possibility of a ‘no landing’ in the US as growth continues to remain resilient. Secondly, we added some protection through Credit Default Swaps to reduce our European credit exposure, an area that may be susceptible to underperformance if Trump tariffs are enacted, putting further downward pressure on the European economy. Thirdly, after very strong performance, we have reduced our emerging market (EM) debt exposure. EM central banks have been toeing a cautious line, well aware of the potential volatility in global markets after the US election and have been reluctant to pre-commit to a path of policy rate cuts in the period ahead. 

Upside risk to US bond yields and a rise in the USD is also a risk for this asset class.

Across our interest rate exposures we are maintaining a bias to Europe where deteriorating economic data in the region has raised concerns that the ECB might need to step up its rate cut pace to secure a soft landing. European rates markets would also be a relative winner in a Trump victory. Australian rates markets are offering more attractive valuations but the lack of progress on inflation and labour market resilience has kept us from adding here as Aussie rates stay higher for longer. Australian credit is better positioned to outperform, with yields elevated, swap spreads tightening and the issuance pipeline drying up. This sets up a very strong environment for Australian credit to play catch up to the strong global market performance observed this year. We continue to prefer Australian and European corporate credit priced at more favourable valuations vs US investment grade and high yield markets. Australian and US mortgages also remain attractive in a higher for longer environment, offering attractive high quality yield, with little signs of credit stress in the economies.

We have recently added exposure to US inflation-linked bonds, which offer some protection for a more permanent move to a ‘no landing’ environment, one which could see inflation remaining stuck above central bank targets as growth stays elevated. Market-based inflationary expectations had moved substantially lower as inflation globally has moderated from very high levels and we believe are now looking cheap. Asset allocation will continue to be a key driver of returns where we are seeing a lot of dispersion across both rates and credit in markets. This has allowed us to be more dynamic rotating between sectors to take advantage of changing valuations as market volatility has increased into the election.

Managed Fund

Schroder Fixed Income Fund - Wholesale Class

Australian Fixed Income

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