Rules are meant to be broken

So much of what we are seeing today is fundamentally different from past cycles. Rules are being tested this cycle. Rules for recession indicators have had a particularly hard time. We recently marked the two-year anniversary of the inversion of the US 2yr - 10yr yield curve. While at some point the US will go into recession, the rule that an inversion is the harbinger of recession has been violated. US manufacturing has had a long track record and over many cycles it has correlated well with activity, but it has been negative for 19 of the last 20 months without a recession. These false positives only reinforce how different this cycle is to those of the past.

A key development over the month has been the step down in growth for the US economy that has prompted talk of recession risks yet again. The so-called “Sahm rule” warns that when the unemployment rate has risen 0.5pp from its trough, we can expect recession. The labour market is a key pillar of the US economy, so we should pay attention. After all, the Sahm rule has accurately predicted all American recessions in the modern era. Is the current cycle set to break the rules once more? Our base case is that much like the other recession signals, the rise in unemployment rate is another false positive. In the 1990s, arguably the other soft landing for the US economy, similar red flags were raised. The yield curve flattened almost completely, money growth ground to a halt, and manufacturing was contracting. Of course, a recession eventually followed, but in the 1990s, it didn’t come for half a decade. History doesn’t repeat itself, but it does often rhyme. The US Federal Reserve might just get what they set out to achieve – an immaculate soft landing with inflation moderating to target and an easing cycle commencing in September that continues to support growth. But we can’t ignore the more substantial weakening in the US economy over the last month, it really does call into question the supposed strength of the US economy.

Over the next few months, it’s the business cycle that is likely to matter more to markets than the election cycle. 

We are positioned for a steeper yield curve driven by lower yields in shorter-maturity bonds and is underpinned by our view that near-term inflation would ease enough to open a clear path toward US Fed rate cuts this year. Such a market move could be boosted by, but does not require, market expectations of a Republican win leading to higher tariffs and related growth pressures. And following the election, history tells us the policies set in motion will matter a lot across markets. We remain alert for impacts across bond markets and corporate sectors that vary based on the outcome.

In Australia, with core inflation missing expectations in July and showing some slight deceleration, the RBA now has a reason to hold rates steady and are unlikely to be hike rates in August. Some lift in growth and inflation forecasts are likely to keep the RBA on an extended hold at 4.35%. While other central banks cut interest rates, inflation reduction in Australia has made minimal progress in a period of cyclical weakness and government stimulus is going to ramp up over the next year with significant uncertainty around how much flows through to the broader economy. The labour market also remains relatively tight, with much stronger jobs growth than had been expected. The market is now priced for the RBA to begin the easing cycle in Q1 2025.

Positioning

With yields falling and credit spreads narrowing in the month of July, we saw very strong performance from both government and corporate bonds. Markets have started to extrapolate the potential for further policy easing by central banks as we move into H2 2024. This has also supported credit markets as rate cuts will support growth. The conditions are now set for more broad based bond market outperformance.

Our interest rate positioning has been a relative story as we approach the turn of the cycle. We have favoured holding interest rate risk in those economies where growth is weaker and central banks are cutting interest rates, like Europe. With improved valuations and our policy models flagging the increased risk that the US Fed needs to pull forward the easing cycle, we extended US interest rate risk at the end of June. This position drove strong outperformance alongside our US curve positioning. Australian has been the market we have been more cautious with inflation stickier and the RBA holding policy higher for longer. In Japan we have been short interest rate risk on the expectation that the Bank of Japan (BOJ) will lift interest rates this year. This position added to performance with the BOJ surprising the market with a 15 basis point hike to 0.25%, alongside plans to reduce government bond purchases in its local market.

We continue to see good value in inflation-linked bonds both in the US and Australia. Market based inflationary expectations have moved substantially lower as inflation globally has moderated from very high levels. Owning inflation-linked bonds offer a real yield, in addition to the passthrough of future inflation. These positions also help protect against upside inflation risk which is now underpriced in markets.

Asset allocation has been a key driver of returns over the last year. Our valuation and cyclical framework had us preferring credit over government bonds where we have seen very strong performance from Australian credit and mortgages both in the US and Australia. Over the last month swap spreads in Australia contracted and drove strong performance across both Australian investment grade credit and subordinated debt.

More recently we have taken some risk off the table where our portfolio is looking more balanced between credit risk and interest rate risk. As the cycle progresses we are likely to be leaning against valuations and the strong performance we have seen from credit markets and rotating into government bonds that have lagged. We have already started this transition, reducing exposure to expensive sectors such as US investment grade credit and high yield into US government bonds.

Learn more about the Schroder Fixed Income Fund below, or visit our website for further information. 

Managed Fund

Schroder Fixed Income Fund - Wholesale Class

Australian Fixed Income

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