Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Macro: Sandcastle economics
Peter Garnry
Chief Investment Strategist
Summary: As we enter Q3 2024, economic growth remains robust, sectors such as defence, AI and obesity drug manufacturing are booming, and asset prices are at an all-time high. But could factors such as unsustainable fiscal spending in the US, geopolitical shocks or gloomy demographic trends destroy our fragile sandcastle economy? In this Q3 Outlook, you can get our take on why European equities and short-duration quality bonds look interesting. You can also read why energy commodities may come in focus and where to look within forex.
We have built a pretty sandcastle
The combination of excessive US fiscal policy since the pandemic and strong investments in artificial intelligence, defence, semiconductors, and obesity drug manufacturing has created surprisingly resilient economic growth. US economic growth remains robust and around trend growth with historically loose financial conditions, reflected in low credit spreads, despite an aggressive increase in monetary policy rates. Labour markets in Europe and the US are cooling but still as tight as they were before the pandemic. Asset prices are also at an all-time high, providing a sense of wealth and comfort.
In Europe, the economy is finally entering a growth phase after healing from the energy and inflation shock stemming from the war in Ukraine. China is adding multiple support measures to bolster economic growth and address the challenges in its property sector. Inflation in the US and Europe has turned out to persist at a higher level than initially thought. But it is easing to levels that are causing people to recoup some of their lost real income during the inflation spike creating an income-driven economic growth. In other words, it is a goldilocks scenario as we enter the third quarter.
The policy paradox of the two-lane economy
The economy has been full of surprises since early 2020, with the lack of recession last year being the biggest surprise to consensus. This year, the big surprise has been the persistent inflation not coming down as fast as expected, underpinning the notion that central banks do not fully understand the current inflation dynamics. Being wrong again on the path of inflation has likely made the Fed more cautious and thus we expect no rate cut until later this year, unless the global economy materially slows down.
Indicators are suggesting parts of the economy, such as real estate and car manufacturing, are struggling with high interest rates, but in other sectors of the economy, such as defence, semiconductors, AI, and obesity drug manufacturing, things are booming. Capital expenditures in those parts of the economy are growing faster than in the decade leading up to the pandemic. It is this “two-lane economy” that is complicating monetary policy, because helping the weak part of the economy can come with prolonged inflation which is more costly.
All sandcastles are vulnerable to even small waves
Sandcastles are fun to build, but they are inherently fragile and the same goes for the global economy. Economic growth will remain stable, but down the road several factors can destroy our sandcastle economy.Fiscal spending in the US is not sustainable in the long run and the current government bond yields are increasing government expenditures related to its debt, carving out resources for welfare and infrastructure. The US government must address the risk of cooling the economy or risking letting inflation run high for longer.
The war in Ukraine has shown that geopolitics can shock the economy unexpectedly and this source of risk will continue for years. Other trends such as friend-shoring of manufacturing and an evolving war economy not just in Europe will also put upward pressure on inflation. Exploding health care budgets, due to e.g. increased focus on obesity drugs, an increase in unpredictable weather patterns, and gloomy demographic trends as the globe becomes older also suggest that we should enjoy our sandcastle economy while it lasts.
Investment allocation
Our macro assessment above suggests a positive outlook in the short-term, ahead of the crucial fourth quarter featuring the US election. In addition, periods with a calm financial turbulence environment and inflation running above the inflation target of 2% have historically been positive for asset class returns and especially equities, commodities, and corporate bonds.
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