Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
Macro Outlook: The US rate cut cycle has begun
Peter Garnry
Chief Investment Strategist
Key points
- A small sign of fragility but no panic: A brief period of volatility in July and August due to the Japanese yen carry trade unwind and weak US macro data signaled fragility, but markets remain calm with a positive outlook for risky assets, as indicated by a low reading in our turbulence index.
- Recession or no recession in 2025: The likelihood of a recession in 2025 is estimated at 25%, with the lagging impact of the higher interest rate period still uncertain. Despite some softening in the numbers, key indicators like growth, capital expenditures, and job postings suggest the economy is not in a recession yet.
- The rate cut cycle and US election will dominate macro in Q4: The fourth quarter will focus on the incoming data and how that shapes the Fed's rate cuts and the US election. Historical rate cut cycles have often been positive for equities, though the 2024 election outcome - whether a Harris gridlock or Trump sweep - will significantly influence the economy and specific sectors like defence and tech.
- Investment allocation: With a calm market environment and inflation still above the Fed's target, the expected returns for commodities have decreased, making it essential for investors to assess their portfolios based on historical data and current economic conditions.
Small signs of fragility but no panic
The setback in equities and in particular technology stocks in July and early August as the Japanese yen carry trade came to an end due to the Bank of Japan’s pivot on monetary policy was a small sign of market fragility. Combined with some weak US macro figures on the labour market and inflation, the market began shifting its stance on the Fed policy trajectory, pricing in an aggressive rate cut cycle through the summer of 2025. Volatility spiked for a while before calming down again to normal levels. Maybe it was a sign of what is to come if a bigger rotation is set in motion.Despite the small hiccup in financial markets in the third quarter, our turbulence index, which measures the degree of dislocation between key asset classes, remains low. This degree of market calm, if sustained, suggests a positive outlook for risky assets.
Recession or no recession in 2025?
In the fourth quarter, financial markets will focus on key events such as the Fed’s rate cut cycle and the US election. While both events are important, the real question for equities in the medium-term remains whether the economy is slipping into a recession in 2025. Based on the factors listed below, the probability of a recession starting over the next year is still low, but not insignificant, and we set the probability at 25%. However, the lagged impact from higher interest rates is still the big unknown variable in the recession equation and thus the 25% probability reflects a likelihood above normal.
- US real-time indicators suggest trend growth around 2% real GDP growth
- Financial conditions remain loose relative to economic activity
- The capital expenditure boom in technology and health care continues
- Equities at an all-time high and minimal funding stress in high yield bonds
- High-frequency US job posting indicators have stabilised since May
- US nominal GDP was 5.9% YoY in the latest reading
- European real-time indicators suggest remains weak
- Wage growth remains elevated in both the US and Europe
Rate cut cycle and US election will dominate macro in Q4
The fourth quarter will be dominated by debates over the pace of the US rate cut cycle and the upcoming US election on November 5. The two rate cut cycles in 2000 and 2007 have anchored investor belief that this rate cycle will also be the beginning of a recession. It is important to consult more than just recent history for guidance. Yes, the current pricing of the Fed funds rate over the next 12 months is more or less consistent with previous rate cut cycles in a response to a recession, but if we adjust for the inflation rate, the current pricing is closer to that of merely shifting the level lower to reflect lower inflation pressures. Second, past rate cut cycles have mostly been positive for equities with only the 1973, 2000, and 2007 rate cut cycles being the exceptions. While rate cuts are important signals to investors, our view is that investors should remain positive and instead rethink whether their portfolios have the right ingredients as the Fed lowers its policy rate.This year’s US election is probably the most important election in modern times. With US political bifurcation at its peak, the election outcome will have impact both on the economy and financial markets. Of the more likely scenarios, a Harris gridlock win (Harris as president, but lacking control of the Senate) is probably the worst for economic activity as the fiscal impulse will likely shift to being negative as a gridlocked US Congress will make it difficult to pass anything except for executive orders over the coming years. Another scenario is a Trump sweep victory with Republicans winning both houses of Congress. This scenario will have a high positive impact on Europe’s defence industry and likely a negative impact on technology and emerging markets from Trump’s ideas on high tariffs.
A Trump gridlock scenario is also possible, in which he wins the presidency and the Republicans take the Senate, but fail to take the House. In this scenario, you get both the gridlock and fiscal impulse decline, but also new high tariffs.
Investment allocation
Every investor’s investment allocation is unique because of individual risk preferences and return objectives. To eliminate human biases it is always good to get the high level picture on asset allocation based on statistics. The current regime is like in Q3 which is a calm turbulence index and inflation still running above the Fed’s target of 2%. Based on periods of similar regime since 2007 we can calculate annualized returns across key asset classes, which can guide investors on how the various asset classes have done in the past in a similar regime. Latest Market Insights
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