What is your macro base case scenario for Europe over the coming months? Will we see a soft or hard landing?
The spectre of stagflation, particularly in Europe, has become more of a risk to financial markets. The European Central Bank (ECB) is in a difficult position with a weakening economic environment, but still high inflation. The room to manoeuvre is limited. The ECB has raised interest rates for what is probably the final time. Given the lag effect, this is unlikely to have a big impact on inflation as inflation is a problem for today. We expect the ECB to keep rates at these levels for longer, with the view that eventually tighter financial conditions and a weaker economy will begin to bring inflation down.
The likelihood of a mild recession in Europe has certainly increased. Our base case is a mild recession, with inflation falling. We do not foresee a hard recession at present, but if the ECB over-tightens to try to deal with inflation, then the risk of a hard landing would certainly increase.
What are the most likely implications for fixed income markets?
We believe that we are close to peak rates and in an environment of generally weaker economic activity, we expect better-quality fixed income to outperform. Shorter-dated fixed income has been the “go-to” place for investors, but we believe returns are capped here. Once rates have peaked, we would think that longer-duration bonds will outperform, and when rates start to be cut, then we would anticipate high yield doing well.
How does your investment approach adapt to tackle market uncertainty?
We have a blended top-down and bottom-up global approach to investing with a hedging overlay. This allows us to determine the overall global economic and financial backdrop so that we can effectively allocate to the parts of the fixed income universe where we see the most return potential. The hedging overlay allows us to mitigate downside risk, which we believe is crucial in uncertain and volatile market environments.
How are you currently positioned?
We have hedged some of our duration risk given the risk of further long-duration weakness in the short term. Central banks remain hawkish, and we have yet to see a crack in the risk markets that would precipitate a rally in longer-duration higher quality bonds. We also have an allocation to good-quality high yield, given the attractive yields that are on offer. We are anticipating a mild or shallow recession so feel that a higher-quality fund with some duration risk makes sense at present.