Geopolitical deadlock spikes inflation fears sending bonds into freefall. But strong earnings and AI gains keep stocks soaring, and HY is cleaning up.
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Welcome to the latest edition of The Weekly Fix. My name is Andrzej Skiba.
Markets are getting tired of the stand-off in the Middle East. As we mentioned before, US is clearly looking for a way out of this conflict, but it takes two to tango. Each party has so far rebuffed multiple peace offers and the blockade of the Strait of Hormuz remains in place. While US is relatively shielded from the growth perspective, it’s not completely immune. Gas prices at the pump are spiking and cost of living issues dominate the domestic agenda. Every passing week of disruptions brings European and select Asian markets closer to a recession.
In the recent week, we’ve seen an aggressive sell-off in government bond markets across the globe, including Treasuries. Inflation fears are rising, and the narrative is shifting from “if” to “when” central banks need to hike rates. While we believe it’s inevitable for the ECB, we’re not 100% sure that the Fed has to follow suit. At the last meeting, Chair Powell indicated the Fed still has an easing bias and we believe it’s unlikely Chair Warsh would strongly disagree. For the time being, we expect the Fed to be on hold and watch incoming inflation data.
While investors are becoming jittery, we don’t see at this stage a return of the ugly price action like we’ve experienced back in 2022. There are a couple of reasons for that. Firstly, US economy is doing well, helped by gargantuan AI spend. Corporate earnings have been very solid, as evidenced by the latest quarterly earnings season that is on pace for being the strongest in the post-COVID era. Secondly, yields are already elevated, which helps to provide a cushion to investor returns through carry income. Finally, it’s tough to speak of an inflation shock when we’re already pricing in a rate hike over the next 12 months.
These diverging narratives understandably led to asset classes performing differently. Stocks have rebounded strongly, fueled by AI complex gains. Treasuries sold off, well past key support levels as inflation fears and diminishing hopes of a quick resolution in the Middle East bite. Credit spreads have been rallying as yield-sensitive buyers add to their exposures in corporate fixed income. Securitized is also trading well as shorter duration assets are in demand and incoming data is not pointing to any material worsening in the space.
In total return terms, this has meant that across the fixed income universe, HY has been a clear winner year-to-date. This, of course, could easily change if the conflict gets resolved, inflation fears abate and a recovery in government bond markets spurs investment grade gains.
In the meantime, we maintain a modest overweight bias. This is driven by what we see as historically attractive yields of fixed income assets and a strong, possibly double-digit forward 12-month total return potential, were this crisis to abate. We continue to favor US assets and stay away from deep cyclicals and over-leveraged issuers. Thank you for your attention.
Key takeaways
Geopolitical fatigue is reshaping markets: Middle East tensions are wearing thin, driving bond selloffs and inflation fears despite US economic resilience.
The Fed-ECB split is real: Europe's rate hike is likely inevitable; the Fed is more cautious and likely to hold, creating divergent monetary policy paths.
High yield is the clear winner year-to-date: Strong corporate earnings, elevated yields, and AI-driven stock gains have made HY the outperformer among asset classes, though this could reverse if geopolitical tensions ease.
