Active Fixed Income outlook: Time to challenge consensus?

This article is an extract from our Q1 2025 Active Fixed Income outlook.

For more than a year, there has been continuous debate among fixed income investors on the relative importance of spreads or yields to the health of our asset class. We think this debate has been answered by the continued inflows into fixed income (at the time of writing, for the past 59 weeks into US investment grade). In our view, these flows have been driven by the yields on offer, which has in turn lead to spreads compressing to multi-decade tights.

In response, we maintained a long credit position across our benchmark and unconstrained portfolios for much of 2024, based on our belief that yields would remain attractive to investors. Fundamentals have also been supportive, both from a top-down position with strong US growth, and bottom-up with improving credit quality. However, it was the technical picture that dominated. We have taken advantage of the compression in credit spreads due to improving credit quality, particularly in European real estate and financials.

As usual, our duration positioning has been very active. We generally held a longer duration bias for most of last year. The disinflation momentum that started in 2023 has been strong, and the beneficial negative correlation between rates and spreads that investors enjoyed for much of the 21st century has re-asserted itself after the shock of 2022/23. Therefore, we think there is again insurance value in duration for fixed income investors. We have also taken advantage of strong consensus beliefs in inflation, against which we successfully took opposing positions (e.g. in Japan’s August ‘flash crash’) as we believe that accurately forecasting inflation is very difficult.

Whither Trump? 

Outlooks for 2025 place a lot of emphasis on the new Trump administration and the sharp reductions in European growth that could result from a combination of Trump’s tariff policies, economic challenges in Germany and political dysfunction in France. Strong views on the actual trajectory of US fiscal and trade policies are hostages to fortune and confidence is difficult to justify, but the market seems both happy that the new government’s package will be supportive for growth and unconcerned about the impacts of tariffs on domestic growth.

We think the risk to the consensus view is to the downside, as the touted tariff package is several times larger than that of Trump’s last term of office. We think this supports our constructive view on US duration and our underweight position in US credit, where spreads at similar tights have not been seen since 1998[1].

Turning to Europe, we see an abundance of caution. Hence we are positioned against the consensus, with a preference to be short on German duration and continue to have a preference for EUR over USD credit.

However, the ‘Santa squeeze’ in December benefited European credit more than USD credit, so we have trimmed that relative position.

Is inflation really behind us?

Our main debate for 2025 revolves around what could cause the strength of investor technicals to reverse.

A rebound in core inflation strong enough to drive the US Federal Reserve to pivot towards a hiking cycle would likely cause that reversal of the technical dominance, as investors would fear negative total returns from credit. Over the last 12 months, any backup in spreads has been bought by investors as the rate-cutting trajectory has given confidence that the yield on fixed income is attractive and accessible. We think it will take multiple months of upside inflation data, or the actual implementation of aggressive Trump policy, to reverse that trend.

We are therefore comfortable maintaining a long credit bias to access that yield from fixed income, despite the paucity of spreads on offer

Read our full Q1 2025 Active Fixed Income outlook.

 
[1] Source: Bloomberg as at 13 December 2024.