Markets enjoyed a great summer - equities are at all-time highs while investment grade and high yield credit spreads have reversed their earlier widening and are now at historically tight levels.
From a macroeconomic perspective, to date, tariff discussions have not led to an out-of-control escalation and markets appear sanguine with the agreements made; they are not expecting an impact on companies’ margins or consumers’ spending power.
Overall, markets also don’t seem particularly phased by ongoing global geopolitics or the US’s larger-than-expected budget deficit while big tech companies appear stronger than ever – bolstered by the artificial intelligence boom.
We, however, believe markets might be being a bit too complacent given there are three notable risks, which are currently not being taken enough into consideration.
The inflation versus growth dilemma
A lot of uncertainty has been removed now that tariff levels are largely known. This has helped risk assets enjoy a great summer. Yet, the question of how these new tariffs will feed into the global economy remains unanswered.
One could argue it should create a supply and demand shock, hence translating into slower growth. Higher tariffs could feed directly into higher prices and higher inflation in the US. Surprisingly, none of the above has been observed over the past few months.
The US Citi Inflation Surprise index has consistently declined over recent months, almost back to June 2015 lows and US growth continues to be particularly resilient despite weaker August and September payrolls. This may be because post-Liberation Day, tariff exemptions were quickly implemented to allow for negotiations, and companies had time to anticipate orders ahead of levy announcements.
However, going forward companies will operate in a higher-tariff environment, so we expect them to have a greater impact on future economic data releases.
This might be the start of further uncertainty: shadowing a risk of stagflation in the US and putting the Federal Reserve (Fed) between a rock and a hard place. Current Fed forecasts suggest two rate cuts by the end of the year, while the market already prices in three. Without a significant deterioration in growth, it is hard to see room for more cuts.
In Europe, while inflation is not a focus, growth will be closely watched. US tariffs might naturally affect companies’ margins and weigh on growth prospects. In the meantime, the European Central Bank (ECB) seems comfortable to remain on hold for the moment but is in a far better position than the Fed on the inflation side to react if the environment were to worsen.
The fiscal mix and supply dynamic
The UK is being reminded how sensitive bond markets can be to fiscal factors with its borrowing costs at their highest for almost 30 years, as concerns escalate that further tax rises will impact growth.
While the UK is still navigating a tight path, it is far from alone. Japan has been struggling over recent months to regain market confidence over its fiscal prospects and issuance dynamic: 30-year Japanese government bond yields are at all-time highs.
In Europe, Germany announced a massive €500bn fiscal plan back in March which triggered a more than 30 basis point sell off in a single day. Germany has already announced that third quarter supply will be higher than previously expected. Germany is unlikely to be an isolated case as most European countries also committed to increase their defence spending.
In addition, US president Donald Trump just signed his ’big, beautiful bill’ that will, without doubt, require additional funding needs which cannot rely exclusively on domestic demand. As markets gear back up in September, it will be important to watch if supply meets demand. Any deterioration in bid-to-cover could put more pressure on the bond market. This risk is already acknowledged by markets as exhibited by the steepening of 10-to-30-year bond curves across regions, yet this trend could have more room to go if things go wrong.
The known unknowns
While markets are embracing a riskier-the-better attitude, such a low-risk perception should advocate for caution - the wake-up call generally comes from something that has not been mapped or was simply disregarded.
There are still a few large ‘known unknowns’ that could impact bond markets. The US president consistently undermining US institutions might at some point weigh on investors’ confidence. Geopolitical risk is structurally higher and can fuel market stress. France has a new prime minister again but will still struggle to deliver a budget that addresses its fiscal issues.
These risks are in everyone’s mind but might not be mapped properly. At a time when risk assets are at all-time highs it would not take much to shake up markets.
From a historical perspective, euro rates are close to historical highs at a time when we expect growth to remain fragile and inflation to remain contained in Europe - and tail risks could drive some flight to quality.
Plenty of new issues could arise and the next few months are unlikely to be plain sailing. But volatility can also offer opportunities. Despite the challenging environment, we continue to identify compelling possibilities across global fixed income with euro fixed income particularly appealing given the current bond valuations and the macroeconomic backdrop.
Overall, we think a diversified approach blending duration and credit risk could be an appropriate solution for investors looking to get the most out of fixed income, particularly in periods of heightened market turbulence.
Johann Ple is a senior portfolio manager at AXA Investment Managers. The views expressed above should not be taken as investment advice.