In an environment marked by a decline in inflation, we could see a decoupling from the United States and a better performance of European government bonds.
As Trump prepares to take office in January, potentially elated by the Republican landslide victory, the financial press explains that this is excellent news for the stock markets, but bad news for the bond markets. But that doesn’t mean bond markets will spend the next four years in hibernation.
We will see in a few months whether, once in office, Trump will honor his campaign promises. In the meantime, it is appropriate to view the United States and Europe as two very distinct bond markets, and to analyze in detail the asset subclasses of each market. Whenever uncertainty reigns, it is generally best to take a nuanced approach, specific to the region in question.
Concerning the United States, Trump has promised fiscal stimulus measures, which will take the form of tax cuts and customs duties aimed at protecting local businesses. This should support consumer spending, US growth and risk appetite in financial markets. It is a safe bet that this policy will be inflationary, which should create an almost perfect environment for the stock markets. But we believe there will also be winners in the fixed income space, particularly the US high yield segment.
Spreads are currently low in the US high yield market, but they may narrow further as growth prospects improve, which should translate into better corporate results, a reduction in default rates and a favorable development in the relationship between supply and demand. And even if rate spreads did not contract, investors would still receive generous coupons, despite the risk of an imminent recession. We have been bullish on US high yield for a while, and Donald Trump’s victory only reinforces the view that this asset class will perform well.
Regarding corporate debt in general, the Trump presidency should also benefit certain American companies in the investment grade universe, even though this segment may prove more sensitive to interest rates than the high yield sector, depending on where you are on the yield curve. Regardless, we expect yield spreads to tighten, which should support corporate debt performance.
The main risk for US bonds will lie in the Treasury market, as the budget deficit could widen even further during Trump’s term.
Given that Trump’s measures will likely fuel inflation, the market is revising downward the number of rate cuts it expects. Just six weeks ago, the market was expecting a 50 basis point drop in November. However, the Fed only lowered its rates by 25 basis points. The probability of a rate cut in December has fallen to 50%. The Fed is still considering lowering rates, but much will depend on economic statistics, the trajectory of which is increasingly uncertain.
In Europe, the collapse of the coalition government in Germany accentuates the risk that France was already running, and the probable implementation of customs duties by the American government could hamper economic growth. This pushes us to be extra vigilant regarding European high yield, as this segment is largely exposed to the automotive and consumer sectors. As a result, we prefer to turn to higher-rated debt in Europe, while waiting to see how the economic situation develops. It seems wise to us to favor higher quality euro-denominated assets when obstacles to economic growth multiply.
The European Central Bank will have a role to play; it will likely have to continue lowering rates to compensate for the slowdown in economic activity. In an environment marked by a decline in inflation, we could see a decoupling from the United States and, possibly, a better performance of European government bonds.
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