In our Q1 issue of Alphorum, we set out a base case for a soft landing, particularly in the US. At that point, most economies across the globe looked strong, interest rates around the world were close to neutral, and corporate fundamentals and technicals were largely robust. In fixed income, spreads were tight – but for the right reasons – making bonds attractive for carry given relatively high rates and steeper curves.
We did, however, flag a range of risks and sensitivities that could disrupt that scenario. The last of those six risks has proved most prescient: that an increasingly fractured geopolitical environment could make crises like the one then unfolding in Venezuela more frequent and problematic. Just two months later, more severe events began to unfold in the Middle East that would have global implications.
The impact of the Iran war will extend beyond the short term
While the war on Iran in many ways bears the hallmarks of what is becoming the Trump geopolitical playbook, it seems this time the consequences are likely to be more severe and long lasting. Geopolitical conflicts tend to create two key risks that can disrupt growth momentum, in the form of volatile commodity prices and disruption to supply chains. While current supply-chain issues are unlikely to endure for long once the Iran conflict is resolved, some impact from the war may persist in commodity prices for some time.
As well as the almost total restriction of traffic through the Strait of Hormuz, the conflict has resulted in lasting damage to key energy infrastructure in the Gulf region. Even in the most benign scenario – in which the conflict is resolved quickly and the Strait fully reopened – damage to oil and gas facilities will take months (in some cases even years) to repair, with significant implications for global supply. The most likely consequence of sustained higher oil and gas prices is stagflation, with growth stalling as energy prices drive inflation higher.
Two factors should be borne in mind to understand the likely impact on fixed income markets:
- Second-round effects. Energy is a key input cost across industries, as well as a major cost for consumers. Even if the conflict is resolved quickly, second-round effects can take some time to wash out, and if it continues, central banks may need to act tough to contain inflation
- Government measures. In countries like the UK, which are most affected by higher energy prices, talk has already turned to government intervention and support. If enacted, the impact on public finances of this additional fiscal push creates an argument for rate curves to steepen.
Read also: Finding signals in the noise of the Iran oil shock
Beyond Iran, bond markets face further evolving risks
In addition to the direct impact of the conflict in the Middle East, we have identified five further medium-term risks that fixed income investors should consider:
- Political risk around the US midterms. Trump may have been looking for a win in Iran as a domestic vote winner. Given his flagging approval ratings, will the US administration opt for a further fiscal push, more geopolitical excursions, or even both? And if so, to what degree?
- The impact of AI. It is unclear when or whether AI will reach the warp speed that proponents are aiming for – so far, evidence suggests it is only having a very minor impact on the labour market. At the same time, political pushback against potential job losses and higher energy costs for consumers may present barriers to AI capex spending plans
- Issues in the private credit market. The gating of funds is becoming a recurring story. If higher rates, spread widening and worsening financing conditions combine with collapsing equity prices and a major hit to SaaS businesses from AI, this could create a perfect storm for private credit.
- Central bank transition risk. Jerome Powell’s tenure as Federal Reserve (Fed) Chair ends in May, but Trump nominee Kevin Warsh has yet to be confirmed by the Senate. Meanwhile, at the European Central Bank (ECB), Vice-President Luis de Guindos will be replaced by Boris Vujčić in June, while President Christine Lagarde is expected to leave before her term ends in October 2027. Two of the most important board members, Philip R. Lane and Isabel Schnabel, are also due to depart in 2027.
- Further geopolitical risk. Cuba is being discussed as Trump’s next focus. Alternatively, he could turn his attentions back to Greenland. Meanwhile, arguments can be made for the Iran conflict to act either as an incentive or disincentive for China to make moves on Taiwan. At a broader level, were Trump to follow through on his threats to abandon NATO, the effective end of the organisation (the US accounts for 60% of its spending) would have global implications.
Expect a decoupling between the US, Europe and emerging markets
As we mentioned at the outset, the good news is that most economies globally entered this latest crisis from a position of relative strength. Policy rates are for the most part close to neutral (perhaps mildly restrictive in the US); in theory, central banks can thus hike or cut rates as required, rather than resorting to unconventional approaches. Our base case is therefore that recession will be avoided for all but the weakest countries.
An important factor to note, however, is that countries have differing sensitivities to the emerging stagflation risk. As an oil and gas exporter, the US could actually benefit from higher energy prices in the medium term, as could emerging-market producers such as Brazil. In contrast, energy importers like Europe, the UK, China and India will be at a disadvantage. At the same time, the actions of central banks will differ depending on whether their remit covers dynamics beyond inflation, available reaction functions and room to manoeuvre.
US: a preference for maintaining growth momentum
US inflation is still above 2% and the labour market remains strong, making the domestic situation look quite resilient. While there could be some trickle-down impacts of higher energy prices, market sentiment is that a rate hike is unnecessary. We tend to agree: this is not the 1970s and corporate America is stronger than labour-force America, making significant second-round effects driven by salary increases unlikely.
The US economy’s lower sensitivity to an energy shock means it will to some extent be business as usual, with previous forces continuing to be dominant and Trump’s domestic political agenda a key factor. At the same time, the Fed’s dual mandate leaves room for it to manoeuvre quickly if and when the labour market deteriorates. It is therefore more likely to focus on maintaining growth momentum unless circumstances force it to do otherwise. With this in mind, the incoming Fed Chair may try to make the case for rate cuts, although he is unlikely to be able to follow through. Overall, we therefore see the US bond market as fairly correctly priced, at least in terms of the monetary policy element.
Read also: Fixed income in 2026: expect a soft landing, but be ready for alternative scenarios
Europe: a laser focus on inflation aversion
In contrast to the US, as a major importer of oil and gas, Europe will feel the impact of higher energy prices and lower growth much more strongly (and the UK will feel it even more). Given its single remit and consequent inflation aversion, the ECB will inevitably need to focus on reigning in any inflationary pressures.
While it will need to reassure markets, the ECB shouldn’t be forced to hike interest rates too severely. In this context, we believe its forward guidance of two hikes before the end of the year at the time of writing may reflect a strategic aim to get ahead of potential inflationary fears as much as inflation itself. It is easier for the bank to lead markets to expect hikes then not deliver them than the inverse situation, which could leave it behind the curve and struggling to catch up. If the Iran conflict ends relatively quickly, one or two hikes, or even none, may be enough. However, it is important for the ECB to use tough rhetoric to manage market expectations and ensure credibility.
FIG 1. Our fixed income convictions scorecard, going into Q21
Portfolio positioning: with uncertainty high, stay close to home
The differences set out above are reflected in current market pricing: in the US, rate expectations are basically flat to the end of the year; in contrast, the ECB’s forward guidance is largely priced in. For us, this is an environment reflective of significant uncertainty. Central banks have adjusted expectations, and bond market pricing has recalibrated in response to the new reality.
In corporate credit, the impact is likely to be very different between Europe and the US. We believe the initial wave of credit market volatility is probably phasing out, and widening has largely retraced. However, greater oil dependency and resultant higher exposure to growth impacts mean the ongoing consequences for European credit will be more severe – as recent spread widening attests.
At the same time, our impression is that markets have traded more on the inflation risk side of the equation and less so on the threat to growth so far, leading to a potential overreaction in terms of rate expectations. It is important to keep in mind that money spent by consumers on energy will not be spent on other products and services. Once this reality sinks in, there may be a pullback on the rates side.
Fund outflows tend to be an important headwind for credit when investors liquidate positions. However, so far this has mainly only been noticeable at the riskier high-yield end of the market, and with investor positioning currently underinvested or defensive, this risk seems less likely.
Given previously robust economic momentum, we believe the environment favours staying invested. However, there is a need to ensure effective diversification and avoid unnecessary risk. While traditionally, fixed income investors might have taken refuge at the front end of the curve, recent repricing has shown that this too can be a volatile segment.
The inherent uncertainty created by highly unpredictable geopolitical forces can create tactical short-term opportunities that emphasise the benefits of being active. An example was on 8 April, when the short end of the European rate curve saw a huge 25 bps rally. However, it also means that this is no environment for major bets. Instead, we are staying close to benchmark but seeking opportunities to increase risk-on exposure opportunistically where we see dislocations emerging.
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