When Volatility Means Flexibility

Marketing communication for professional investors only

François Collet, What Is Your Outlook for H2?

We continue to expect a slow and somewhat sluggish global recovery. While Europe had been a bright spot after a difficult year, recent data has not been so cheerful given the ongoing wobbles in China and the political uncertainty plaguing the Euro region.

And the US has shown some signs of weakness that are worth watching. Data has weakened somewhat, with the economic surprise index plunging. Banks have slowed lending. And the construction sector, which is more sensitive to rate hikes than other parts of the economy, is stalling.

Overall, a slightly slower recovery will keep inflationary pressures at bay and allow central banks to begin their cutting cycle – which the ECB and others have embarked on, despite some setbacks in Australia and elsewhere. We don’t expect major central bank easing outside of a recession, simply because most of the disinflation is behind us and inflation likely won’t return to their 2 percent targets long-term.

It’s more about central banks striking a balance to support the ongoing expansion.

Will Markets Become Less Volatile as a Result?

We expect macro and rate volatility to remain high – even if the economic backdrop remains benign – for several reasons. The first is politics. We’ve seen recently that political upsets in the European Union and potentially in the French election can have an outsized financial impact given the ever-evolving policies of candidates like Marine Le Pen and Jean-Luc Mélenchon.

And we’ll have to wrestle with a Donald Trump Presidential run as well, with his policy platform becoming a key investor concern. Markets hate uncertainty and must handicap these extreme outcomes – «Frexit», fiscal standoffs, massive trade tariffs et cetera.

Even if these candidates show fiscal restraint, it will take some time for markets to truly trust them. Until there’s more certainty, therefore, politics should inject volatility in markets. Second, many countries are on unsustainable fiscal paths anyway, compounding the fallout from any fiscal misadventures.

France, for instance, has a debt-to-GDP ratio of around 111 percent, its highest since 1887 outside of Covid and World Wars. Meanwhile, its fiscal deficit, at -5.5 percent, puts it well offside with the EU’s 3 percent limit – along with Italy (-7.4 percent) and Spain (-3.6 percent) – and sets the stage for a potential showdown with Brussels.¹ 

Given this, such countries will have to walk a tightrope, especially given high foreign ownership of their public debt. Any missteps, like that of Liz Truss, could soon be punished severely by so-called «bond vigilantes», and there are already signs that Japan is selling some French OATs.

Finally, we can’t overlook geopolitics. Whether an escalation with Russia or in the Middle East, which would pressure supply chains and send oil and inflation ripping higher again, or a renewed US-China trade spat war and deglobalization are inflationary.

And, as we saw in 2022, if we do get an inflationary spiral, even because of conflict, bonds are unlikely to come to the rescue.

How Should Fixed Income Investors Approach H2 and Beyond?

We have been saying for some time that we are entering a new paradigm, with political, fiscal, economic and even geopolitical forces putting upward pressure on inflation and increasing market volatility, especially for fixed income. In such a scenario, traditional 60/40 portfolios are unlikely to be as successful as they have been in the past.

We have begun to see this already, with stocks and bonds being positively correlated in recent years. In fact, the great moderation period of 1-2 percent inflation now seems a historical anomaly, rather than a permanent «new normal».

If you look back centuries, rather than decades, you’ll see interest rates and yields right now are actually quite consistent with history. What does this mean for investors? It argues in favor of having as much diversification in one’s portfolio as possible and as much flexibility.

So, having vehicles that can invest across the duration spectrum and even go short when needed could be beneficial. Similarly, assets and strategies that have as many natural hedges as possible might prove useful.

Written in June 2024

¹Source: Bloomberg DataMarketing Communication. For professional investors only. Past performance is not indicative of future results. All investments involve risk, including the risk of capital loss. The provision of this material and/or reference to specific securities, sectors, or markets within this material does not constitute investment advice, or a recommendation or an offer to buy or to sell any security, or an offer of services. Investors should consider the investment objectives, risks and expenses of any investment carefully before investing. The analyses, opinions, and certain of the investment themes and processes referenced herein represent the views of the portfolio manager(s) as of the date indicated. These, as well as the portfolio holdings and characteristics shown, are subject to change. There can be no assurance that developments will transpire as may be forecasted in this material. In Switzerland: This material is provided by Natixis Investment Managers, Switzerland Sàrl, Rue du Vieux Collège 10, 1204 Geneva, Switzerland or its representative office in Zurich, Schweizergasse 6, 8001 Zürich.

NATIXIS INVESTMENT MANAGERS Paris 453 952 681 Capital: 178 251 690 € 43, avenue Pierre Mendès-France, 75013 Paris www.im.natixis.com

DNCA FINANCE - Affiliate of Natixis Investment Managers. DNCA has been approved as a portfolio management company by the French Financial Market Authority (Autorité des Marchés Financiers) under number GP00-030 since 18 August 2000. 19, place Vendôme 75001, Paris, France.