Still waters run deep in global markets

Markets have held up surprisingly well, even as pressures build beneath the surface. Since the war in the Middle East erupted in February, investors have had to contend with rising energy prices, renewed inflation concerns, and a quasi-U-turn in monetary policy expectations. This disconnect between extraordinarily high levels of uncertainty and relatively benign market conditions, the strength of technicals within fixed-income markets, and the implications of inflation and AI-driven productivity gains were among the topics I recently discussed on Bloomberg Intelligence’s FICC Focus podcast. 

We’re seeing a disconnect between what are probably the highest levels of uncertainty that I’ve seen for these relatively benign market conditions. So, what’s driving markets? I believe a large part of that can be explained by strong technicals. But I also believe we’re arriving at a point where inflation will begin feeding through into markets as a result of the Strait of Hormuz being closed for this long and energy prices staying higher. That’s true for Europe, and especially Germany, given its reliance on natural gas.  

I expect those inflationary pressures to become more visible during the third and fourth quarters of this year. It takes time for the higher costs to flow through into consumer behavior and broader economic activity, but I believe it’s increasingly unavoidable that inflation begins to move higher from here. And that has naturally changed the conversation around central banks and the expected monetary-policy path. I do believe markets have moved somewhat ahead of themselves, especially looking at the euro and sterling yield curves. While I expect interest rates in the Eurozone to move higher, I don’t believe policymakers will deliver the full extent of tightening currently being priced into markets. And as for the US, I still believe the next move from the Federal Reserve (Fed) is more likely to be a cut than a hike, though we’re likely entering a much longer pause than investors had previously anticipated. I don’t think that pause is necessarily a bad thing though. Earlier in the year, there were concerns around the possibility that the Fed could become overly politicized and cut rates too aggressively. I believe those fears are now off the table. The Fed seems to exhibit patience while assessing how inflation and growth evolve over the coming quarters. 

The current environment is also forcing investors to rethink traditional safe havens. For years, the US dollar has been the unquestioned defensive asset during periods of instability. While I still believe investors will lean on the dollar in times of acute stress, I also think we’re beginning to see a broader diversification trend emerge, where investors are looking at more diverse baskets of safe-haven assets. Gold is one example, while currencies such as the euro and the Swiss franc can make up part of a diverse currencies basket. In a more fragmented macroeconomic environment, there’s perhaps a desire not to rely too heavily on a single safe-haven allocation.  

And that same search for diversification supports flows into emerging-market fixed income. In my view, part of the strength in fixed-income technicals reflects the growing perception of fixed income as a safe-haven asset, particularly in investment grade and parts of emerging-market sovereign debt given healthier debt-to-GDP dynamics across many emerging economies compared with developed markets. I also believe volatility has strengthened the opportunity set within emerging-market local currencies. This year, we’ve spent a significant amount of time tactically adjusting exposures and actively managing carry trades. For example, going into February, we were significantly overweight oil producers because we believed oil prices were trading below their longer-term median and that investors were being offered more premium than they should have been for taking that risk. As volatility increased throughout the crisis, we repeatedly adjusted those positions while maintaining our broader conviction around energy markets and the medium-term direction of the dollar. For active managers, environments like this can create substantial opportunities, in my view.  

An eye on AI 

Aside from inflation, energy, and central banks, one of the themes I remain most focused on is artificial intelligence (AI) and the productivity boom that may already be beginning to emerge beneath the surface of the global economy. I believe AI has the potential to deliver significant productivity gains, which is relevant for both the US economy but also for the emerging-market economies servicing that US economy. In some respects, those productivity gains may help explain why equity markets have remained surprisingly resilient despite rising inflation concerns and geopolitical instability. 

But productivity gains also have another side. Greater productivity means companies can produce more with fewer workers. Over time, that may create the risk of labor market disruption, rising unemployment, and growing financial stress among heavily indebted consumers who could become the “productivity solution.” For me, that connects directly to one of the broader structural themes I think markets are only beginning to grapple with: the widening gap between rich and poor. I suspect AI productivity will exacerbate existing inequalities and deepen political polarization across developed economies. Those tensions are poised to intensify over the coming years. 

If you’d like to listen to the full conversation I had with Damian Sassower, Bloomberg Intelligence’s chief EM fixed income strategist, see below.