Quarterly fixed income review and outlook | Insight Investment

Incoming data continue to point to an environment where growth is improving but remains below par, supported by resilience in manufacturing. The backdrop is reinforced by strength in corporate earnings and underlying company fundamentals, as was evident during the latest reporting season. However, the balance of risks is still uneven in our view. It suggests some moderation ahead, particularly if the Middle East ceasefires and initial peace agreements fail to hold sufficiently provoking renewed uncertainty and volatility in investor sentiment. Inflation remains above-target and is rising in some areas. The data continue to show a clearer transmission from energy and geopolitical pressures, and the near-term outlook suggests this pressure is likely to persist while the oil shock remains in place. The impact is expected to be most acute in Europe and Asia, where larger energy importers appear more exposed to further cost pressures. This is reflected in rising input and output costs, alongside longer supplier delivery times. Under both the base and alternative cases, inflation remains in an above-target and rising regime, with energy effects continuing to feed through in the near term.   

Our central case remains that GDP growth will be close to 2% both this year and in 2027, underpinned by the ongoing surge in digital and AI infrastructure development. Although the inflation cycle appears likely to turn soon, given the agreement between the US and Iran, we believe the inflation rate will remain above target for some time, being just below 3.5% in 2026 and decelerating to 2.5% next year. Any renewed flare up in hostilities increases risks to both growth and inflation. Through the outlook is still uncertain, we expect the Fed will leave rates unchanged while policymakers assess the impact of the energy price shock on employment and inflation. A prolonged shock would raise near-term inflation risks while increasing the risk of weaker growth. We do not expect the Fed to respond by raising short-term rates, despite market pricing. Countering that view, near-term price pressures are likely to delay potential Fed cuts, while second-round effects could weigh on consumption and the labour market. The duration of the oil supply shock is critical. Monetary policy is poorly suited to stagflation, but strong global incentives to ease energy prices support the case for eventual resolution to the war. We believe 10-year Treasury yields are likely to be close to current levels in a year’s time, around 4.40%. Yields at shorter maturities are expected to ease below 4% over time.   

Prior to the war in the Middle East, leading indicators for the eurozone had been reasonably resilient. The recovery was being led by Spain. German and French growth was anaemic, while Italy's was slowing as tailwinds faded. The manufacturing sector that has been under pressure for some time is showing signs of recovery. We believe positive real wage growth in 2026 could support consumption, but savings rates remain elevated. Consumer confidence remains low as a consequence of the conflict and added to consumer expectations for inflation. However, the labour market appears to be resilient and the prospect of additional support coming from Germany’s expanded fiscal spending had added upside risks to the admittedly modest growth forecasts. We see GDP expanding by 0.7% in 2026 with an improvement to 1.2% in 2027. Meanwhile, the headline level of inflation is expected to remain above the 2% ECB target level, at just below 3% for this year, before easing back to almost 2% over the next year. Having increased rates once already, we expect the ECB is likely to hike once more before allowing a pause as inflation begins to moderate, before easing policy gradually back toward 2%. We see 10-year German government bond yields close to current levels this time next year around 2.9%, with the curve steepening to some degree as shorter-dated yields fall back as inflation pressures reduce.  

Our expectations for UK economic activity align closely with the market consensus, with GDP expected to expand by a little more than 1%, both this year and next year. Inflation, which has spike higher as energy prices have been driven upward, is expected to be relatively sticky despite the sluggishness of GDP growth. We anticipate headline inflation to be 3.3% over 2026 and then decline slightly next year to 2.7%, still some way above the BoE’s 2% target. The imminent change of prime minister may result in some changes to where public policy emphasis lies, but we do not envisage significant immediate changes to fiscal policy. Monetary policy is also unlikely to be altered in the short term, in our view. We believe the BoE will maintain rates at the current level for some time and believe they are likely to still be at 3.75% in a year’s time. The gilt curve is expected to steepen, with yields at shorter maturities easing back below 4%, while 10-year gilts yields are expected to be 4.70%, close to prevailing levels.

Chinese growth continues to be driven by a strong contribution from net exports, particularly form hi-tech manufacturing, and AI-related and transport related goods. There are also tentative signs that domestic demand is starting to improve. The drag from the property sector seems to be declining and policy support from fiscal policy as well as the focus on measures to support consumption are likely to help. We believe emerging sectors such as chip-making and hi-tech manufacturing are likely to remain pockets of above trend growth. Soft inflation should start to move higher as a result of the global increase in commodity prices. Core inflation has also remained weak, which we consider to be representative of more slack in the economy than many commentators are aware of. The key perspective on inflation is that, unlike other corners of the world, the People’s Bank of China (PBoC) do not see it as a problem at this stage. We continue to think the PBoC would prefer to conduct the bulk of any policy support via targeted lending facilities rather than via broader rate cuts.

In other emerging markets, on growth, domestic fundamentals remain robust, but we expect external conditions will have diverging effects in different economies. Energy exporters will benefit, while energy importers suffer, and this will show up in inflation, currencies and external accounts, where those countries with subsidies will see fiscal deterioration. Most central banks generally have room to ease, although concerns about an energy-led inflation shock have shifted some to a more outwardly hawkish stance.

Spreads tightened sharply in the second quarter, supported by strong earnings momentum and hopes of conflict de-escalation. This move returned valuations close to the tightest levels since the global financial crisis. However, elevated all-in yields continued to draw investor demand despite heavy primary supply. This issuance has been led by hyperscaler tech companies, whose capex financing needs remain relentless. They are accessing global markets at pace across a range of different currencies. If this trend persists, then the tech sector’s weight in major bond indices will rise materially, albeit from a low base.  For now, we favor US dollar issuance, where the market depth provides greater resilience to near term saturation. That said, we are closely monitoring non-dollar markets for emerging relative value opportunities. Strong tech supply is exerting pressure on spreads within that sector, with AA-rated issuers now trading in line with A-rated credits in other sectors, reflecting ongoing supply overhang.  Where mandates allow, we see an opportunity to add selectively at these levels. In this environment, dispersion is rising, reinforcing the importance of disciplined active management, careful security selection, and a focus on relative value.   

Despite a volatile global backdrop, high yield markets have shown notable resilience, with steady income continuing to underpin returns. Encouragingly, many issuers remain disciplined, actively deleveraging and managing balance sheets in contrast to rising leverage at the sovereign level. However, the market is becoming increasingly differentiated, with rising levels of dispersion among issuers. AI is a key catalyst for this, driving new supply to fund the infrastructure build‑out, while also disrupting existing business models, especially in the software sector. Although there are positive signs that the conflict in the Middle East may be on a deescalating path, the outlook remains uncertain. This leaves us with a bias towards US issuance given that the US has a stronger growth outlook and is more insulated from higher energy prices. Defaults remain low by historical standards, and we see little reason for a material deterioration given the improving quality of public high yield debt issuers and the continued migration of weaker credits toward private markets. We see promising opportunities to add exposure in telecommunications, healthcare, and other industries that are likely to be less affected should the conflict flare up once again.

Across emerging market (EM) markets, valuations of hard currency sovereigns in both investment grade and high yield areas appear stretched in both absolute terms and when viewed against the equivalently rate US markets. We retain a preference for local rates markets and a marginal preference for high yield sectors. We believe the setbacks in Colombia have been unjustifiably excessive and see that market as attractive. A resilient growth environment and the seeming resolution of the US-Iran war means we are tactically more positive on EM corporates. Lower oil prices mean lower recession risk, offering a more constructive backdrop. BB EM high yield issues look particularly attractive on a spread basis relative to equivalent BBs in the US.  In local markets, however, there are risks that those factors could be materially undermined if the Middle East conflict flares up again. The growth differential between EM and developed market (DM) economies is still expected to remain favourable. Inflows to the asset class are also expected, while EM corporate fundamentals appear robust compared to DM corporates, with the market also benefitting from low net supply.

Fears that the outbreak of war could weaken the US growth outlook proved short-lived, as economic data continued to point to resilience while falling energy prices helped ease inflation risks. In the US, the labor market showed signs of improvement, which should counterbalance higher gasoline prices. If the Strait of Hormuz fully reopens, energy prices should decline further, which would take pressure off the Fed to hike. In Europe, the European Central Bank has tightened policy, and while the growth outlook has weakened, we believe the region should avoid recession. Given this relatively benign outlook, demand has shown no signs of softening, with new issues typically well oversubscribed and secondary markets well bid. Issuers have increased supply to take advantage of these conditions, particularly in consumer-related sectors. Our focus remains on senior, well-protected parts of the capital structure, prioritizing transactions with robust underwriting, strong servicing and structural protections that preserve cashflows in downside scenarios. We believe this positioning should help insulate portfolios from ongoing macro, inflation and geopolitical uncertainty, while allowing us to pursue attractive income and relative-value opportunities through 2026.  

We remain constructive on the municipal market as we expect new issue supply to remain steady but manageable, supported by continued solid demand from retail investors via flows into mutual funds and ETFs. Municipal credit conditions remain strong. The disruption of traffic through the Strait of Hormuz pushed energy prices higher, raising operating costs for transit systems and utilities, and pressuring household budgets, effects that can soften broad based tax collections. The US-Iran deal has the potential to ease this risk, although markets will likely treat the successful resumption of traffic through the Strait of Hormuz as the acid test. Cybersecurity risk has also increased, with US public finance issuers facing elevated vulnerability to retaliatory attacks tied to the conflict. We continue to prioritize issuers with strong balance sheets, robust liquidity, and meaningful operating flexibility. We believe the municipal intermediate maturity segment (10 to 20 years), which is steep, remains attractive. We expect this portion of the yield curve to capture the largest roll down benefit.

Currency markets are likely to be shaped by the tension between strong US growth and persistent concerns over the longer-term outlook for US fiscal policy. We expect the USD to remain supported in the near term by relatively resilient economic activity, elevated inflation pressures and a less dovish Fed outlook. However, structural issues including large fiscal deficits and policy uncertainty could limit broader dollar gains over time. Elsewhere, the euro may recover gradually if growth benefits from increased defence spending and if energy pressures ease, while sterling faces headwinds from policy uncertainty, energy vulnerability and potential BoE easing. The yen is challenged by weak fundamentals and energy import dependence, with any official intervention likely to have only a temporary impact. The Australian and New Zealand dollars are supported by resilient domestic economies but remain vulnerable to changing rate expectations and risk sentiment. The Canadian dollar appears less compelling given softer growth and policy uncertainty. In Europe, the Norwegian krone continues to benefit from higher oil prices and a relatively hawkish central bank, while the Swedish krona relies more on improving growth and attractive valuations. The Swiss franc is likely to remain supported by its safe-haven status. Overall, while the dollar is likely to stay firm, relative fiscal strength, energy exposure and external balances may become increasingly important drivers.