Quarterly fixed income review and outlook | Insight Investment

Largely through its effect on energy prices and constraints on supplies of a range of commodities, including oil, gas, and other petrochemical and industrial products, the ongoing war in the Middle East is likely to have a combined dampening effect on global growth, while also putting upward pressure on inflation. While our baseline expectation is that strong global efforts to contain pricing pressures will help limit the duration of the conflict, the longer it lasts the more substantial and prolonged the negative effects on the world’s economy are likely to be. As well as raising the spectre of possible recession in many countries, softening growth prospects have the potential to create significant problems for many governments already facing painful fiscal challenges. Higher inflation, having led to higher yields, could result in deeper difficulties for government funding. Central banks, which were either expected to cut rates further or at least remain on hold, may find themselves needing to increase official rates in the face of higher inflation levels and prospects. Other geopolitical crises, notably the Russia/Ukraine war, have still not shown signs of any resolution and, with the West’s focus turned to the Middle East, may continue to rumble on.

The ongoing conflict in the Middle East is significantly heightening risks to the current baseline forecasts for both economic growth and inflation. Our forecasts are for GDP growth of 2.3% in 2026 and 2.2% in 2027, with inflation expected to be 2.6% this year, moderating to 2.4% next year. However, the potential for variance around those forecasts is elevated. While immediate inflationary pressures are likely to delay any potential rate cuts by the Federal Reserve, the secondary impact on growth is becoming increasingly pronounced, raising the possibility of further weakness in the labour market and potentially necessitating additional policy action later in 2026. The length of the oil supply disruption will be crucial in shaping the outlook. Monetary policy may not be particularly effective in addressing the stagflationary consequences of a sustained oil price shock. Given the heightened risks to growth stemming from elevated US oil and gas prices, much may depend on the trajectory of US growth amid rising input costs but, for the time being, we expect the Federal Reserve to keep rates unchanged. Rate cuts are more likely to be implemented later in the year or in 2027 and we see the Fed funds rate at around 3.5% in the next 12 months. We expect 10-year and 30-year Treasury yields to be around 4.05% and 4.70% respectively, though volatility is possible, and even likely, with so many contributing drivers, particularly as the midterm elections approach.

The eurozone economies face headwinds from higher energy prices. As in most regions, the risk is that inflation may rise rapidly in 2026, with the duration of the Middle East conflict strongly influencing how long it remains elevated relative to the central bank’s target of 2%. We expect inflation to be around 2.0% in 2026, moderating slightly in 2027. Meanwhile, we see downside risks to our recently increased GDP growth forecasts of 1.5% in 2026 and 1.7% in 2027. We acknowledge that the level of activity is relatively sluggish compared to the US and emerging markets and is subject to revision as the extent and duration of the war in the Middle East becomes clearer, along with its effect on commodity prices. We believe the European Central Bank is the least likely of the central banks to look through the energy price spike and will be alert for any signs of second-round effects. However, it begins from a stronger position than most others, with inflation close to target and inflation expectations consistent with its inflation target. We expect 10-year German government bond yields to remain close to current levels over the next 12 months, at around 3.00%. However, increased borrowing at longer maturities could push 30-year yields up to 3.5% as the curve steepens.

The UK’s economic prospects are likely to be affected by the sudden increase in energy prices, with higher inflation widely expected based on past experience and recent changes in transport fuel costs alone. Economic activity is also expected to face increased headwinds, leading to sub-trend GDP growth. We currently forecast 1.0% growth in 2026 and 1.5% expansion in 2027, with potential downside risks. Inflation is likely to be pushed higher, at least in the interim, by increased fuel prices among other influences. The extent to which this increase will be prolonged is unclear. Our forecast is currently for 2.3% inflation in 2026, with risks to the upside, and for it to remain above the BoE’s 2% target level in 2027 as well. As the MPC adopted a more hawkish stance than many expected at its March meeting, we believe policymakers may be willing to act to increase rates should the anticipated rise in inflation threaten to worsen or become entrenched. The risk of further downside to economic activity, in which the possibility of recession becomes material, may help to stay their collective hand. Broadly, if the outlook for inflation maintains its general declining trajectory, the BoE may be able to reduce rates later in the year, but that is no longer a clear likelihood. Having increased markedly in March, we expect gilt yields may remain volatile, as the government’s fiscal position remains in the spotlight. We see 10-year gilt yields close to 4.50% or higher in a year’s time, with 30-year yields around 5.10% or higher.

Even prior to the advent of hostilities in the Middle East, we were anticipating Chinese GDP growth to decelerate to just 4.0% in 2026 and further to 3.8% in 2027. In the event of a widespread global slowdown, China’s export sector, often considered a bulwark of the country’s momentum, could come under further strain, putting ever greater pressure on the domestic economy to make up any shortfall. We expect inflation to remain positive, at around 1.0% in 2026 and be slightly higher in 2027. The People’s Bank of China is likely to make little change to interest rates, while bond yields are expected to move higher over time, taking the 10-year yield above 2%.

In other emerging markets, high energy prices could have a similar dampening effect on activity and push inflation upwards, undermining the ability of many central banks to reduce rates further. At the same time, in a reversal of the weakening US dollar trend, the recent strength of the USD could further reduce the scope for more central bank rate cuts. If the US economy holds up more strongly than other regions, those countries with greater export exposure to the US market may feel some relative benefits.

The conflict in the Middle East has materially increased risks to both growth and inflation. Higher energy prices are weighing on growth while simultaneously reinforcing inflationary pressures, pushing back expectations for Fed easing and raising the prospect of rate hikes in Europe. As a result, government bond yields have risen and credit spreads have widened, albeit from historically tight levels. Corporate fundamentals remain resilient, supported by stable balance sheets, while higher absolute yields have further increased the attractiveness of investment grade credit. The market continues to expect an elevated level of new issuance, with supply likely to remain an important theme through the first half of 2026, driven by M&A activity and rising AI-related capital expenditure. If the conflict de-escalates quickly, then the positive macroeconomic environment might start to reassert itself and spreads could begin to tighten again. However, a more protracted conflict could build further pressure on corporate spreads, given the implications for central bank policy rates, lower consumption and weaker corporate earnings. From a supply perspective, we are observing that primary markets are broadly continuing to offer new issue concessions, helping to cushion broader spread volatility, while rising dispersion favours a disciplined focus on active management, security selection and relative value. We also see continued opportunities from issuers accessing non-domestic markets, particularly US corporates issuing into European markets.

Spreads have widened in 2026 as the conflict in the Middle East has introduced uncertainty to the growth outlook. Combined with an upward shift in rates and a flattening of the high yield curve, we believe the current conditions may present potentially attractive opportunities. The high yield market continues to be supported by resilient technical factors, manageable default expectations, and limited near-term refinancing pressure, and we would expect these to reassert themselves over time. Defaults remain low by historical standards, and we see little reason for material deterioration given the improving quality of public high yield debt issuers and the continued migration of weaker credits toward private markets. However, spread dispersion is rising, particularly in AI-exposed sectors and among more highly leveraged, rate-sensitive borrowers. In this environment, we believe a cautious approach remains warranted, especially in sectors with elevated issuance, such as technology. We favour maintaining an underweight position in issuers rated CCC and highly cyclical exposures, while focusing on issuers with resilient cash flows, balance sheet flexibility, and clear refinancing paths. We believe credit selection is important and expect active security selection to remain the primary driver of excess returns through 2026. Looking ahead, we believe there may be promising opportunities to add exposure in telecommunications, healthcare, and other industries that are likely to be less affected by ongoing global disruptions.

Across emerging market (EM) markets we retain a preference for local rates markets and a marginal preference for high yield sectors in hard currency and corporate space. In local markets, we believe the setbacks in Colombia have been unjustifiably excessive and see that market as attractive, particularly as we believe the election outcome may prove favourable for locally denominated sovereign debt. The recent global market turmoil makes us believe there may be value in those markets that appear relatively robust, such as Poland and Czechia. Hard currency markets appear less attractive to us, partly due to valuation concerns. Overall, we remain constructive on EM corporates as we see several factors as supportive of the market. However, there are risks that those factors could be materially undermined if the Iran war continues for an extended period. The growth differential between EM and developed market (DM) economies is still expected to remain favourable. There remains hope that global trade may not deteriorate materially, and the US tariff regime may become less onerous if the recent Supreme Court ruling can stymie further efforts by the US administration to impose them. Additionally, the US dollar weakness may resume. Inflows to the asset class are also expected. Likewise, EM corporate fundamentals appear robust compared to DM corporates. EM corporates also benefitting from low net supply, which we expect to continue into 2026.

The conflict in the Middle East has increased the downside risks to growth, but we believe these will be offset by fiscal stimulus in both the US and Europe, alongside the lagged impact of earlier central bank easing. Together, these forces could be sufficient to keep growth in positive territory. We believe elevated energy prices are likely to delay further rate cuts, which, for a floating-rate asset class, helps to keep income levels attractive. Market technicals remain constructive, in our view, with healthy investor demand supporting primary issuance across core asset-backed securities sectors such as autos and residential mortgage-backed securities. While parts of private credit and lower-rated collateralised loan obligation (CLO) tranches have come under pressure, higher-quality securitised assets remain well supported, with spreads broadly stable and valuations attractive relative to cash. We continue to see opportunities to add value through primary markets, where new issue concessions can offer the potential for compelling risk-adjusted returns, as well as through selective rotation into higher-quality structures amid rising dispersion. Our focus remains on senior, well-protected parts of the capital structure, prioritising 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 macroeconomic, inflation and geopolitical uncertainty, while allowing us to pursue potentially attractive income and relative-value opportunities through 2026.

We see a broadly constructive outlook for municipal bonds in 2026, with taxable muni yields remaining attractive, in our view, versus similarly rated corporate credit. Credit fundamentals appear strong, supported by robust reserves and cash balances built up in recent years. With the economy expected to slow, we favour defensive sectors such as public power and water/sewer utilities for their essential nature and predictable cashflows, while maintaining an underweight in state and local general obligation bonds given their lower premium to Treasuries. We remain cautious on healthcare due to rising labour and equipment costs. Following significant curve steepening, we view the long end as compelling and prefer barbell strategies, combining short maturities to seek benefit from Fed easing with long maturities to capture the yield levels available. Although spreads are tight by historical standards, we believe they remain supported by solid credit fundamentals and steady investor demand.

Elevated geopolitical tensions, particularly with the Middle East in mind, have increased uncertainty through higher energy prices, posing risks of both lower growth and higher inflation. External balance strength continues to be an important differentiator across currencies, with countries exhibiting stronger fiscal positions and net external assets generally outperforming. In the US, we expect a moderation in its growth advantage over the coming year. While higher energy-driven inflation could constrain the Fed’s potential to ease policy, potentially offering support to the USD in the near term, longer-term structural challenges, including fiscal sustainability concerns and policy uncertainty, remain a headwind. In Europe, elevated energy costs also weigh on growth and inflation in the near term but increased domestically focused defence spending has the capacity to support investment and capital inflows, leaving the euro with a modestly positive outlook against the dollar over the medium term. Sterling remains vulnerable given its sensitivity to energy prices and rising political risk. In Japan, unfavourable terms of trade continue to weigh on the yen, which remains a funding currency, although excessive weakness could prompt policy concern. Overall, currency markets remain characterised by subdued volatility, with medium-term trends driven by relative growth, energy dynamics, and external balance fundamentals.