Bond managers ideally want to see three things: attractive valuations and elevated yields; policy certainty; and an economic backdrop of lower growth and lower inflation.
This is true for Ben Edwards, who manages the BlackRock Corporate Bond and BlackRock Sustainable Sterling Strategic Bond funds. Today, the UK is the only market that fits the bill for all three requirements.
In the US, government bond valuations are attractive, but with Donald Trump about to enter the White House, there is a lot of uncertainty about which fiscal and economic policies he will introduce.
Trump’s election victory is a “gamechanger”. Prior to the presidential election, Edwards was expecting labour market weakness and disinflation in the US, but “all of that has changed post-Trump” and now he thinks the US economy is less likely to deteriorate.
Tax cuts will probably stimulate growth and inflation in the short to medium-term and deregulation will pick up the baton in the medium to long-term, he said.
In Europe, the situation is reversed. Government bonds have “terrible valuations”, with 10-year German bunds yielding 2.15% at the time of writing.
“Europe has a growth problem” and with a German election in February, the direction of policy is uncertain here as well, Edwards continued. Germany currently has the ability but not the political willingness to pursue pro-growth policies but that may change after the election, he said.
In the UK, however, all three elements of Edwards’ wish list are aligned. The UK has “growth like Europe, not the US, and yields like the US, not Europe”. Following the Labour government’s landslide victory, the UK benefits from political stability and policy certainty.
The UK economy is struggling due to weak consumer confidence and only time will tell whether consumers had been holding off from spending ahead of the general election, he observed.
The Budget was, at the same time, bigger and bolder than people expected but underwhelming in its ability to stimulate economic growth. The government’s initial spending plans are focussed on the NHS, schools and policing, which are not a recipe for a growth and productivity uplift, he said.
The £25bn “tax on employment” could prompt businesses to hire fewer people, make redundancies or hold wages down, he continued.
All of this means that the Bank of England may ultimately cut interest rates to a greater extent that the market has currently priced in, which would be supportive for bond markets.
Once government bonds are yielding more than savings accounts, Edwards thinks investors will move out of cash and into bond funds to lock in yields. Lower interest rates would be a catalyst.
UK-based investors ploughed £631m into bond funds in October as yields surged ahead of the UK Budget and US election, according to Calastone’s Fund Flow index. This was the best month for inflows since June 2023.
Even so, US and European bond funds have seen far higher inflows over the past year compared to sterling fixed income, said Edwards.
The current yield from 10-year gilts is well above inflation and FTSE 100 dividend yields, which “we haven’t seen in a while”, Edwards pointed out.
The gilt yield was 4.3% on 27 November and it has been drawing near to 4.5% in recent days. By comparison, the Consumer Prices Index (CPI) rose 2.3% in the 12 months to October 2024 and the FTSE 100 dividend yield is 3.6%.
Last year, 10-year gilt yields broke the 4.5% barrier several times but core inflation was much higher and additional rate hikes were priced in, whereas the reverse is true today and real yields look much more attractive.
Edwards also expects the correlation between gilts and treasuries to fall. Trump’s ‘Fortress America’ agenda may be positive for the US economy, which is relatively self-sufficient, but it is negative for European and Asian economies that are more dependent upon global trade. Less correlation would be “a gift for active managers”, he concluded.