Ahead of the Curve: Economic convergence and what it could mean for bond investors
Key takeaways
- We believe US economic growth may decelerate and inflation could remain sticky as the impact of trade policy continues to feed through. Offsetting these headwinds on growth are easier Federal Reserve policy, ongoing fiscal support and strong investments in AI technology, which should help to sustain growth momentum over the medium term. However, political risk adds an extra layer of uncertainty.
- In contrast, Europe’s growth outlook appears to be improving, largely due to increased German fiscal spending, which should result in larger deficits, stronger growth and higher inflation. In turn, we think this could lead to the European Central Bank breaking with the Fed and potentially hiking next year.
- The convergence in economic growth and consequent expected divergence in policy direction between the US and Europe has important implications for fixed income, particularly global portfolios that are able to capture the relative value differential between the different regional markets. Overall, with valuations tight and the outlook uncertain, we retain a defensive stance and are focused on maintaining a balance between expected returns, diversification and downside risk management.
This year has seen huge shifts in the macroeconomic and geopolitical landscape. Principles such as free trade, globalisation and central bank independence that have underpinned the global economy for decades are being challenged. Despite this, credit spreads are at all-time tight levels and equity markets at historic highs.
What are fixed income investors to make of the current environment and how should they best position portfolios to capture results?
At Capital Group’s latest biannual Portfolio Strategy Group (PSG) forum, we attempted to make sense of the noise and identify the key themes we think will drive markets.
Amid the shifting landscape, we think a key trend we identified back in the spring, namely a cyclical convergence of growth between the US and the rest of the world, is likely to continue. At a secular level, however, the picture is less clear with the US caught between AI and fiscal stimulus on the one hand, and a deterioration of institutional trust on the other.
The US’s implementation of tariffs and re-ordering of global trade continues to reverberate through the global economy. Although their full effect has yet to be felt, we think the stagflationary impact of tariffs on the US will continue as companies adjust to the more restrictive trade environment. Our expectation is that this has an impact on consumer and investment activity and leads to a moderation of US economic growth, but a recession is unlikely, with fiscal stimulus and Federal Reserve policy helping to offset trade headwinds.
In contrast, Europe has better cyclical growth potential, largely as a result of Germany’s proposed fiscal spending plans. This increase in spending, which comes against a backdrop of broader economic resilience in the eurozone, could add to inflationary pressures in the region and mean the European Central Bank hikes rates next year.
Taken together, this suggests global growth will moderate but remain positive in 2026 and could potentially reaccelerate in the second half of the year.
Over the past 12 months, periods of market stress have seen fixed income markets provide the diversification expected of the asset class. This is largely due to duration, which has rallied in anticipation of central bank easing. That said, divergent monetary policy cycles and long-term policy risk in the US mean a more nuanced approach is appropriate, using relative value positioning to capture the opportunity rather than a traditional allocation to US Treasuries to provide diversification.
This remains a pivotal time for the global economy, with many certainties of the past 40 years or more seeming to be in flux. The possible convergence of economic growth and divergence of policy between the US and Europe provide some potentially exciting investment opportunities. However, given the ongoing uncertainty and tightness of valuations, active management remains crucial, and we continue to position fixed income portfolios defensively, focusing on idiosyncratic opportunities while closely watching developments.
Flavio Carpenzano
Flavio Carpenzano is an investment director at Capital Group. He has 20 years of industry experience and has been with Capital Group for four years. He holds a master’s degree in finance and economics from Università Bocconi. Flavio is based in London.
Peter Becker
Peter Becker is an investment director at Capital Group. He has 27 years of industry experience and has been with Capital Group for seven years. He holds a master’s degree from The Ingolstadt School of Management. He also holds the Chartered Financial Analyst® designation. Peter is based in London.
