Hedge Funds

There is Donald Trump 2.0, with tariffs, tax cuts and deregulation on the table. The geopolitical landscape looks increasingly uncomfortable, while elections in Germany could give the far right a seat in government. The major global economies appear to be in better shape, but fears of reviving inflationary pressures remain, while government debt levels give cause for concern.

In the meantime, stock markets remain polarised between the astonishing strength of the US, and the weakness of almost everywhere else. This has flattered the performance of index funds over active funds, and created a dilemma for investors. The bond markets have proved similarly uncertain, with significant shifts in interest rate expectations over the year. At the same time, narrowing credit spreads have left little wiggle room should economic conditions turn south.

Across government bond markets, Edwards is looking at three fundamental reasons to invest: valuation, policy certainty, and a catalyst for weakness in the economy. On this basis, he is finding the most compelling value in the UK bond markets.

He says: “In the US, there are great valuations, but not quite as much policy certainty as a few months ago. The economic outlook now appears more pro-growth and pro-inflation. In Europe, there is low growth, but there is also policy uncertainty, and valuations are not compelling, with yields of around 2.25% on 10-year German government bonds.

“Then you have the UK, where all three of these elements are broadly aligned. There is growth that looks more like Europe than the US, and there are yields that look more like the US than Europe, and since the election, there is a lot more policy certainty.”

He points out that 2024 has seen record inflows into bond funds, but most of them have gone into US and European bond markets, while flows into UK bond markets have been anaemic. He adds: “It is worth taking a moment to look at the last time bond yields were at their current level – it was in June last year. At that time, core inflation was 6.8%, the Bank of England hadn’t started cutting rates and the market was pricing three or four extra hikes. Now, core inflation is half that level, the Bank of England has cut rates twice and the market is pricing three interest rate cuts. It is a fundamentally different picture, but the yield on a 10-year gilt is still at a similar level.”

The relative weakness of the UK economy is also likely to be positive for the bond market. Consumer confidence and spending have been relatively weak, though uncertainty around the budget may also have played a role.

“Growth has flatlined in Q3 and is likely to be weak in Q4. The budget was bigger and bolder than many people expected, but was underwhelming in terms of the likelihood that it would create sustainable growth. Short-term investment is about patching up the NHS, schools and policing. All those things need to happen, but they’re not a recipe for an uplift in productivity. At some point next year, my assumption is that the Bank of England will start to focus on the weakening labour market outlook rather than the sticky inflation outlook.”

What’s the catalyst that would bring together attractive valuations, with the weaker economic outlook? Edwards adds: “People buying the asset class, like they have in Europe and the US. The catalyst will be when high cash rates start to disappear.”