Markets vs. macro: Follow the fundamentals in fixed income

Fixed income investors have had to adjust to a dramatic shift in market conditions as the year has evolved.

Having begun 2026 pricing rate cuts and falling inflation, government bond yields have been reset higher in recent weeks as the war in the Middle East has kept pressure on oil prices and forced central banks to turn hawkish. While growth and labour markets have held up well, higher oil prices and renewed inflationary pressure, alongside a surge in hyperscaler bond issuance and concerns over central bank credibility, have impacted total returns in fixed income year-to-date.

Despite the more complicated macro outlook, economic fundamentals continue to show resilience with growth and labour markets holding firm. And while persistent weakness in government bonds creates an uncomfortable environment for investors, higher yields mean fixed income markets are now offering higher breakevens than they have in years, and in our view, there remains a strong case for staying invested in corporate credit and fixed income assets in general.

Markets can absorb some of the energy price shock

The current climate of elevated oil prices cannot continue indefinitely without becoming a drag on the global economy. However, it has yet to have a meaningful impact on growth, partly because countries have drawn down their reserves to protect consumers. The global economy appears able to manage the impact of Brent crude trading at around $80-90 per barrel, but we would expect significant breakage if prices were sustained closer to $120. 

US growth is still expected to be around 2.1% for 2026, while UK and Eurozone growth rates are closer to 1% (see Exhibit 1). While projections are lower than pre-conflict, considering the scale of the energy shock the picture remains positive, particularly for the US economy which added 162,000 jobs in August. Exhibit 1: Resilient growth has defied expectations
 

Second round inflation effects are limited

The rise in commodity prices has put significant pressure on inflation, though it is worth noting here that the rise has been driven almost exclusively by energy (see Exhibit 2), a marked difference from the broader prices and “second round” effects that were evident in 2022.

Still, second round effects remain a legitimate concern for markets and for central bankers, evidenced by the Federal Reserve’s (Fed) interest rate hike last month. Of the US, the UK and the Eurozone, only the latter had inflation at or below target before the conflict in the Middle East. The US has been above its inflation target since February 2021, while the UK was last below its target in September 2024. The current inflation cycle may require central banks to raise their estimates of the neutral rate (the level at which interest rates neither stimulate nor restrict economic activity), which is one of the reasons market pricing points to further hikes from the Fed and other central banks.
 

Geopolitical outlook calls for selectivity

It is no exaggeration to say the world order has fundamentally changed in recent years, with President Trump reshaping the relationships the US maintains with some of its most important allies. Increased geopolitical uncertainty can prompt higher risk premiums as investors might require additional compensation for the wider spectrum of possible outcomes. 

Elsewhere in the West, voters remain highly polarised, which increases the probability of extreme scenarios going forward. Recent election results in Australia and in particular Germany have solidified this assessment, while the possibility of a Le Pen-Mélenchon run-off in France’s presidential election next year means political tensions are not going away. The election of either candidate in France may result in policy uncertainty, which could affect investor perceptions of French sovereign debt.

The geopolitical uncertainty exhibited in countries such as France has highlighted the value of political stability. Giorgia Meloni’s government recently became the longest-serving Italian government since World War II. For investors, this continuity has translated into tighter spreads, which in our view are justified.

This underlines the need to be selective and somewhat diversified across sovereign markets, as they offer different degrees of political stability, debt dynamics, fiscal credibility and yields. We currently have a greater preference for Bunds over US Treasuries (USTs) than many of our peers, for example. The US government’s debt-to-GDP ratio is significantly higher and more challenging than Germany’s, while US inflation appears more demand driven than in Europe. Despite the recent rate hike in the US, we believe lingering Fed credibility concerns support our preference for Bunds. 

Hyperscaler supply is reshaping the long end

Hyperscalers are one area of the fixed income universe that has brushed aside the geopolitical headwinds, becoming one of the year’s defining themes. Bond issuance is expected to reach a record $250bn this year, helping fund the rising capital expenditure. 

While hyperscaler volumes are significant on their own, their impact on the long end of the US Treasury curve is particularly noteworthy. Since 2025, a disproportionate share of hyperscaler debt has been issued at the long end of the curve. The extension of tenors has created a glut of supply, which is now competing for the same investors who have traditionally bought USTs, which has helped to push 30-year yields higher.

While credit spreads across sectors remain tight relative to history, hyperscaler bonds are one area where we see potential relative value, because the weight of supply has pushed the spreads of certain issuers abnormally high relative to their ratings; our focus is on hyperscalers with strong fundamentals and established cloud businesses.

Beyond hyperscaler bonds, rising leverage and the circularity of the artificial intelligence (AI) trade, as well as tech valuations, are of concern. The amounts involved have become hard to ignore from a macro point of view. Turmoil in this sector might not be circumscribed to tech or AI only, which means we must remain vigilant even if we do not have a large exposure to the sector.

Corporate fundamentals underpin spreads below long-term averages

European financials have never been as well capitalised in the last 10 years as they are right now. The Common Equity Tier 1 (CET1) ratio sits around 16% for European banks, while the non-performing loan (NPL) ratio remains around 2%, underpinning bank stability and free-flowing credit. 

The strength of financials is further highlighted by their improvement in credit ratings. In 2019, around 20% of Additional Tier 1 (AT1) debt was majority investment grade rated; now it is just under 40%, underscoring the improved average credit quality of European banks, while default rates remain under control.

Together, these factors have created an environment in which subordinated financials have outperformed the market year-to-date. With strong capital positions, improving credit quality and low default rates, we believe this outperformance of broader credit markets can continue.

Non-financial corporates also exhibit strong fundamentals, with leverage and interest coverage ratios that remain well under control.

Considering this backdrop, we would note that spreads well below their long-term averages does not necessarily equate to spreads being “expensive”. In our view, there is good reason why spreads are tight, and while we do not think they look overly “cheap” at this juncture, nor do we think they look prone to a large sell-off.

Resilience, but selectivity is key

Despite the changing backdrop, fixed income fundamentals have remained resilient throughout 2026. The higher yield environment has hurt year-to-date returns but has also made the opportunity set more attractive. Selectivity remains essential though. 

While government bonds do look attractive to us with a medium-term view, we believe the case for overweighting credit remains, though with a significant bias towards higher quality names, moderate duration and high vigilance towards the broader macro risks.