20 Jul 2026
June prompted investors to reassess inflation prospects. The apparent resolution of tensions between the US and Iran drove oil prices sharply lower, improved the near-term outlook for headline inflation (although latest reports suggest the ceasefire could be over). However, resilient economic data and cautious central bank messaging suggest markets may have become too optimistic about the path back to target. We could therefore be navigating a macro environment where trending lower energy prices are masking more persistent underlying inflation pressures.
The US economy continues to outperform expectations, although the underlying picture is becoming more nuanced. Consumer spending has held up, albeit potentially flattered by temporary World Cup-related effects, while housing and labour market indicators have softened, pointing to gradual cooling rather than a material slowdown.
The inflation backdrop has become increasingly complex. While lower oil prices are expected to reduce headline inflation over coming months, core inflation remains sticky, and demand has yet to weaken sufficiently to provide confidence that inflation will return sustainably to target. Nevertheless, markets continue to price a benign inflation outlook, with headline CPI expected to fall below 2% next year - a view that appears more optimistic than recent data and central bank rhetoric would suggest.
Central bank communication reflects this disconnect. The Fed remains on hold, balancing resilient activity and stubborn core inflation against easing energy prices and softer labour market signals. While Chair Warsh's appointment has eased concerns over central bank independence, it has also increased uncertainty around the Fed's reaction function. In Europe, the ECB continues to leave the door open to another rate hike in September should inflation remain persistent.
Government bond markets rallied as falling oil prices improved the outlook for headline inflation, however, beyond the near-term, markets may be placing too much weight on lower energy prices and too little on the persistence of underlying inflation pressures. While lower energy prices should ease headline inflation, resilient growth, sticky core inflation and still-cautious central banks suggest underlying inflation pressures remain. At the same time, fiscal deficits and elevated government issuance continue to pressure longer-dated yields. We therefore continue to favour a tactical approach to duration rather than a meaningful extension of portfolio interest-rate risk.
Credit markets have proved resilient despite demanding valuations. Investment grade spreads remain close to historical tights, supported by solid corporate fundamentals and persistent demand for income. AI-related issuance continues to be well absorbed, although the growing supply pipeline warrants closer monitoring as it could eventually test market technicals.
Positioning therefore remains selective. Tight spreads leave little scope for capital appreciation, making carry the primary source of returns. Within high yield, selected BB-rated issuers continue to offer attractive risk-adjusted value, supported by exceptionally low default rates and spreads that comfortably exceed realised credit losses. Overall, stretched valuations and diverging technicals reinforce the case for favouring higher-quality credit while selectively adding risk where compensation remains attractive.
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Marion Le Morhedec
Global CIO, Fixed Income