Benstead on Bonds: in a worst-case scenario, can gilts deliver?

When Donald Trump was initially elected president, investors celebrated. The S&P 500, measured in sterling, rose about 12% from 5 November 2024 to the end of January this year.

Bond yields initially fell for US and UK government debt, caused by investor buying, pushing bond prices higher. This didn’t last for long. Fears of rising inflation pushed bond yields higher from December until mid-January.

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But the honeymoon period is well and truly over now. Investors are losing confidence in Trump’s rhetoric that he would measure his success on the strength of the US economy and stock market. The “Trump put”, that if stock markets fell too much, he would reverse policy, may no longer hold. He has said that there would be a “transition period” before “bringing wealth back to America”.

Trump is see-sawing on tariffs against Mexico, Canada and China, and threatening to withdraw all military support for Ukraine, which is another indicator of how isolationist the US is becoming.

Investors are now fearing that Trump could tip the US into recession, as well as cause an inflationary spike, as tariffs would increase the costs of goods for consumers and most companies have complex international supply chains. Above all, investors are struggling to interpret the president’s plans, which causes uncertainty.

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The market response has not been pretty, with US shares falling 11% from their highs, erasing all the gains since Trump’s election. Global shares are down about 8.5% from their highs and the Nasdaq 100 technology index is around 14% lower. This includes a 20% drop for the Magnificent Seven technology shares.

What could the economic impact be?

The worst-case scenario if Trump continues with tariffs could be really damaging for the global economy, the UK included.

Ed Heaven, head of sustainable investments at Montanaro Asset Management, says that history suggests that the overall economic impact of tariffs will be negative.

“Protectionism has a poor track record. The early signs point in this direction: US GDP growth has already been revised downward, signalling a weaker outlook,” he said.

Ruffer, the fund manager, says that inflation is already ticking higher and the worst could be yet to come.

“Remember those inflation targets? January’s US CPI data sent a clear signal: core consumer prices are rising at the fastest monthly rate for two years. Worryingly, the five-year rolling average US inflation has more than doubled from 2% pre-pandemic to 4.3% – a level last seen in 1986.

“And that’s even before any impact from the new administration’s inflationary policies, such as tariffs, export controls and deportations. The evidence suggests we’ve entered a new regime of structurally higher and more volatile inflation,” it said.

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However, bond yields have moved lower, caused by higher prices, as investors turn to fixed income as a safe haven.

The US 10-year Treasury now yields 4.3%, down from 4.8% in the middle of January. The 10-year UK gilt has moved from 4.9% to 4.7% over the same period. 

But bonds could be pulled in two ways – a recession could be good news, as it would prompt central banks to cut interest rates. On the other hand, higher inflation may limit rate cuts so as not to stimulate the economy and add to inflationary pressures.

Can fixed income be a safe haven?

It can, according to Huw Davies, manager of the Jupiter Global Macro Bond fund. His view is that despite inflationary risks, fixed income is still a relevant diversifier in portfolios.

His view is that we have re-entered a period when inflation is low enough to show diversification benefit of bonds in a weak equity environment. However, he adds that inflation is now easier to generate than before due to a pullback from globalisation.

“But in the UK, the Bank of England knows it can’t do much about the impact of tariffs, so it can look through that risk. The counterpoint is that if service inflation rises then that would challenge the Bank of England’s view,” Davies said.

The fund manager adds that markets actually show US inflation expectations falling as the risk of an economic slowdown are more relevant than any inflationary consequences of tariffs.

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On gilts, he says that 5% yields from the longest maturity gilts are attractive, but also gilts maturing in five to 10 years also offer good value and could see capital gains as interest rates move lower.

He also says that long-dated inflation-linked gilts, which can offer 2% yields above the RPI inflation rate, also offer great value for investors who are worried about inflation, so long as they are happy to hold to maturity and sit through any price volatility.

Monthly bond funds, which pay out income each month also look attractive he says, with annual yields in some cases above 6% and capital growth possible if rates fall more than markets expect.

Another optimist on fixed income is Jason Borbora-Sheen, multi-asset portfolio manager at fund manager Ninety One.

He says that fixed income as an asset class looks far more compelling than 10 years ago due to higher yields, but the type of bond you buy makes a big difference.

“Holding gilts to maturity means you won’t lose money, but you can still see a short-term loss due to price movements, especially on longer gilts. The further you are away from maturity the more other factors influence the price of bonds.”

While you can still lose money in the short term on gilts, he says that the diversification benefits of bonds are real.

“Bonds have the potential to benefit from meaningful rate cuts, giving you capital gains, and there is also income on offer via coupons,” he said.

However, Borbora-Sheen warns that corporate bonds are currently expensive and the extra yield on offer over government bonds does not compensate investors for the greater price risk.