Edmund Shing:

Hello and welcome to a new podcast from BNP Paribas Wealth Management.

This week I want to talk about the bond market. Why the bond market? Well, there's been quite a lot of action in the bond market over the last few weeks, on the back of the lack of a deal to reopen the Strait of Hormuz, despite the U.S. Iranian ceasefire, and despite talks between the U.S. and Iran and between the U.S. and China recently.

If we look at the oil market today, we can see that Brent, for delivering December of this year, was in the 80 to 85 dollar range for most of March and April during the conflict, but is now higher at 91 dollars per barrel, reflecting a lack of progress in reopening the Strait of Hormuz and falling oil stocks. And even more so, this is evident in the dated cash Brent oil price, which is at 115 dollars, so remains at a big premium to the price for December.

At the same time, if we look at the price of oil products, such as U.S. diesel, this is now 5.60 dollars a gallon, and it was 3.70 pre-conflict. So that's far, far higher, a big impact potentially over time on consumers and on industry. Jet fuel in Singapore is almost two times pre-conflict levels, so particularly on long-distance flights, huge pressure from rising fuel costs leading to, of course, demand destruction as airlines reduce the number of flights in their schedule over the coming months given these higher prices.

So yes, we are seeing demand destruction, but at the same time we are also seeing higher inflation prints. For instance, in the U.S. for the month of April, both in terms of CPI and PPI numbers have been higher than were expected by consensus. For core CPI in April, you had a reading of 3.8 percent year-on-year, 3.7 percent was expected, and on producer prices, excluding energy, so core producer prices, we saw a reading of 5.2 percent versus 4.3 percent expected. So these higher fuel costs are coming through in not only energy inflation, but also non-energy inflation. Core inflation is also seeing the second-round effects starting to come through, particularly in the U.S. This, in turn, has hit bond markets. If we were to look at the 10-year benchmark government bond yields, they have risen in the U.S. from early May 4.36 percent to 4.65 percent now, so 0.3 percent higher yield.

For the German 10-year, we've gone from 3 percent to 3.17, and for the Japanese 10-year, we have gone from 2.47 percent to 2.78 percent, so a rise of somewhere between 0.2 to 0.3 percent across the board for 10-year bonds, reflecting higher inflation volatility. But interestingly, the adjustment in bond yields has been driven much more by higher real yields, not so much by higher inflation expectations over the longer term. So it's more the uncertainty that is leading to these higher yields. This, in turn, these higher bond yields should pressurise equity valuations, particularly in the US, where PE valuations are relatively high. And again, we are may be starting to see that now in the last few days, some weakness in the U.S, particularly in the S&P 500 and Nasdaq 100, after a very strong run- up on the back of very strong Q1 results, maybe a little bit of cooling now, pressured by these higher bond yields.

Now the question really is here: is this today an opportunity to buy bonds? Well, we think it probably is. If we look at corporate bond yields for investment grade, so for high quality bonds in Europe, you see an average of 3.8 percent today. And to recall, it was 3.2 percent yield for these investment grade corporates in Europe at the end of February pre-conflict. In the US, similarly, we're at 5.5 percent today for US investment grade corporate yields versus 4.9 percent pre-conflict. So both in the US and in Europe, a rise of around 0.6 percent in yields since the beginning of this conflict. So really offering much higher yields. And remember that with bonds as an asset class, the long-term expected returns are very close generally to the initial starting yields. So if you have a higher starting yield as we do today, then you should get higher expected returns over the long term.

Even if we come back to Europe, if you look at Italian government BTPs, they are now standing at 3.9 percent for the 10-year BTP. So again, much more attractive than they were pre-conflict. In my view, one of two situations can arise: either the negative sort of the glass half-empty scenario, the Strait of Hormuz remains closed for a lot longer, shortages of oil and oil products and demand destruction become much more widespread. This will lead to slow growth and indeed a much higher risk of global recession. And in the end, that should be good for bonds. Bonds tend to do well at times of slowing growth or when the risk of recession is rising.

Or on the other hand, the glass half-full scenario is that the Strait of Hormuz is reopened in the short term, then inflation pressures should ease gradually as the flow of oil and gas restarts. It will take some time, a few months, but again, it will restart. And we therefore, then in that scenario, expect both oil and gas prices to drift lower, easing those inflation pressures and again, that should be a pretty positive scenario for bonds.

So frankly, particularly for European investors, we would suggest that today is actually a pretty good entry point into the fixed income market, and I would certainly be looking very closely at European investment grade corporate bonds as a starting point.

Thank you very much for listening to this podcast from BNP Paribas Wealth Management. Please like, share, and subscribe to our weekly series of podcasts. Until next week, thank you for listening, and goodbye.