Kellie Wood.

Based on recessionary indicators, there is a 70 per cent chance of a recession occurring in the US over the next twelve months, according to the fixed income team at Schroders.

A US recession will significantly impact Australia’s economy due to close trade and financial ties. It will reduce demand for Australian exports, decrease investment flows, lower commodity prices, weaken the Australian dollar, and reduce tourism.

The extent of these effects, however, would entirely depend on the severity and duration of the recession, as well as other factors affecting the global economy.

There will likely be no adverse effects on Australian bond markets, however.

“We are very excited about this year and next year in terms of decent returns from bond markets,” Schroder fixed income fund manager Kellie Wood said at a media lunch recently.

“We’ve also seen a huge restoring of valuations across the whole of the fixed income universe over the past year.”

She added that the economic cycle has started to support very decent returns from bonds, and there has been significant volatility over the last month.

“There has been a lot of volatility surrounding the US/European banking crisis,” Wood said, referring to the banking crisis that commenced with the collapse of Silicon Valley Bank.

Firstly, Schroder has seen a flight to quality where bonds have out-performed every other asset class. There has also been a significant collapse in bond yields, and the market pricing the real risk of recession.

Secondly, credit spreads have widened driven by the uncertainty associated with the banking crisis and the fear of a dislocation in funding markets.

“This is where we’re seeing the scramble for liquidity,” Wood said, adding that there has also been a significant increase in banks accessing central bank liquidity facilities.

Although the situation is contained to banks in the US and Europe, Schroder believes there will be broader implications.

“We’re seeing a financial system being extremely stressed, and we’re expecting government bonds to out-perform equities over the next few years.”

Therefore, Schroder is positioning itself for a significant tightening of lending standards over the next three to six months, and this will do the work for central banks.