In light of the many foreseeable political risks, we are more cautious in our outlook for the second quarter. If drivers of higher rates in Q1, namely rebounding inflation and U.S. fiscal optimism pause, the main risk is that U.S. rates might tilt lower. That said, government bond yields in much of the world rallied in Q1, taking them to the bottom of perceived trading ranges, potentially reflecting much reduced optimism that the world can break out of its long-term “secular stagnation.”
The Federal Reserve’s current strategy seems to be to raise rates opportunistically, picking moments that would be minimally disruptive to financial markets. The implication for fixed income investing is to build a portfolio that will out-carry and out-tighten the pace of rate hikes. Picking the right carry opportunities, ones that offer the best risk-adjusted return, will be a key component of outperformance.
We remain optimistic about the prospects for emerging market (EM) fixed income as country fundamentals and the macro environment remain supportive. Differentiation remains key. Those countries that are heavily reliant on global trade could be potentially challenged given pressures on globalization. On the other hand, commodity exporting countries could still benefit from improving fundamentals, higher commodity prices and undervalued exchange rates, while commodity importing countries that run large current account deficits are likely to underperform despite attractive carry cushions.
In corporate credit, we expect continued tightening across credit assets. In the U.S. we expect that continued robust demand for the investment-grade (IG) and high-yield (HY) asset classes will lead spreads tighter. In Europe we envision that both IG and HY should be well supported by the European Central Bank (ECB) and Bank of England (BoE) corporate bond (nonfinancials) purchases.
We continue to underweight agency mortgage-backed securities (MBS) due to their historically tight nominal and option-adjusted spreads, as well as the increasing risk that the Fed may decide to discontinue the reinvestment of MBS paydowns.
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