Insights
Let the Good Times Roll! But for How Long?
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Global Fixed Income Bulletin
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February 17, 2023
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Let the Good Times Roll! But for How Long?
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February 17, 2023
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Let the Good Times Roll! But for How Long?
Let the Good Times Roll! But for How Long? |
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What a difference a few days make. 2022 ended with a bear growl. Bond returns were deep in negative territory for December and for the year, as were U.S. equities. Move forward 30 days to the end of January and bonds are generating 4% returns while the S&P 500 index was up over 4.5%, recouping most of December’s losses. Indeed, after yields rose dramatically in December, bond markets made a U-turn and fell dramatically in January. Markets do not simply change direction this abruptly without a reason, and in this case, there were many.
First and foremost, the absence of central bank meetings gave markets some freedom to examine the state of the global economy and assess where it stood after the aggressive 2022 rate hikes. Additionally, central banks, by and large, did not come out with hawkish actions or comments in January. Surely, the pace and magnitude will slowdown, reasoned the market. And the market was proven right in early February when both the U.S. Federal Reserve (Fed) and the Bank of England (BoE) reduced the size of rate hikes from 50 basis points (bps) to 25 bps. While this outcome was market consensus, it validated the idea that monetary policy will be less of a drag on economies and markets in 2023. As such, volatility fell, supporting the idea that risk premiums could fall and support risk assets. As volatility diminished, the U.S. dollar continued to fall as the need for safe havens diminished and the economic outlook improved outside the U.S., particularly in Europe and in emerging markets.
Second, fundamentals generally went the right way. Inflation came down significantly in the U.S. Goods price inflation was negative. The U.S. housing market continued to weaken. The business outlook, as summarized in the ISM manufacturing and service sectors, pointed to outright recession. And the labor market seemed to be loosening, e.g., deceleration of wage and employment growth, a key factor in reducing service sector inflation. Yields had reached levels that suddenly seemed attractive if fundamentals were likely to continue to improve and generate one of the rarest of beasts, a “soft” economic landing. A big change from 2022 when markets bounced like a pin ball between the walls of fear of recession and inflation.
Third, FOMO—fear of missing out—certainly played a role, especially as fundamentals looked like they had turned the corner. After the dire financial performance of most financial assets in 2022, the danger of missing out on a bull market (bear market correction) must have been on people’s minds. After all, the best performing asset (outside of commodities) was U.S. dollar cash. Not a stretch to surmise that the investment community was likely long this asset coming into 2023. So, technical conditions played a role as markets rallied over the month. Short covering by speculators and the reduction of underweights by institutional and retail investors helped drive markets higher.
In summary, January was a gangbuster month for financial markets. A lot of fear and loathing evident in December disappeared allowing bonds, equities and non-U.S. currencies to rally. The continued decline in volatility was a key factor in allowing bond yields to fall, equities to rally and credit spreads to materially tighten. In fact, we believe the only way to square the circle of these asset returns is to suggest the market was both oversold, under owned, and a “soft” landing was coming, obviating the need for much more central bank tightening.
Fixed Income Outlook
Investors should not get too giddy about the start to 2023. Performance has been so exceptional in January, we think it will be difficult to replicate in the months ahead. While we do not anticipate giving back too much of the returns so far in 2023, a correction and range trading may be in order.
The market has been oscillating between the idea that the February Federal Open Market Committee (FOMC) 25 bps rate hike will be the last (or the last for a while) and the idea that inflation has not been beaten and more hikes will be warranted. Unfortunately, data in February has undermined the “soft” landing thesis which, in conjunction with the January rally in bond markets, is likely to generate a consolidation if not a modest correction in yields and spreads.
If risk-free and investment grade yields are going to fall further, inflation needs to keep falling, the economy cannot rebound too much, and the Fed (and other central banks) must stop raising interest rates. Yet, in no country is there evidence that labor markets are softening enough to bring down wage growth and thus core service sector inflation. Growth needs to be slow enough to bring down inflation, but not so much as to risk inflation and continued central bank rate hikes, and certainly not enough to cause a recession. Do not expect the Fed to lower rates unless there is a meaningful rise in unemployment, meaning well over 4%, unless inflation falls back to 2% on its own. Not impossible, in fact, that is the Fed forecast but, crucially, there is no rate cut in their forecast.
Markets and central banks no longer disagree much on the terminal (or peak) official interest rate in each country. The big debate is over how long they will stay at the peak. And on that question, there are reasonably big differences of opinion, with markets generally hopeful/optimistic that rates will peak no later than mid-year and then begin to fall later this year, and more substantially in 2024. The Fed believes this number, just over 5%, is likely the floor. The market not only believes it is the peak, but that it will fall significantly over the course of late 2023 and into 2024.
If the Fed is right, meaning the U.S. economy is stronger and/or inflation remains sticky, the U.S. bond market will need to reprice. This would likely take U.S. Treasury 10-year yields back toward 4%. The good news is that the likely poor outcome is only about a 25 bps increase. Much less than what happened in 2022 and less detrimental to returns given higher starting yields (and already realized 2023 returns). Similar analysis applies to other developed country bond markets.
In summary, government bond yields are stuck in a range for now. Markets probed the lower end in mid-December and again in January. Given the strong U.S. labor market data and ECB pushback on the dovish interpretation of its February rate hike, we are not likely to revisit those lows near term. Given prevailing uncertainties and a likely modest rise in volatility, we believe close to neutral positions in interest rate risk look appropriate for now.
In terms of sectors, we remain most positive on the securitized credit market. It has underperformed credit markets in 2023, which bodes well for further gains given the strong performance of credit. The securitized market consists primarily of residential and commercial mortgage-backed securities and asset-backed securities. Yields on most of these bonds are double last year’s, with spreads materially wider than in corporate credit markets (except for CCC-rated corporate bonds). We believe credit concerns are overdone and yields (either through spread compression or lower government yields) will end 2023 lower. Our favorite category of securitized credit remains non-agency residential mortgages, despite expectations that U.S. home prices will likely fall in 2023. Agency mortgages should outperform U.S. Treasuries, but we still worry about structural demand given the Fed’s quantitative tightening and bank’s reduced demand.
Corporate credit has performed exceptionally well in 2023. So well, in fact, we see little upside in further spread tightening in the near term. With U.S. investment grade (IG) spreads near long-term averages and a lot of uncertainty remaining on the economic and policy outlook, we do not think it is a great time to be overly bullish. That said, absolute yields look fine on a longer-term basis, especially if inflation does fall back to target over time and the Fed does not overdo the tightening, meaning they stop hiking around 5.25%. Euro investment grade looks like a better opportunity as the European Union (EU) benefits from falling energy prices, expansionary fiscal policy and a China reopening. This combination should also benefit the euro. We are buyers on weakness.
A similar analysis supports high yield credit markets, albeit with more risk stemming from a possible 2023 recession. Performance has been outstanding in 2023 and cannot continue at this pace. That said, we do not see a recession in the next six months and inflation should continue to improve, buttressing household cash flows and supporting aggregate demand. Default rates are likely to rise, but not spike, and remain more idiosyncratic than systemic. With high yield indexes yielding around 8%, we think there is still ample room for spreads to modestly widen and generate mid-single digit returns, if not higher. We prefer B-rated and selective CCC issuers.
The U.S. dollar is likely to remain under pressure in 2023 despite the January U.S. employment report. Like most assets in 2023, the dollar may have fallen too far too fast, but it should resume its downward trajectory as it becomes clear the U.S. economy is not exceptional currently. Other countries' growth outlooks are better, and their central banks are likely to raise rates more and the dollar still looks overvalued. But further depreciation may take time, particularly if the Fed follows through on NOT cutting rates in 2023. Emerging Market (EM) bonds continue to gain in attractiveness, and we expect local markets and FX to outperform. Real yield differentials to U.S. Treasuries remain at historically wide levels. As usual, investors need to be aware of the various idiosyncratic risks in each country. EM is not a homogenous market. China’s reopening should be quite positive for EM in general and helpful for the global economy.
Developed Market Rate/Foreign Currency
Monthly Review
Yields fell broadly to start the year, reversing the brief sell-off in December. In the U.S., while economic data continued to show that inflation levels were elevated and labor markets were tight, data also showed that the economic strength was starting to potentially weaken. PMI/ISM data depicted consistent, contractionary levels and retail sales were weak. In terms of inflation concerns, the CPI print was in line with expectations, but showed further progress as inflation rates fell from prior levels. Likewise, the employment cost index was lower than expected, but still at an elevated level. Elsewhere in North America, the Bank of Canada hiked 25 bps as expected, but indicated that it was most likely pausing for now. The data in Europe contrasted with the U.S., as Eurozone economic data surprised to the upside, and core inflation data remained resilient. Finally, the Bank of Japan (BoJ), in a highly anticipated decision, chose to keep the yield curve control policy the same, resulting in Japanese government bonds initially rallying, but subsequently rising back close to the 50-bps level by the end of the month.1
Outlook
While some of the recent economic data has started to show signs of potential weakness, and inflation levels are starting to roll over, there is still considerable uncertainty in terms of the future path for interest rates and economic data. In our view, the rates market is priced close to fair provided the current data; however, central bankers have been quite clear in their determination to keep rates high, and while inflation will continue to come down from their peaks, inflation and labor market data prints are still indicating that the economy is overheated. Following the rally during January, the market is still eagerly hoping that inflation will come down quickly, with the market pricing in considerable cuts from the Fed over the next two years, in direct contrast with the Fed’s own messaging. As a result, the risk for rates still seems to be for them to go marginally higher. In terms of foreign exchange, last year the U.S. dollar benefited from tighter Fed policy and growing global growth concerns; however, that trend stopped at the end of 2022 and has continued to reverse as 2023 begins. Broadly, we think that U.S. dollar weakness could continue for now.
Emerging Market Rate/Foreign Currency
Monthly Review
Emerging markets debt (EMD) continued its strong rally from the end of 2022 into the New Year. The U.S. dollar continued to weaken which helped many EM currencies rally, in particular Asia currencies. China’s reopening after a dramatic reversal of its longstanding zero-COVID policy is likely to increase growth and eliminate some uncertainty in the region. In Peru, protests escalated in January following an attempted coup and arrest of Peru’s former President Catillo, which escalated instability in the country. Technicals started to recover in the last few months of 2022, but January saw a substantial shift in investor interest for the asset class. Both hard and local currency funds experienced notable inflows with $5.8 billion and $1.9 billion, respectively. All EMD risk factors produced positive performance during the month.2
Outlook
The asset class is positioned to continue the rally in 2023. Local rates in particular are attractive, in our view, as real yield differentials between emerging and developed markets remain high. As the Fed continues to moderate policy, this will be supportive for many EM countries. The asset class experienced record outflows in 2022, but sentiment shifted in the fourth quarter and continued in a dramatic fashion in January with strong positive flows for both hard and local currency funds. We expect inflows to continue as investors begin to add risk back to their portfolios. Fundamentals continue to improve and valuations remain compelling, but there is wide dispersion among countries and credits so evaluating all opportunities from the bottom up is critical.
Corporate Credit
Monthly Review
Euro IG spreads outperformed U.S. IG spreads in the rally this month as a combination of improving sentiment and a strong technical supported the market (consensus expectation was reported as moving from a mild recession to a soft landing). Drivers in the month included inflation data trending lower, China policy focusing more on growth and fourth quarter corporate reporting that exceeded expectations.3
The U.S. and global high yield markets kicked off 2023 with a strong opening act in January. Investors took advantage of historically attractive starting yields, on average, amid increasing expectations that the Fed was nearing the end of its aggressive campaign of rate increases. The supply/demand balance was supportive in January as the high yield primary market reopened and retail funds experienced net-inflows.4 The lower quality segments of the market generally outperformed and the top performing sectors for the month were natural gas utility, brokerage, asset managers and exchanges and finance companies.5
Global convertibles started the year strongly on a rebound in high-growth assets as investors began to forecast a slow down to rising rates. In January, convertibles performed in between global stocks and global bonds with the Refinitiv Global Convertibles Focus Index returning 4.76%. This was the best month for convertibles performance since November 2020 as it was pushed up by most of the key underlying factors – equities, spreads and rates. The only detractor to asset class valuation was a drop in volatility which typically acts as a hedge against equity markets, where vol often rises when stocks are up and falls when stocks are down. There was, however, a slow start in the primary market, as just $2.4bn in new paper was priced.6
Outlook
Looking forward, our base case view is that we are compensated to own credit as we view corporate fundamentals to be resilient and the macro backdrop to likely improve as monetary policy pivots and China re-opens. We view companies as having built liquidity and implemented cost efficiencies under the COVID-era. We expect margins to be pressured and top-line revenue to be challenging, but given the starting point, we believe corporates will be able to manage a slowdown without significant downgrades or defaults.
The rally in high yield bond markets in January may persist in the near term; however, it seems likely that it will eventually fade given the extent to which valuations have already compressed in January and the risks that still lay on the horizon.
Securitized Products
Monthly Review
Agency MBS spreads and securitized credit spreads were tighter in January. Securitized credit spreads lagged much of the corporate credit spread tightening in the fourth quarter and continue to look attractive on a relative value basis. New issue securitized supply remains very low as loan origination in both residential loans and commercial loans has declined substantially. Securitized fundamental credit remains stable – delinquencies are rising slowly, but remain low from a historical basis, and do not appear to be threatening to the thick levels of structural credit protection for most securitized assets. U.S. home prices have fallen ~5% from the peak in June, and we expect home prices to fall another 5-10% in 2023.7
Outlook
U.S. residential credit remains our favorite sector, despite our expectations of home price declines, with a strong preference for seasoned loans (originated in 2020 or earlier) due to the sizable home price appreciation over the past few years. We remain more cautious of commercial real estate, which continues to be negatively impacted in the post-pandemic world and could also be impacted by a recession. We pivoted meaningfully away from our European overweight to the U.S., as risk-adjusted opportunities looked more compelling in the U.S., but as spreads have normalized and economic conditions have improved, we have become less concerned with European opportunities.