April 10, 2023
Reasons to Worry (Or Not Worry)
April 10, 2023
Investors were “dazed and confused” about the events of March and their potential impact. Worries about “too strong” growth flipped into worries about weak growth. Early in the month, after a string of stronger than expected U.S. economic data, it became clear that the Federal Reserve was more likely to dial up its hawkishness than dial it down, notwithstanding other central banks moving to pause their rate hiking cycles. But just as markets had repriced U.S. Treasury yields higher post Chairman Powell’s Congressional testimony, problems in the banking sector arose in dramatic fashion, with the failure of regional U.S. banks and the takeover of Credit Suisse. This sent U.S. yields tumbling. From March 8 to March 13, the U.S. Treasury 2-year yield fell from 5.07% to 3.99%, a 108 basis point (bp) drop in three business days (unprecedented outside of easing cycles and the financial crises). Worries of a “no landing” of the U.S. economy (which had just grown from “soft landing”) switched to worries of a “hard landing.” Consensus expectations now foresee no U.S. economic growth for the remainder of the year. Instead of worrying about a potential 6% Fed funds rate in a “no landing” scenario, the market became worried about a 3% Fed funds rate.
The banking sector turmoil caused significant market volatility in March, impacting multiple sectors, but primarily government bonds. Developed market rates experienced historic price action following hawkish Fed rhetoric early in the month, with yields initially rising and the unprecedented yield curve inversion intensifying. Other countries' yields duly followed. The further inversion of yield curves was completely unwound once the banking sector turmoil began, as investors sought safe havens in U.S. Treasuries and other government bonds.
During this tumultuous period, key economic data was mixed. A slightly stronger than expected CPI print showed that inflation remained sticky, supported by still strong service sector spending. Central banks in the developed economies largely remained committed to rate hikes. What was notable was the dialing down of forward guidance with regard to future rate hikes given the uncertainty of the consequences of banking sector stresses.
In contrast, emerging markets (EM) held up relatively well, with strong performance in EM local assets. Many EM currencies, particularly Latin American currencies, strengthened during the period as fears of a more pronounced slowdown in the U.S. economy, if not recession, grew.
Credit markets weren’t so lucky and experienced elevated volatility following the regional banking crisis, with markets demanding a higher risk premium. Fortunately, credit markets settled down after there were no further events that would suggest widespread volatility within the banking sector.
While developed markets experienced historically high price volatility, emerging markets held up well. The U.S. and global high yield markets saw increased volatility, but little lasting damage, while Euro investment grade (IG) spreads underperformed U.S. IG spreads. The securitized credit market also saw widening spreads. Despite the challenges, central banks largely remained committed to rate hikes, and the market gained confidence as the risk of a widespread banking crisis declined.
Fixed Income Outlook
Given the repricing of government bonds and heightened risk of recession in March, the spread widening was surprisingly muted. And price action in early April pushed credit spreads back towards their pre-banking turmoil levels. So, is it all a tempest in a teapot? A false alarm? Or something more sinister? Whichever answer is correct will have huge implications.
There are reasons to be worried and reasons to be more sanguine. What we do know is that the probability of a recession is higher now than it was in February, and the economic data in March was disappointing. While we do not believe the events of March are a harbinger of a new financial crisis, it does point to weak links in the economy and increased stresses that are likely to unfold in the months ahead. That said, the global economy rebounded strongly in the first quarter. The service sector outside the U.S. boomed. Whether or not that can continue in the face of weaker U.S. data remains to be seen.
March banking events laid bare the costs of the Fed's aggressive hiking on the banking system. Even without a crisis, we believe profitability looks challenged and unrealized losses on asset holdings look high as a percentage of capital. This is likely to lead to reduced lending and stricter lending standards as profitability is restored. Evidence released from the Fed already points to a significant slowdown in bank lending. Whether or not this gets worse we do not know. We think this should lead to slower growth in the months ahead, which should help keep yields low and put upward pressure on credit spreads.
Moreover, inflation is not beat. And the situation is worse outside the U.S. with inflation being particularly intransigent in Europe (although good news should start arriving by summer). This puts central banks between a rock and a hard place. Financial stability is wobbling. Economies are likely to decelerate over the next few quarters (albeit after surprisingly strong growth in Q1), which suggests pausing now or even considering rate cuts by the end of the year. But, labor markets and core inflation continue to signal strength, not weakness. The Fed is unlikely to take too many chances, so they are unlikely to respond to higher unemployment unless we get a string of negative job reports.
So, the conundrum to policymakers and investors. Has enough been done on the rate front to halt tightening and countenance easing? Or is the big Treasury rally a head fake, a knee jerk reaction to the banking turmoil and the need to price a higher probability of a crisis even though it is not likely to happen? The longer more problems do not emerge in the global banking sector, the more likely the rally in government bonds will pause if not reverse. Inflation data will continue to be key. If core inflation remains intransigent, the more likely a “hard landing” will occur to the benefit of government bonds and the detriment to credit markets, particularly lower rated bonds. Balancing these risks suggests to us that the Fed will hike rates 25 bps in May, but that will likely be the last rate hike of 2023. What happens after May remains to be seen.
While government bond markets look overbought for now, longer term it does appear recent events are likely to lead to a recession, lower yields and steeper yield curves. In this context, we are biased to buy higher yields: curves may be too steep in the short term due to expectations of too many rate cuts but will likely be steeper by year end, and credit markets will need to reflect weaker economic growth as central banks remain committed to bringing down inflation even at the cost of recession. But our baseline scenario remains one of modest economic weakness, with any significant credit spread widening a buying opportunity.
In terms of sectors, we remain most positive on the securitized credit market. We think the credit risk of residential and selective commercial mortgage-backed securities (MBS) like multi-family housing is attractive given the strong starting point for household and corporate balance sheets, and strong household income growth. Our favorite category of securitized credit remains non-agency residential mortgages, despite expectations that U.S. home prices will likely fall in 2023.
Recent events look to be negative for the U.S. dollar. U.S. growth is likely to be weaker medium term, the probability of a recession has increased, and whatever the Fed does it is not likely to help. If the Fed holds policy rates unchanged to combat inflation in the face of weaker data and/or banking sector stresses it is likely to be negative for the dollar. If the Fed cuts rates while inflation is still too high in response to economic weakness or financial stability concerns, it is likely to be negative for the U.S. dollar. We continue to like being underweight the dollar versus a basket of developed and emerging market currencies.
Developed Market Rate/Foreign Currency
The March price action for developed market rates was staggering and historic. At the start of the month, hawkish language from Fed members including Chairman Powell saw yields continue their movement upwards; however, that was quickly reversed as the collapse of Silicon Valley Bank (SVB) unfolded. After spiking, rate volatility slowly declined from the highs but remained elevated throughout the month as the market digested news and tried to interpret the impact the banking situation will have. Beyond the banking story, key economic data was mixed, but a slightly stronger than expected CPI print showed that inflation was still sticky. In terms of central bank meetings, prior to the SVB collapse, the RBA raised rates 25 bps and the Bank of Canada paused. Following the banking situation, there was a shift to more dovish language, but central banks largely remained committed to hikes, with the ECB and Swiss National Bank hiking 50 bps, while the Fed, Norges Bank, and Bank of England raised rates 25 bps.1
The issues in the banking sector led to more volatility in markets and new uncertainties. At this point, it seems the market is adjusting for a shift in the tail risks, as scenarios where the Fed goes much higher (i.e. taking rates to 6%) seems much less likely, while a recession has become more likely. Unfortunately for the Fed, while the banking issues will likely be disinflationary, core inflation is still elevated and sticky. Given the uncertainty, it is difficult to concretely express an outright view on interest rates, and it may be wise to be patient for now, awaiting further clarification while taking advantage of more relative dislocations. In terms of foreign exchange, coming into this situation, we thought the U.S. dollar could weaken, which it has continued to do. We still believe that dollar weakness could continue.
Emerging Market Rate/Foreign Currency
Emerging Markets broadly held up well, especially EM local assets, during the elevated volatility from the U.S. bank fallout. Many EM currencies strengthened during the period, particularly LatAm currencies. The EM rate rally was less volatile than U.S. rates, which created a good tailwind for EM local assets.2
We are cautiously optimistic on the asset class as peak inflation and hawkish policy are likely behind us. Emerging markets assets performed well during the heightened volatility in global markets during the month and local assets, in particular, remain attractive. Bottom-up country and credit analysis will remain crucial to identify pockets of opportunity.
Euro Investment Grade (IG) spreads underperformed U.S. IG spreads this month amidst elevated credit market volatility as banking sector concerns dominated both markets. Euro IG closed 22 bps wider at 170 bps while U.S. IG closed 14 bps wider at 138 bps. Despite authorities providing solutions that addressed the question of systemic risk, markets demanded a higher risk premium. More broadly markets focused on the risks of higher funding costs impacting profitability, liquidity risk following runs on deposits, the potential that lending standards would tighten impacting future growth, and inflation data continuing to drive terminal rate expectations. Towards month-end the market took confidence from no follow-on headlines suggesting the events were somewhat idiosyncratic resulting in equity and interest rate volatility falling supportive of tighter credit spreads.3
Volatility in the U.S. and global high yield markets leapt higher in March following the bank turmoil. The supply/demand balance was erratic in March as the high yield primary market ground to a halt amid the spike in volatility as demand retreated and U.S. high yield retail funds experienced a net-outflow. The higher quality segments of the market generally outperformed in March, after lagging in the first two months of the year.4
Global convertibles had mixed performance in March as markets reacted to weakness in the banking sector and the prospect of a looming recession.5
IG credit fundamentals can be summarised as “things are better in 2023 but far from good.” Despite support for the IG credit market from numerous sources, multiple headwinds suggest IG credit warrants an above average risk premium. Recent banking news highlight the idiosyncratic risks in the market, central banks are still raising rates, inflation is likely to be sticky given the strength in the labour market, and corporate profitability will be pressured by higher input costs. Technical demand for IG credit has been a positive, we expect IG credit to benefit from demand for an attractively valued high-quality asset in an environment of increased uncertainty. Valuation levels suggest room for spread tightening as well as an attractive running yield.
We remain cautious on the high yield market as we enter the second quarter of 2023. Episodic weakness accompanied by volatile spread movement seems to be the most likely path forward.
Interest rates rallied as investors sought safe havens in U.S. Treasuries, and spreads in most fixed income credit sectors, including securitized credit, widened in March as part of this risk-off shift. New issue securitized supply remains very low as loan origination in both residential loans and commercial loans has declined substantially. We continue to believe that the fundamental credit conditions of residential housing loan markets remain sound, but also believe that higher risk premiums are warranted across all credit assets given projected economic weakness.6
U.S. home prices have fallen approximately 6% from their peak in June, and we expect them to fall another 5-10% for the remainder of 2023. Despite our expectations of home price declines, U.S. residential credit remains our favorite sector, 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. This stress has been exacerbated by the weakness in regional banks as future lending may be more constrained. We pivoted meaningfully away from our European overweight to the U.S., as risk-adjusted opportunities looked more compelling in the U.S. As spreads have normalized and economic conditions have improved, we have become less concerned with European opportunities.