Global Fixed Income Bulletin
June 14, 2023
June 14, 2023
Underpromise and Overdeliver
June 14, 2023
Expectations for the month of May were set low for the U.S. economy, but even with all the volatility during the month, the U.S. economy appeared to come out stronger. As the banking turmoil from March entered the rearview mirror, all eyes turned to the U.S. debt ceiling. Once a deal became imminent, that uncertainty subsided and all eyes turned back to the economic data. The U.S. did not disappoint, further pushing off to the future recession and Fed rate cuts.
Coming into May, the scene was set for a weakening U.S. economy relative to the Euro-area and China, but economic and labour market data came in stronger than expected. Employment data surprised to the upside for the 13th month in a row (only to be surpassed with data released in early June). Other labour market data prints, including JOLTS, ADP and initial jobless claims, were also on the stronger side. In Europe, the markets were confronted with downside surprises in both headline and core inflation and slowing growth expectations. In China, data also came in weaker than expected, disappointing China bulls, with May PMIs confirming the economy’s weakness and the economy showing a continued drag from the property sector.
Developed market central banks continued to raise policy rates to fight recalcitrant inflation. This drove global yields materially higher, with the 10-year U.S. Treasury up 22 basis points (bps), and credit spreads wider. Stronger U.S. data, a somewhat hawkish Fed and lower than expected eurozone inflation supported U.S. dollar strength, reversing course from the first quarter. Credit markets are still worried about tighter lending conditions due to the U.S. regional banking problems, with the Fed’s senior loan survey showing recession-like conditions. By the end of the month, however, sentiment did improve, tightening spreads from their intra-month wides. The U.S. agency mortgage market continued to experience wider spreads as the spectre of bank and Fed selling hurt confidence. The stronger U.S. economy and more hawkish Fed also negatively impacted Emerging Market Debt (EMD) as the U.S. dollar outperformed most EM currencies.
Fixed Income Outlook
Bringing down inflation remains the name of the policy game, but it is clear the end is near for the rate hiking cycle. Economic data has slowed in the Eurozone, suggesting that the tightening has been effective at slowing the economy and inflation has begun to slow meaningfully, albeit from very high levels that remain above that in the U.S. However, inflation is not falling fast enough, nor are labour markets and wages showing signs of moderating. No developed market central bank is predicting its next move will be a rate cut. In fact, in early June, the central banks of Australia and Canada surprised markets and analysts by raising rates somewhat unexpectedly, providing evidence that a “pause” in rate hikes does not mean the hiking cycle is over. Although headline inflation has fallen significantly and continues to fall, core inflation numbers remain high in the Eurozone and elsewhere with wage acceleration still an issue. We plan to maintain a relative duration underweight in the Eurozone as we expect the European Central Bank (ECB) to be relatively more hawkish than other DM central banks. In the U.S., the issue for markets is that inflation is not coming down fast enough to stop the central bank from continuing to raise rates. A still resilient service sector is offsetting weakness in manufacturing/industrial activity. An unusual combination by business cycle standards, but then this business cycle is like no other.
Rate cuts have been priced out of the U.S. market for 2023. While a pause in June may still be in play, it is uncertain whether or not the U.S. will need to continue to raise rates at both the June and July meetings. Even the most ardent hawks on the Federal Open Market Committee (FOMC) concede that policy is not in restrictive territory. The question is how restrictive and how long does the Fed want to take to get inflation to target. We do not expect a dovish outcome; neutral maybe, even hawkish, if they raise the dot plot. The Fed’s renewed hawkishness in recent months and surprisingly strong data has further strengthened the U.S. dollar. We do not think this is generally sustainable and recommend an underweight stance.
The resolution of the U.S. debt ceiling crisis and solid employment and household consumption data is likely to keep the U.S. out of recession this year. The absence of a trigger for household and corporate spending retrenchment suggests the economy will do fine over the summer (as will most developed market economies) and is positive for risk assets. Our strategy remains one of taking risk where opportunities suggest adequate yield to compensate for unexpected volatility or surprising bad news, whether geopolitical, economic or policy induced. Medium term risks of an economic slowdown remain, with the impact of tighter lending conditions, tight monetary policy and a slowing labour market picture still to be fully felt by consumers and corporates. We envision a moderate recession in 2024 with no dramatic rise in defaults or risk premium - maybe a semi-soft landing?
We believe corporate bonds should be able to earn their yields through the third quarter. Issuance is likely to remain elevated in June, with corporates looking to take advantage of demand for investment grade credit with front-loaded supply acting as a headwind for spread tightening. Given the broader economic headwinds, but still positive momentum, we see carry rather than capital appreciation as the likely driver of investment grade corporate returns in the second half of 2023.
With yields expected to rise, we will look to increase interest rate risk in portfolios on further setbacks in Treasury yields. Economies are growing slowly and inflation is falling, both good for bonds. Additionally, we continue to look for ways to intelligently upgrade credit quality, minimizing give-ups in expected returns. We think credit markets look modestly undervalued but, in the investment grade space, this value comes predominantly from bonds issued by financial institutions. Spreads are above average but not materially so, making credit a carry game with limited opportunities for near-term spread compression. Given that we expect an economic slowdown but no meaningful recession this year, shorter-dated high yield bonds look attractive and, if chosen carefully, can generate an attractive return.
Securitized credit continues to look like the most attractive sector. We think the credit risk of residential and selective commercial mortgage-backed securities (CMBS) 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 continue to be negative for the U.S. dollar. We continue to like being underweight the U.S. dollar, over the longer term, versus a basket of developed and emerging market currencies. We also continue to like emerging market local government bonds versus hard currency debt and versus developed market government bonds.
Developed Market Rate/Foreign Currency
Developed market rates were broadly higher in May, with the 10-year U.S. Treasury yield up 22 bps, 10-year gilts up 42 bps, and Australian 10-year bond yields up 27 bps. Bunds outperformed, down 3 bps on the month following weaker than expected economic and inflation data in Europe. Overall, much of the data depicted economic resilience and sustained inflationary pressure as shown for example in the U.S., Australia, and especially the UK. The well anticipated Senior Loan Officer Opinion Survey showed that credit conditions had tightened, but perhaps not as severely as the market was expecting. The Fed, ECB, BoE, and Norges bank all opted to hike rates by 25 bps, as expected by markets. The Antipodean central banks decisions were more surprising to markets, with the RBA hiking 25 bps after pausing the month before. In contrast, the Reserve Bank of New Zealand slightly surprised markets by only hiking 25 bps (as opposed to a potential 50 bps), while keeping the policy path the same versus expectations for a more hawkish policy path.2
Now that the acute issues related to the banking sector seem to have settled down and the debt ceiling has been resolved, the market has shifted to focusing on interpreting new economic data. Additionally, in the U.S., the market is now assessing the implications of the Treasury General Account (TGA) rebuild following the debt ceiling resolution. While the banking sector crisis has calmed, credit conditions are still tight and may tighten even further, putting increased pressure on borrowers. With that said, despite the tighter credit conditions and expectations for a slowdown, hard economic data has yet to deteriorate significantly, and the market is again starting to price in higher terminal rates and price out cuts. We recommend patience, awaiting further clarification while taking advantage of more relative dislocations. In terms of foreign exchange, with a more resilient U.S. economy and more confidence in the U.S. banking system, the U.S. dollar strengthened during May. We expect the U. dollar to continue weakening and have tactically made adjustments where attractive.
Emerging Market Rate/Foreign Currency
May performance was negative for Emerging Markets Debt. EM currencies generally weakened but some bright spots were Colombia, Mexico, and Peru, which strengthened. The Turkish lira fell to a new low following the news of President Erdogan’s re-election. Corporate spreads widened while sovereign spreads marginally compressed month over month. Year-to-date flows dipped into outflow territory. May’s flows were negative due to hard currency outflows, however, local fund flows were positive.3
We remain constructive on the asset class. We expect the U.S. Fed is nearing a pause in its tightening cycle which may relieve pressure on the U.S. dollar strength. This could put some emerging markets central banks in a position to ease policy. Some Latin American central banks have already started to cut rates including Costa Rica, Uruguay and most recently the Dominican Republic, cutting rates by 50 bps on the last day of the month. Growth, inflation, and policy vary considerably among emerging markets countries and credits so bottom-up analysis is crucial to uncover value.
U.S. investment grade spreads outperformed Euro investment grade spreads this month amidst elevated credit market volatility. driven by several factors. Firstly, concerns over the U.S. debt ceiling negotiation were key for most of the month, though it resolved within a few weeks.. Secondly, U.S. regional banking volatility remains elevated despite sentiment improving over the month as First Republic was taken over by JPM. Economic data continued to weaken over the month globally, particularly in manufacturing. Additionally inflation data remained sticky to the upside. Finally equity and commodity markets were weaker, excluding the Technology sector that benefitted from the focus on the multiple uses of AI.4
U.S. and global high yield markets were weaker in May, with the weakness generally attributable to higher rates versus emerging credit concerns. The technical conditions in high yield continued to improve in May amid reduced volatility. Monthly issuance once again increased month over month. The lower quality segments of the market generally outperformed in May, after also outperforming in April.5
Global convertibles managed to eke out a small positive return in May despite a pullback in both equity and credit markets. MSCI global equities fell 1.32%, the Bloomberg Global Aggregate Credit index declined 1.86%, and the Refinitiv Global Convertibles Focus Index rose 0.24%. Stocks and credit floundered on recessionary concerns, but convertibles performance was boosted from technology . Issuance also had a boost with $7.9 bn in new supply, coming mostly in the U.S. and providing the second-best month of 2023 for supply.6
Looking forward, our base case is a mild economic slowdown. The magnitude and impact on downgrades and defaults is likely to be low, as a combination of strong employment and conservative corporate management supports credit markets. Finally, the demand for high quality fixed income remains robust as evidenced by strong supply being matched. We remain cautious on the high yield market as we progress through the second quarter of 2023. Episodic weakness accompanied by volatile spread movement seems to be the most likely path forward. Convertibles continue to look appealing due to cheap valuations and sub-par prices in many names.
Securitized yields remain at historically wide levels. We believe these wider spreads offer more than sufficient compensation for market risks. Fundamental credit conditions remain stable despite recession risks. Although delinquencies across many asset classes are increasing slowly, overall delinquencies remain low from a historical perspective. We believe delinquency and default levels will remain non-threatening to the large majority of securitized securities. Our European securitized holdings were essentially flat in May, but we have meaningfully reduced our European securitized exposure over the past year.7
We continue to believe that the fundamental credit conditions of residential mortgage markets remain sound, but also believe that higher risk premiums are warranted across all credit assets given projected economic weakness. Our favorite sector remains residential mortgage credit, despite our expectation that U.S. home prices will likely fall another 5-10% in 2023. We have 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, especially office, which continues to be negatively impacted in the post-pandemic world.