Insights
Navigating through the Fog of War
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Global Fixed Income Bulletin
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March 23, 2022
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Navigating through the Fog of War
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March 23, 2022
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Navigating through the Fog of War
Navigating through the Fog of War |
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February was a challenging month for financial markets, with most assets reporting negative returns. Most of the month was dominated by stronger-than-expected inflation causing central banks to turn more hawkish, causing fixed income assets, government bonds in particular, to perform poorly. However, the large-scale Russian invasion of Ukraine, which most investors did not anticipate, caused risky assets—equities, corporate credit, emerging market debt—to sell off. European assets did worse than U.S., which makes sense given Western Europe’s economic linkages to central and Eastern Europe. The rise in energy prices—both oil and natural gas—is of particular concern for the European economic outlook given it is effectively a tax on consumers. European bank debt and equity also suffered due to concerns about Eastern European exposure and the impact Western sanctions will have on the financial sector. While government bonds staged a dramatic rally in response to the invasion, they still delivered negative returns for the month. The U.S. dollar and Swiss franc rose, given their “safe-haven” status, as did commodity currencies like the Australian and New Zealand dollar. The Russian ruble depreciated around 30% due to the impact of sanctions; other Russian assets also depreciated in value significantly, the extent to which is difficult to know for sure given illiquidity. Reduced liquidity in financial markets is exacerbating downward price pressures making it difficult to disentangle changes in fundamentals from temporary dislocations.
Note: USD-based performance. Source: Bloomberg. Data as of February 28, 2022. The indexes are provided for illustrative purposes only and are not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See below for index definitions.
Note: USD-based performance. Source: Bloomberg. Data as of February 28, 2022. The indexes are provided for illustrative purposes only and are not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See below for index definitions.
Note: Positive change means appreciation of the currency against the USD. Source: Bloomberg. Data as of February 28, 2022.
Note: Positive change means appreciation of the currency against the USD. Source: Bloomberg. Data as of February 28, 2022.
Source: Bloomberg, JPMorgan. Data as of February 28, 2022.
Source: Bloomberg, JPMorgan. Data as of February 28, 2022.
Fixed Income Outlook
Financial markets have gone from worrying about COVID-19 to worrying about the Russian invasion of Ukraine. The main impact on economies, beyond the immediate region, will be through higher commodity prices, mainly energy (natural gas and oil), but also food (wheat) and metals. The main concerns for investors are: what impact will this have on economic growth, central bank policy and corporate profitability. At present our expectation is that the conflict may continue for several months, but we are hopeful that it will not escalate further or expand into a broader regional or global conflict. This means the economic impact will primarily be felt through higher commodity prices, with the market already pricing in the expected supply disruption. There is a risk that sanctions, which have cut Russia off from global financial markets, destabilize global financial conditions, but we are optimistic that central banks will be quick to respond to any signs of stress.
Higher commodity prices will effectively act as a tax on household and businesses, reducing demand for other goods and services, and pushing up inflation. It will be relatively obvious for central banks to ignore commodities’ impact on inflation (which should be transitory) but more difficult for them to decide how much to tighten policy given inflationary pressures from other sources are strong but the growth outlook is now a lot more uncertain. Given economies were rebounding strongly before the conflict started, we think they will still grow at a robust rate, meaning central banks will remain committed to normalizing monetary policy, just more cautiously than before. So, expect 25 basis points (bps) rate hikes rather than 50bps jumps, getting to the same point in the end but taking a few months longer. This means we still expect government bond yields to rise from current levels, and credit products to remain under pressure (even if underlying asset quality remains sound). Uncertainty about the length and intensity of the conflict remains the biggest issue. That said, the meaningful sell off in credit products in March, particularly in investment grade bonds is already pricing in a significant deterioration in economic conditions and in the case of euro denominated credit, almost recessionary economic conditions. Central banks have their work cut out for them but for now we expect central banks will follow through on their pre-invasion monetary tightening strategies.
The impact on corporate profitability is likely to be varied. The Energy, Commodities and Defense sectors are likely to benefit (not that we see a lot of this being priced in at present, especially in emerging markets); Healthcare and Telecoms will be least affected, and for Utilities it will depend on their exact regulatory and commodity exposure. Both Industrials and Consumer sectors will be negatively affected, but at least they were experiencing strong demand going into the crisis. However, there is no denying that the impact will be negative, with European corporates more affected.
Still, we think the growth backdrop is strong enough that default risk remains low given the extent corporates have repaired their balance sheets over the last two years. We therefore think corporate credit remains attractive and have a preference for high yield over investment grade. The conflict has also created opportunities in emerging markets, which have repriced cheaper due to liquidity and contagion reasons; many of them ought to be beneficiaries of higher commodity prices, but this is not reflected in the recent price action. The U.S. dollar and Swiss franc have benefitted as “safe havens” and are likely to remain strong during this uncertain tumultuous period. Longer term the U.S. dollar looks stretched and may explain why it has not risen even by more than it already has.
Developed Market Rate/ Foreign Currency
MONTHLY REVIEW
The month began with more signs of persistent inflation and further hawkish shifts from central banks, leading to a broad increase in rates. That narrative was interrupted as the attention shifted to Russia’s invasion of Ukraine, which disrupted global markets across asset classes. The initial increase in rates reversed, as a flight to safety supported government bonds and markets anticipated that central banks may move slowly when removing accommodative policies. The U.S. dollar appreciated due to its “safe-haven” status. Inflation remains a key theme, with data continuing to surprise to the upside, and the outlook exacerbated by higher commodity prices due to the Ukraine conflict.1
OUTLOOK
Developed economy central banks face a more difficult job, as they now need to balance increased downside economic risk against stronger than expected inflation. Most economies are mainly affected by Ukraine through higher commodity prices, which are effectively a tax on consumers and will reduce demand for other goods. There are also concerns about what sanctions will do to global financial liquidity conditions.
We still expect central banks to normalise policy. However, the pace is likely to be more cautious than previously speculated. This should mean that government bond yields still rise through 2022, as the conflict is likely to delay the pace of normalisation for three to six months rather than stop it. We have limited conviction on the direction of currencies.
Emerging Market Rate/ Foreign Currency
MONTHLY REVIEW
Emerging markets debt (EMD) experienced a large increase in volatility upon Russia’s decision to invade Ukraine towards the end of the month. Broader global markets did experience a related increase in volatility, but really focused on Russian and Ukrainian assets as well as those in the immediately surrounding countries. Local Russian fixed income assets were down an estimated 70% in value. U.S. dollar-denominated corporate debt,2 local sovereign debt,3 and U.S. dollar- denominated sovereign debt were also down.4
OUTLOOK
The outcome of this situation is quite fluid and path dependent, including the degree of broader geopolitical impact and contagion into global capital markets as large scale sanctions begin to take effect. Various macro implications include further global inflation as a result of supply side shocks and the West’s tolerance level for autocratic regimes.
Corporate Credit
MONTHLY REVIEW
Investment grade corporate credit spreads widened in February with general market volatility continuing amidst macro disruptors. Government bond yields rose globally. The Russian invasion of Ukraine was the major news event in February where the sentiment is fluid reflecting each new piece of information. Other news impacting markets included upside surprises to the global inflation data. Corporate news in the month was dominated by fourth quarter reporting.5
The high yield corporate market remained weak in February. Concern over elevated inflation readings and increasingly hawkish messaging from the U.S. Federal Reserve remained a consistent theme.
The Russian invasion of Ukraine injected additional volatility into the market. Over the month, yields rose by 35 bps and spreads widened.6
Global convertibles continued the worst start to a year on record as investors weighed the impact of rising rates and of war in Ukraine. Issuance was low in down markets in February. Growth sectors lagged again while only Energy and Materials rallied.7
The senior floating-rate corporate loan market lost ground in February driven by market volatility. Despite the modestly negative performance, loans fared better relative to other capital markets, including equities and high-yield corporate bonds.8
OUTLOOK
Looking forward with valuations significantly above the long run average for spreads and nearing the wides of the fourth quarter 2018, we see value opportunities but expect volatility given the near-term uncertainty of geo-politics and the limited liquidity available if flows increase.
Securitized Products
MONTHLY REVIEW
Agency MBS underperformed again in February. Spreads are now wider than pre-pandemic levels as the market anticipates the end of quantitative easing and potentially the beginning of quantitative tightening, but agency MBS spreads could widen further from supply-demand pressure. U.S. non- agency RMBS spreads were also wider across most residential sectors in February, as nearly all risk assets cheapened given concerns about inflation, central bank policies and geo-political events. U.S. ABS spreads were also wider, but fundamental performance remains strong and issuance remained high through the month.9
OUTLOOK
We believe the securitized market still offers a unique combination of low duration, attractive yields, and solid credit fundamentals. We remain constructive on securitized credit and cautious on agency MBS and interest rate risk.
Risk Considerations
Diversification neither assures a profit nor guarantees against loss in a declining market.
There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in a portfolio. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Certain U.S. government securities purchased by the strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. High-yield securities (junk bonds) are lower-rated securities that may have a higher degree of credit and liquidity risk. Sovereign debt securities are subject to default risk. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default, and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. The currency market is highly volatile. Prices in these markets are influenced by, among other things, changing supply and demand for a particular currency; trade; fiscal, money and domestic or foreign exchange control programs and policies; and changes in domestic and foreign interest rates. Investments in foreign markets entail special risks such as currency, political, economic and market risks. The risks of investing in emerging market countries are greater than the risks generally associated with foreign investments. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, and correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). Due to the possibility that prepayments will alter the cash flows on collateralized mortgage obligations (CMOs), it is not possible to determine in advance their final maturity date or average life. In addition, if the collateral securing the CMOs or any third-party guarantees are insufficient to make payments, the portfolio could sustain a loss.
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