Insights
Alea iacta est ('the die is cast')
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Global Fixed Income Bulletin
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February 15, 2021
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Alea iacta est ('the die is cast')
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February 15, 2021
|
Alea iacta est ('the die is cast')
Alea iacta est ('the die is cast') |
|
January ushered in a pause in the global melt-up in asset prices. Government bond yields rose in most countries with the sell-off in U.S. Treasuries amongst the worse. Only Australian and Canadian government yields rose more, while emerging market countries generally saw their yields rise even more. Returns were muted in credit markets as a deluge of supply in the high yield market counteracted good macro fundamentals. Securitized credit bucked the trend and delivered solid if not stellar returns (in some sectors).
The big policy news was of course the implications of the Democratic sweep of the Georgia U.S. Senate runoff elections. A Democratic majority in the Senate, combined with the inauguration of President Biden, offers a radical change in prognosis for fiscal policy. Instead of contentious negotiations with a Republican-controlled Senate, the new administration can use the Congressional budget reconciliation process (the one used by Republicans to get their tax cuts passed in 2017) to push through aggressive fiscal expansion. As of early February, it looks like the Democrats will aim to push through another fiscal support package north of $1 trillion. It also looks likely that this stimulus package will be followed by another in the fall of another $1 trillion or more, possibly with tax hikes included. These, of course, come on the heels of the $900 billion fiscal package passed just recently. If the Democrats succeed in legislating these two new fiscal deals, a truly extraordinary amount of support/stimulus will be injected into the economy. Forecasts of 6% plus 2021 U.S. GDP growth could be low. Indeed, the U.S. might grow faster than China!
What this means is that the hope/belief that yields on government and other high quality bonds would remain stable and low have been challenged. Expectations of low inflation, the pandemic, central bank quantitative easing (QE), and central bank forward guidance are slowing the rate rise, but rising they are. The Fed and other central banks are unlikely to enter the fray (meaning commenting or doing something policywise) until the consequences are known. Financial conditions remain very easy in the U.S.; not as easy in the eurozone but with euro credit spreads low, most government bond yields negative and, maybe most importantly, with10-year Italian/German bond yield spreads sub 100 basis points (bps), there is little evidence that financial conditions are not propitious for economic recovery.
On the other hand, the global economy looks to have decelerated in Q1 due to rising COVID-19 infection rates/hospitalizations, renewed/enhanced targeted social distancing and a slow rollout of vaccinations. The emergence of new COVID-19 strains also gives rise to new risks concerning the efficacy of vaccines and the potential continuation of social distancing restrictions further into the future or continued conservatism of households and companies with regard to normalization of behavior. The good news is that social distancing restrictions seem to be working in bringing down infection rates, vaccination rates are improving and the Johnson & Johnson vaccine looks likely to be approved for emergency use in the U.S. soon.
As previously discussed, interest rate/duration risk has not been friendly to bond market returns in 2021; this is likely to continue. Massive (proposed) U.S. fiscal spending is expected to propel the U.S. economy stronger, with some of the spending spilling over to the rest of the world. Increased spending in conjunction with greater normalization of behavior should be good for corporate cash flow (earnings will depend on costs), which should be supportive of credit markets. We remain positioned to benefit from riskier fixed income assets outperforming and government bonds underperforming, with duration likely to be a headwind to returns rather than a tail wind, like in 2020.
Note: USD-based performance. Source: Bloomberg. Data as of January 31, 2021. 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 January 31, 2021. 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 January 31, 2021.
Note: Positive change means appreciation of the currency against the USD. Source: Bloomberg. Data as of January 31, 2021.
Source: Bloomberg, JPMorgan. Data as of January 31, 2021.
Source: Bloomberg, JPMorgan. Data as of January 31, 2021.
Fixed Income Outlook
Policy news continues to be good for the global economy. Despite wobbles in Europe and deceleration in the U.S., the economic outlook remains positive, leading to a rebound in growth over the course of the first quarter into the second. The benefits of vaccinations should become more and more apparent as vaccination rates rise, targeted restrictions on social mobility should be relaxed; and fiscal policy is running at its most procyclical in generations. The Biden administration appears determined to add another huge dollop of spending to the U.S. economy as it accelerates later in Q1. Moreover, the likely surge in the U.S. economy will occur when other countries are also expanding again, resulting in a synchronized global expansion. Financial conditions are easy: policy rates are zero (in most of the world outside of emerging markets (EM); short and long-term real yields are negative; corporate yields are low (if not negative in real terms for higher quality companies); companies continue to report better-than-expected earnings; commodity prices are rising; inflation is rising but off very low levels; and, big time fiscal easing is coming in the U.S., more modestly in Europe, and importantly, no tightening anywhere else. These conditions are an excellent backdrop for risk taking; not so good for government bonds.
With policymakers fixated on expansionary policies, obsessed with not making the same mistakes post-global financial crisis, we may end up with pro cyclical monetary and fiscal policies for the first time in a generation. There is a commitment to get unemployment down in the U.S. almost at any cost, it seems. The logic is that any delays (not related to COVID imposed restrictions) will lead to hysteresis in unemployment, the tendency of high unemployment to persist such that we end up in an equilibrium with too high an unemployment rate and a very unequal distribution of that resultant unemployment. Thus, expect monetary and fiscal policy to focus on creating boom-like conditions, risking of course, that inflation rises sooner than later, an outcome welcomed if contained; problematic if it rises too quickly.
Thus, outside of ongoing pandemic risks (vaccination rates, vaccine-resistant new strains), policies are looking very, very easy, risking going too far, resulting in inflation rising faster and more than expected, putting pressure on central banks to dial back monetary policy, before employment/growth targets are achieved. We think central banks will resist any calls to reign in policy measures and will allow inflation and nominal yields to rise. Indeed, with short rates anchored, this is a recipe for steeper yields curves globally. Of course, the more vaccines work, the more powerful effect easy policies will likely have, creating a powerful virtuous circle in terms of stronger and stronger growth and lower and lower unemployment and higher yields. And, as long as rises in yields do not tighten financial conditions, central banks are likely to stand aside and let them rise (a big change from market views at the beginning of the year). This reflation process is unlikely to be smooth, and asset prices and interest rates will likely fluctuate along the way. In this environment, we believe active management, security selection and valuation will be critical to generate a robust fixed income strategy.
This suggests that one of the impediments to investment returns in 2021 might be duration, the reverse of 2020 when falling government bond yields significantly boosted the returns of other assets. The duration of the bond universe has lengthened significantly in recent years, helping boost returns as yields fell. Now markets are at risk of the reverse: longer-duration bonds with higher yields lead to even lower returns. While we are not looking for large upward movement in yields, they are likely to trend higher. Indeed, markets may decide, as they want to, to test the Fed’s mettle when it comes to levels which might be construed as uncomfortable for the Fed. This is a recipe for overshooting to the upside. All this suggests the optimal investment strategy is to reduce interest rate sensitivity where one can.
Given the procyclical policies expected in 2021 and beyond; the synchronized nature of the global business cycle and the relatively low level of nominal and real yields, we believe fixed income asset allocation should be oriented towards cyclical assets and away from high quality/high interest rate-sensitive ones. However, discrimination remains key given valuation levels. The search for yield in a yield-starved world has eliminated undervaluation in most sectors. But, we believe to generate reasonable income, more risk needs to be taken. Given the very strong macro outlook, a movement to generally reduce credit quality; reduce interest rate sensitivity; overweight emerging markets and look for reasonable risk premium seems appropriate. This includes moving down the credit spectrum in high yield from BB to B; from A to BBB in investment grade: more default risk, less interest risk. Of course, the major risk to this outlook is a resurgence of the pandemic, or more likely, the inability of the world to rid itself of COVID-19 to the degree it does not keep households socially distant.
Therefore, discrimination remains key in our choice of assets, and we continue to try to avoid the two tails of the risk spectrum: very high-quality/low yielders and very low-quality/high yielders in credit, securitized and sovereign markets. We want to own exposure in those areas that can withstand some further volatility in macro/virus backdrop and higher yields but have enough yield/spread to offer reasonable 2021 return potential.
Developed Market (DM) Rate/Foreign Currency (FX)
Monthly Review
In anticipation of a strong rebound in growth by the end of 2021, government bond yields across the developed markets moved higher in January, despite the emergence of new, more contagious COVID-19 strains. The “reflation trade” continued to pick-up momentum in the markets, as inflation breakevens hit multiyear highs.
Outlook
We expect a global economic recovery, especially in procyclical sectors. Central banks will likely remain accommodative and keep yields low almost regardless of how robust the recovery turns out to be due to a desire to close output gaps and return inflation to target levels, or possibly higher. Having arguably tightened too quickly in the previous economic cycle, having inflation stay below target is more of a credibility threat to most central banks than having it above. In addition, higher inflation is likely to help the post-COVID deleveraging process. Nonetheless, this still means the risks are skewed to government bond yields rising. In terms of currencies, we expect the U.S. dollar to weaken due to continued easy monetary policy and fiscal policy, risk-positive sentiment and a relative decline in U.S. real yields versus other currencies.
Emerging Market (EM) Rate/FX
Monthly Review
EM debt posted negative returns in January across the board, i.e., in both local and hard currency bonds. From a sector perspective, companies in the Financial, Diversified and Infrastructure segments led the market, while those in the Oil & Gas, Telecom (TMT), and Transport sectors underperformed.
Outlook
Despite the performance setback in January, we still hold a positive outlook on EM debt for the rest of 2021.Our constructive view on risk assets, and expectations of a weaker U.S. dollar, should be supportive for the emerging market asset class. Excessive optimism about reduced trade frictions under the Biden administration (particularly, in U.S.-China relations) could challenge our positive scenarios for global trade and growth, and thus negatively impact the performance of growth-sensitive EM assets.
Credit
Monthly Review
Spreads were unchanged over the month in spite of an increase in equity market volatility and increased political risk in Italy. On the technical front, January supply was heavy, as expected, and credit funds and ETFs experienced net outflows.
Market Outlook
We see credit being supported by expectations of an economic rebound in 2021. Our base case reflects the consensus view that COVID-19 is transitory and continued positive support from monetary and fiscal policy will likely drive spreads tighter in the medium term. We expect an overshoot in valuations in H1 2021, especially given central banks continue to support credit markets directly and indirectly, but with a likely correction in H2 as M&A activity increases and corporates shift some of the cash they have hoarded to business expansion activities. We think issuance could be lighter, given many companies prefunded in 2020.
Securitized Products
Monthly Review
Agency MBS and securitized credit continued to perform very well. Mortgage prepayment speeds showed no signs of slowing as mortgage rates again hit new historic lows in January. U.S. asset-backed securities (ABS) were generally tighter, while European RMBS spreads were largely unchanged in January. U.S. non-agency residential mortgage-backed securities (RMBS) and U.S. commercial mortgage-backed securities (CMBS) spreads tightened in January, with AAA CMBS spreads now trading 75-90 bps above comparable duration swaps.
Outlook
We expect continued strong performance in the coming months. Agency MBS looks moderately expensive, but benefits from continued Fed buying. U.S. non-agency RMBS have largely recovered to pre-pandemic levels, but still offer reasonably attractive relative value. U.S. ABS has a mixed outlook for 2021, with traditional consumer ABS (credit cards and auto loans) looking relatively expensive while the most COVID-challenged ABS sectors offer much greater recovery potential. CMBS valuations have also richened over the past few months, but the sector remains very idiosyncratic, with some attractive value opportunities and some potential credit problems as well. Multifamily housing (apartments) and office buildings have performed better and have lower risks of near-term default, but could still face challenges if there are fundamental shifts in how people want to live and work in the post-pandemic world. European markets are experiencing similar sector-specific performance dynamics, and overall European credit performance has been comparable to U.S. markets.
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, 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.