Insights
An Early Holiday Present
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Global Fixed Income Bulletin
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December 15, 2022
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An Early Holiday Present
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December 15, 2022
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An Early Holiday Present
An Early Holiday Present |
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What a difference a few weeks make. October was characterized by stern Fed messaging about inflation risks, a surprisingly strong U.S. labor market report and higher than expected inflation. By October 24, U.S. Treasury 10-year yields were making a new historical high around 4.24%, up 43 basis points(bps) from the end of September. Fast forward to the end of November and things look a lot different. U.S. Treasury 10-year yields ended the month at 3.61%, down a whopping 61 bps lower from their October peak. Real yields joined the party as well with U.S. 10-year real yields down approximately 20 bps over the month, about 50 bps down from their intra-month high. What gives?
First, it wasn’t just the U.S. bond market that rallied. It was truly a global phenomenon. Outside of Japan and a few Emerging Market (EM) countries, 10-year yields fell anywhere from 23 bps in Australia to 185 bps in Hungary. Second, not only did risk-free yields fall, but credit spreads narrowed as well, significantly so in Euro denominated bonds. Third, the U.S. dollar fell significantly. The Japanese yen, for example, rose over 8% versus the dollar from its October low, not coincidentally corresponding almost to the day U.S. Treasury yields peaked. November fixed income total returns measured in U.S. dollars or local currency were truly staggering.
The key to the rally was threefold. Two of which were not so surprising, with the third more so. In October several central banks made it clear they were uncomfortable with raising rates further or uncomfortable with the size of rate hikes. Eastern European central banks were in the vanguard of this movement, but they were joined by the central banks of Sweden, Norway, Australia and Canada. Notably missing from this list was the Fed, who in October took seemingly the opposite stance. The first November surprise was a better-than-expected U.S. inflation report. After many months of disappointment on this front the market embraced this one data point as evidence that inflation had now peaked and was on its way down. Secondly, the U.S. inflation surprise could not have been better timed relative to market positioning. After the surge in yields over October, bond markets were ripe for a correction or at a minimum bear market rally/squeeze. Lastly, the coup de grace so to speak, was the apparent toning down of Fed hawkishness, with more FOMC members vocalizing their belief that enough had been done, at least for now. While in many ways this wasn’t surprising, at some point, the Fed had to start to acknowledge that it had raised rates a lot and needed to slow down/pause to assess its impact. And off to the races we went.
The bond rally was thus sparked by reduced worries about central bank over tightening, better news on the inflation front, a market under exposed to duration and credit, and lastly, high yields, making bonds look attractive. Interestingly, equities also had a gangbuster month. The S&P 500 index was up over 14% from its October low.1
But, if central banks were reigning in their hawkishness does this not mean that they also expect economies to weaken in 2023 to the extent necessary to bring down inflation, thus warranting a less hawkish policy? Shouldn’t weaker growth be a negative for equities or credit in general? Not necessarily so. What the markets have done is price in a so-called soft landing. In other words, growth slow enough to bring down inflation, but not so slow as to meaningfully hurt earnings/revenue. The higher probability of a soft landing was reinforced by the market’s belief that the Fed would be quick to cut rates in 2023/2024 and by a substantial amount. As of early December, the market is expecting up to seven rate cuts over this period.
What central banks have done is narrow the distribution of potential outcomes or scenarios. For example, there was always the chance that the Fed would keep raising rates to 6%. Even if the market did not think this would happen, the possibility that it might happen would have to be incorporated in the baseline forecast for the future Fed funds rate as a possibility. Less central bank hawkishness has reduced the probability of these high-rate outcomes which reduces risk and volatility, which raises expected returns from risky assets, including longer duration bonds. And voila! We have a rally even though the market’s central forecast for rates for mid-2023 has not changed. Layer on expectations of medium-term rate cuts, and we have an even more powerful rally across all fixed income sectors.
Whether or not this rally can continue or at a minimum maintain these higher bond prices and reduced credit spreads is another matter and ultimately will be determined by data. In the interim enjoy the early holiday present. Let’s hope the Grinch does not come and steal it!
Fixed Income Outlook
Strong fixed income performance for 2023 just got a little less strong after November’s surprisingly powerful rally. While the foundations for a meaningful rally were in place due to valuations, market positioning, and data surprises, one month does not make a trend. More important, central bank pivoting to a less aggressive path of hiking does not mean that we can sound the all clear. Is it possible? Of course. Market performance and the information flow does increase the probability of a softish landing of the economy and bond market, but we do not think there is enough evidence to justify a bullish stance on rates at current levels.
Increasingly, investors believe peak rates are now embedded in yield curves. While this may prove to be correct, the odds are against it. Indeed, central banks including the Fed, have continued to emphasize the need for further rate hikes or the need to avoid premature cutting of rates, even if inflation looks like it has peaked. Instead of rate cuts in the second half of 2023, the Fed could plausibly be raising rates if wages/inflation are not behaving. And, as a reminder, inflation is still far away from acceptable levels. Central banks are aware of the risk of cutting rates before the disinflationary trend is well established and reigniting inflation. What investors need to figure out is how high is high enough. How long is long enough. The pace, the current market obsession, is of secondary importance. The rally based on future rate cuts in the U.S. looks overly optimistic as does hope that rates are for sure high enough to achieve medium term inflation objectives given the level of inflation and the state of labor markets. We must remember that not only does inflation need to fall, but central banks need to be confident it will stay down. What this means is that the underlying drivers of inflation need to be tamed as well, which as we all know, comes down to wages and the state of the labor market.
While we are skeptical that optimism about inflation and growth will prove to be as easily achieved as the market expects, this is more about market pricing than the likely evolution of fundamentals. However, it is not all doom and gloom. Central banks have made tremendous progress in getting policy rates into restrictive territory, raising policy rates at a pace not seen for 40 years and helping push real rates, the more important indicator of monetary tightness, up substantially. Until the past month, global financial conditions were tighter than they have been for over 20 years, excluding the global financial crisis period in 2008. The U.S. bond market is now discounting a peak Fed funds rate of approximately 4.9% (down 20 bps from last month) by mid next 2023. Even the most die-hard hawks on the FOMC have not been talking about rates much higher than this. Income has returned to the fixed income market, making bonds a much more attractive investment than they have been for over 15 years. Unless inflation continues to rise, it might just be possible to begin talking about peak rates. But given recent rallies in rates and spreads, we would be cautious about adding more at current valuations.
Given the rally in most non-U.S. bond markets, we remain cautious. We are likely to reduce interest rate exposure on further drops in yields. Valuations have been pushed back to levels last seen in the Spring, which look low relative to current and prospective short rates. This is true for most developed country bond markets. We think UK government and Australian government bonds will be outperformers. Euro government bonds remain bedeviled by high and still rising inflation, a problematic economy with amplified risks, and a hawkish central bank who is somewhat constrained by intra-eurozone fiscal issues in Italy, for example.
Last month we touted the attractiveness of investment grade bonds due to their relatively high yields, a combination of higher-than-average spreads and high government bond yields. This is no longer true, especially with regard to U.S. as yields and spreads are materially lower. Euro investment grade looks better as it’s spreads remain above their long-term average. But, given the rally in the U.S. market combined with valuations, we are more cautious. U.S. credit markets have moved to the tighter end of their recent range and do not look especially attractive at the current time. With the bottom of their recent spread approximately at their long-term average, spreads would have to be able to move to the expensive side of their long-term average to be especially good value. For now, we expect the broad ranges established in 2022 to be maintained, which implies credit spreads have little room to rally, near term. But fundamentals still remain solid so there is also no reason to get particularly bearish.
The U.S. high yield market is in a somewhat similar position as investment grade. Returns outpaced expectations this year, bolstered by continued solid economic growth, sound balance sheets (for high yield companies), low defaults and 70% less issuance, a strongly positive technical backdrop. Spreads are also near the bottom of their late 2022 range, making them less interesting. Importantly, although not our central forecast, we do not think hard landing risks are sufficiently discounted. On the other hand, we do not expect any widening in spreads beyond what recent history suggests. We are buyers on dips. The U.S. agency mortgage market has done very well of yet, matching if not exceeding the performance of investment grade corporate bonds. As such, we no longer view them as unambiguously attractive and believe positions should be trimmed. Other securitized sectors (CMBS, ABS) continue to look inexpensive on most metrics. The U.S. dollar looks like it has peaked, falling significantly versus most currencies over the past 2 months. Further gains will likely be more challenging unless there is another reassessment of U.S. monetary policy implying no rate cuts in 2023 and 2024. 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. China’s reopening should be quite positive for EM in general and helpful for the global economy. On the negative side, a stronger Chinese economy may make it harder for developed market central banks to bring down inflation. EM external remains the least favored sector in the EM fixed income complex. On all fronts we remain patient and conservative.
Developed Market Rate/Foreign Currency
Monthly Review
Developed market rates continued where they left off at the end of October, with yields falling and curves bull flattening during November. While the Fed hiked by a fourth consecutive 75 bps hike at their November meeting, the view that central banks are starting to slow the pace of hikes remained a key theme. Given they have already tightened policy significantly, there is some evidence of inflation slowing, and the growth data is uncertain. The U.S. dollar depreciated broadly as markets started to price less aggressive central bank tightening.2
Outlook
Recent Fed communication indicates a likely reduction in the pace of hikes to 50 bps for the Fed’s December meeting. The far more important questions are how high the peak in rates will be, and how long it will stay there. In our view, the market’s current pricing is below the likely peak, and it also seems unlikely the Fed will cut rates before the end of 2023 unless the economy is in severe recession. Inflation and labor market data suggest the economy is overheating, so the risk is skewed to yields going higher. In currency markets, the U.S. dollar is richly valued and likely to depreciate broadly unless investors become concerned about central bank tightening causing recession risks.
Emerging Market Rate/Foreign Currency
Monthly Review
Emerging Markets debt (EMD) had a dramatic rebound in November as markets coalesced around the narrative that both inflation and Fed hawkishness may have peaked, and that China may begin relaxing its COVID-zero policies as well as stepping up support of its ailing property sector. Additionally, expected growth differentials between EM and DM have increased, and persistent outflows from the asset class are abating.3
Outlook
We are broadly constructive on EMD markets at this time as macro uncertainty appears to be easing, fundamentals are improving, technical tailwinds are abating, and valuations remain compelling. We continue to place an emphasis on differentiation among countries and credits.
Corporate Credit
Monthly Review
Euronpean Investment Grade (IG) spreads outperformed U.S. IG spreads in the rally this month as the marginal news was positive. Generally, this was the second month of spread compression. Subordinated financials outperformed non-financials, BBBs underperformed higher-rated, and short-dated paper tightened less than longer-dated. Following the conclusion of third quarter corporate results, earnings were mixed but broadly stronger than expectations.4
The high yield market exhibited moderate weakness in the opening days of November before putting together a strong three-week run. Third quarter earnings of high yield issuers, on average, continued to exceed very modest expectations and technical conditions in the high yield market were largely supportive. The lowest quality segment of the market continued to generally underperform in November. The top-performing sectors for the month were gaming, banking and home construction.5
Global convertibles rose for the second consecutive month in the improving macro environment. Convertibles lagged (at +3.49% compared to other risk assets such as MSCI global equities +7.60% and Bloomberg Global Credit +5.80%) as embedded equity options are out-of-the-money after a year of equity market correction combined with little new supply of at-the-money securities. Issuance in November did provide a bright spot, however, as $7.2 bn in new paper was issued, providing the best month of the year for supply.6
Outlook
Market valuations continue to price a very negative outcome for corporate downgrades and defaults. Our base case view is that we are compensated to own credit as we view corporate fundamentals to be resilient. We view companies as having built liquidity in recent quarters. We expect margins to be pressured and top line revenue challenging, but we believe corporates will be able to manage a slowdown without significant downgrades or defaults (base case low default and mild recession).
In the high yield market, corporate fundamentals still appear to be somewhat resilient, and the market is entering 2023 from a place of relative strength. However, today’s strong fundamentals are likely to weaken in the year ahead.
We anticipate a good rebound year for convertibles in 2023 on the back of attractive technical valuations, equity recovery potential and a stronger outlook for the primary calendar.
Securitized Products
Monthly Review
Rates rallied and spreads tightened in November, leading to the best monthly performance of the year for nearly all fixed income assets. However, securitized credit sectors underperformed many other credit markets as securitized spreads tightened less, and as securitized assets tend to have shorter durations and spread durations. Current coupon agency MBS spreads tightened and the Bloomberg U.S. Agency MBS Index returned 4.08% in November and is now -11.42% year-to-date. U.S. Non-agency RMBS spreads tightened in November, although to a slightly lesser degree than other credit markets. U.S. ABS spreads, helped by the lack of new issuance and lighter secondary selling, were also tighter in November. U.S. CMBS spreads followed suit and tightened during the month, however, fundamental credit conditions remain challenging in many commercial real estate markets, most notably office and retail shopping centers. European securitized markets bounced back in November as the heavily selling (mostly UK pension liability driven investment crisis related) from the previous month abated.7
Outlook
Our fundamental credit outlook remains positive overall, although we are becoming slightly more cautious. Credit spreads for many securitized sectors remain at levels last seen at the depths of the pandemic, but credit conditions appear materially better today than during that period. Although we believe that a recession is likely in 2023 for both the U.S. and Europe, we also believe that the post-GFC securitized market has been structured to withstand GFC-level stresses, and these securities should comfortably weather a less severe recession scenario.
1 Source: Bloomberg. Data as of November 30, 2022.
2 Source: Bloomberg. Data as of November 30, 2022.
3 Source: Bloomberg. Data as of November 30, 2022. EM corporates represented by The JP Morgan CEMBI Broad Diversified Index.
4 Source: Bloomberg Indices: U.S Corporate Index and the European Aggregate Corporate Index. Data as of November 30, 2022.
5 Source: J.P. Morgan and Bloomberg US Corporate High Yield Index. Data as of November 30, 2022.
6 Source: Refinitiv Global Convertibles Focus Index. Data as of November 30, 2022.
7 Source: Bloomberg. Data as of November 30, 2022.