The strong post-2020 economic recovery has led to a new era ruled by rising yields and higher inflation. Going forward, we believe it will be critical to invest in areas of fixed income that may be less impacted by rising rates. In our view, the Morgan Stanley Global Fixed Income Opportunities Fund is well-positioned for this environment.

• The Fund’s unconstrained approach aims to decorrelate from the interest rate cycle to generate alpha—which is particularly beneficial in a rising rates environment. Due to its flexible mandate, the Fund is both able to help preserve capital and generate alpha by tactically reducing duration amid rising rates via active duration and curve management. Currently, the Fund currently has approximately 3 years of duration.
  
  
• Our asset selection within the spread sectors, particularly higher yielding credits, should also help offset any further rise in rates. Within high yield, we continue to favor lower credit quality, primarily single Bs vs. BBs as high yield typically outperforms investment grade rated bonds in recovery periods. Given default rates have plunged, we believe allocating to lower quality bonds is beneficial for additional yield pick-up. Lower rated B rated bonds tend to outperform BBs if default risk continues to decline and investors reach for yield down the credit curve. Conversely, we believe avoiding low coupon, long duration BB credits should help mitigate the risk from a move higher in rates.

The Global Fixed Income Team’s Views on Inflation

The global economic recovery has been underwritten by expectations of continued fiscal and monetary policy support. Inflation has surged to multi-year highs, but most of this increase is expected to be transitory, and not something central banks have said they will respond to. However, there is a risk that they will change their mind, both because the inflation figures have been far stronger than expected, and because there is a risk that the inflation shock turns out to be more persistent than expected.

While inflation has continued to surprise to the upside, it is still our view that the surge is mainly transitory due to base effects, higher commodity prices, temporary bottlenecks in the economy and statistical issues. However, we expect the current high elevated inflation to continue, with year-over-year rates beginning to decline in 2H22. In the coming months, we also expect central banks to begin to slow or will have announced their intention to begin slowing asset purchases. Nevertheless, there is a risk that inflation is persistently higher going forward due to: 1) higher housing and accommodation costs, which tend to be sticky; 2) higher wages and labor costs, due to the economic scarring from COVID (lower participation rates); and 3) higher inflation expectations. Even if inflation, and inflation expectations, just return to 2010-15 levels, this should cause a significant repricing in fixed income markets.

Components of inflation like shelter/ accommodation costs and other prices that have historically been “sticky” (i.e., do not fluctuate much) have started to increase (Display 3). If price levels remain sticky, then this may drive wages higher that may create inflation risks longer term. Display 4 conveys that the average weekly earnings are rising, especially for lower-paid workers due to the shortages of workers (particularly in the services industries). In fact, data from the Federal Reserve Bank of Atlanta shows that median hourly wages for people in the bottom 25 percent of earners have risen at a 4.6 percent rate in the past year, compared to 2.8 percent for the top 25 percent.¹ Furthermore, the Fed’s index of common inflation expectations (CIE) is now slightly above the 2 percent levels, after staying well below persistently prior to the recent surge in inflation risks (Display 5).

If the inflation shock persists, there is a risk that bond yields will start to rise. However, for now, the backdrop for the U.S. Treasury (UST) market remains sanguine. We believe for most of 2H21 we will see UST 10y yields in a range between 1.75% and 2.00%. We believe the surge in yields is likely behind us, with the peaks in growth, inflation and rate of fiscal spending seen in 1H21. Now, with the peaks likely behind us, the base effects for growth, inflation and fiscal spending will be harder to surpass and represent a de facto tightening of support programs and facilities. Additionally, tapering of asset purchases will begin in the U.S. in November, as expected.

¹ Source: Federal Reserve Bank of Atlanta, as of August 2021.

Risk Considerations

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 this portfolio. Please be aware that this portfolio may be subject to certain additional risks. 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. 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. Some U.S. government securities are not backed by the full faith and credit of the U.S., thus these issuers may not be able to meet their future payment obligations. High yield securities Investments in securities rated below investment grade present greater risk of loss to principal and interest than investment in higher-quality securities. Public bank loans are subject to liquidity risk and the credit risks of lower rated securities. Foreign securities are subject to currency, political, economic and market risks. The risk of investing in emerging market countries are greater than risks associated with investments in foreign developed countries. Sovereign debt securities are subject to default risk. 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). Collateralized mortgage obligations. Due to the possibility that prepayments will alter the cash flows on 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 strategy could sustain a loss.