Global Fixed Income Bulletin
March 12, 2023
March 12, 2023
The facts changed, so the market changed its mind
March 12, 2023
After a very optimistic January, markets changed their view on the economic outlook in February. In recent market terms, the economic soft landing morphed into a no landing scenario. The facts which led to this change were mainly about inflation, which now looks stickier than previously hoped, while the growth outlook improved. Central banks are now priced to tighten more aggressively, a change that risky assets have been able to withstand without too much damage since the growth outlook was also upgraded.
With hindsight, the rosy scenario the market painted in January -- of rapidly falling inflation allowing central banks to reverse tightening soon while economic growth remained robust -- was too good to be true. The part of the story which, in our opinion, looks increasingly unlikely is that inflation will fall quickly enough, without a recession, to allow central banks to cut interest rates aggressively this year. The better economic data also means that recession risks have eased. Therefore, markets have priced central banks tightening policy further out and for longer.
Current expectations are starting to look demanding: The Fed is priced to raise rates to 5.50%, the European Central Bank (ECB) to 4%, and on some metrics government bonds are the cheapest they have been for more than a decade. However, with yield curves inverted, there is a risk that investors looking for low risk/return options will opt for cash rather than government bonds.
The resilience of credit spreads over the last month is notable and makes sense given the better economic data. It is also something which has facilitated the rise in sovereign yields. Central banks, especially the ECB, would struggle to raise rates aggressively if credit markets became distressed, but tighter spreads allow them to pursue their inflation mandate without worrying too much about financial stability and growth. While the better data have supported credit markets, tighter spreads make it more difficult to be bullish on credit products.
Of course, the data are unlikely to stay the same going forward. We should expect central banks and markets to change their minds in the future again. This is a key risk if economies prove to be as resilient to tighter monetary policy as the market currently expects. Slower growth could not only weigh on risky assets, but also cause markets to price in easier monetary policy.
Fixed Income Outlook
Markets experienced a significant sea change from January to February. While risk assets managed to hold on to most of their gains, with equity returns positive year-to-date and credit spreads tighter, developed market government bond yields are either at, or approaching, their highs in recent years.
The problem for investors is the same issue which weighed on markets last year: inflation. Inflation data released in February generally surprised to the upside. Even more troubling for central banks (and hence for investors), the components they are most focused on; that is, core services, are barely showing signs of slowing down. These upside surprises were also consistent with better-than-expected growth data and the continued evidence of tight labour markets.
How much higher can government bond yields rise? The market is now pricing central banks to raise interests to significantly higher levels than previously expected: the Fed to 5.50%, the ECB to 4.00%, and the Bank of England (BoE) to 4.75%. This seems aggressive, with the market finally anticipating more rate hikes than central banks. To surpass these numbers will require more disappointment on inflation (or maybe additional good news on growth). Optimism on rates has turned into pessimism. Moreover, real yields have risen to multi-year highs, suggesting government debt is getting attractive. However, the value argument is somewhat undermined by inverted yield curves, which means carry is negative. Investors who are looking for a low-risk rate of return might prefer to hold cash or shorter maturity bonds at increasingly attractive levels. So, while government bonds may be starting to offer value, this might not be enough to stop yields rising further if investors fear more aggressive central bank tightening and a continuation of stronger than expected data.
A good catalyst for a recovery in the market outlook with regard to the rates outlook would be signs that the Fed’s and other central banks rate hikes are causing a slowdown in economic activity and a further decline in inflation. Government bond yields would likely be capped above the 4% level in 10-year U.S. Treasuries and put a lid on further U.S. dollar appreciation. Data in upcoming weeks and months will be important to decide the “true” strength of economies and underlying inflation pressures.
Credit sectors, and risky assets more generally, have been more resilient than government bonds. This is understandable, as the better growth data has somewhat offset the concerns about tighter monetary policy. In particular, there seem to be fewer discussions now about the risk of an imminent recession, which is particularly supportive for lower quality credit sectors. However, given the spread tightening we have already had year to date, we think a lot of the better news is already reflected in the price, making them a difficult buy at the moment. Moreover, stronger data now means tighter monetary policy later, and while recession risks in 2023 have receded, it is not unreasonable to raise them for 2024. Recession is very bad for risk assets. Tighter credit spreads have also had a role to play in driving bond yields higher, as they have effectively eased financial conditions, allowing or forcing central banks to be more aggressive in their bid to slow the economy and bring down inflation. This is a particularly relevant topic in the Eurozone, where financial sector fragmentation is a more significant risk. The ECB is only likely to follow through with the aggressive rate hikes now priced by the market if sovereign and spreads remain well behaved. Luckily for the ECB so far, they have.
In terms of sectors, we remain most positive on the securitized credit market. We think the credit risk of residential and selective commercial mortgage-backed securities (MBS) and asset-backed securities (ABS) 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. Agency mortgages should outperform U.S. Treasuries, but we still worry about structural demand given the Fed’s quantitative tightening and bank’s reduced demand.
Given its strong performance year-to-date, we see limited upside for high quality corporate credit. With U.S. investment grade (IG) spreads near long-term averages and a lot of uncertainty remaining on the economic and policy outlook, we do not think it is a great time to be overly bullish. That said, absolute yields have become more attractive. Euro investment grade looks like a better opportunity as the European Union (EU) benefits from falling energy prices, expansionary fiscal policy and China’s reopening. We think this combination should also benefit the Euro. We are buyers on weakness.
A similar analysis supports high yield credit markets, where the improvement in the growth outlook year-to-date is reflected in tighter credit spreads. That said, we do not see a recession in the next six months and inflation should continue to decline, buttressing household cash flows and supporting aggregate demand. Default rates are likely to rise, but not spike, and remain more idiosyncratic than systemic. With high yield indices yielding nearly 9%, we think there is room for spreads to widen and for the product to still deliver attractive returns. We prefer B-rated and selective CCC issuers.
Looking at currencies, relatively better U.S. economic data helped the U.S. dollar reverse its depreciation in January. However, it remains rich on a real effective exchange rate basis, so unless the U.S. economy can continue to outperform (which we do not expect), it is more likely to depreciate against most other G10 and emerging market (EM) currencies. We expect select emerging market local currency bonds and FX to outperform given real yield differentials to U.S. Treasuries remain at historically wide levels. As usual, investors need to be aware of the various idiosyncratic risks in each country. EM is not a homogenous market. China’s reopening should be positive for EM in general, as well as the global economy, but our preference is mainly for the Latin American markets.
Developed Market Rate/Foreign Currency
The rally in January was short-lived as global developed market interest rates witnessed significant movements upwards in February. While the market appeared to interpret Powell’s press conference during the February FOMC meeting as more dovish than expected, that narrative quickly reversed. Many key economic data points, including labor market data, PMI surveys, and inflation data were stronger than expected, with some reversing from the prior month’s weaker data. Alongside the rise in yields, the curve flattened further. Overall, it was a busy month for developed market central banks, with the ECB, BoE, Reserve Bank of New Zealand, and Riksbank hiking 50 bps, while the RBA hiked 25 bps. The Fed shifted down to a 25-bps hike from their prior 50 bp hike in December.1
Overall, much of the economic data in February showed that any expectations for inflation to rapidly come down to target and for the Fed to quickly cut rates aggressively was likely premature. Inflation, the labor market, and economic growth appears resilient, especially in the U.S. There is still considerable uncertainty in terms of the future path for interest rates, and given the data, the situation for central banks is likely more difficult. In our view, especially with the recent repricing higher, the rates market is priced close to fair provided the current data. However, central bankers have been quite clear in their determination to keep rates high, and while inflation will continue to come down from their peaks, inflation and labor market data prints are still indicating that the economy is overheated, which could keep central banks aggressive. In terms of foreign exchange, the U.S. dollar benefited from the tighter Fed policy, however we think that U.S. dollar weakness could return.
Emerging Market Rate/Foreign Currency
The emerging markets debt (EMD) rally that started in late 2022 stalled in February. Lingering inflation and revised expectations for higher U.S. rates put pressure on the asset class. The U.S. dollar strengthened along with increasing rates, which hurt most EM currencies. A couple bright spots for local currencies were the Dominican Republic, Mexico, and Peru, which strengthened during the month. While flows year-to-date are positive for the asset class, flows began to turn for both hard and local currency funds by mid-month.2
Uncertainty has been reintroduced to the macro environment as the Fed may turn back to a more hawkish policy in the short term. Lingering inflation and higher U.S. rates have started to weigh on emerging markets, but segments of the market provide an opportunity for investors. Local rates in particular are attractive, as real yield differentials between emerging and developed markets remain high. There is wide dispersion among countries and credits, so evaluating all opportunities from the bottom up is critical.
Euro IG spreads outperformed U.S. IG spreads in the sell-off this month amidst refreshed concerns of elevated inflationary pressures. Fourth quarter corporate earnings saw prevailing themes continue where forward guidance is challenging amidst macro uncertainty, margins are compressed amidst cost inflation, but balance sheets and fundamentals remain robust with no signs of distress. Financials continue to benefit from the tailwind of higher interest rates, and no signs of concern via non-performing loan provisioning.3
The U.S. and global high yield markets got off to a strong start in the first couple of days of February as the Fed stepped down rate hikes. The tone quickly softened after a strong January payrolls report. Interest rates began to climb in response to a string of strong macroeconomic readings and higher than consensus expectations for the terminal federal funds rate. The supply/demand balance weakened in February as the pace of primary issuance slowed and U.S. high yield retail funds experienced net outflows.4 The lower quality segments of the market generally outperformed during the month and the top performing sectors for the month were transportation, brokerage, asset managers & exchanges and REITs.5
Global convertibles fell with other risk assets in February as rising inflation data dented market hopes for a soft landing. In the month, convertibles outperformed on the downside compared to global stocks (MSCI global equities fell 2.98%) and global bonds (Bloomberg Global Aggregate Credit fell 3.14%) while the Refinitiv Global Convertibles Focus Index fell 2.06%. Market liquidity has improved in the first two months of the year with reported trade volumes up close to 50% from last year, as investors have positioned on either side of a market recovery. Market supply has been above the pace of 2022 as well, with over $10 bn in new deals in February and over $13 bn so far year to date.6
Looking forward, our base case view is that we are compensated to own credit as we view corporate fundamentals to be resilient and the macro backdrop to likely improve as monetary policy pivots and China re-opens. We view companies as having built liquidity and implemented cost efficiencies under the COVID-era. We expect margins to be pressured and top line revenue to be challenging (as evidenced by fourth quarter numbers) but given the starting point we believe corporates will be able to manage a slowdown without significant downgrades or defaults. Our base case is low defaults with low growth).
In U.S. and global high yield markets it appears likely we will continue to experience episodic volatility given the extent to which valuations have compressed this year and the risks that lay on the horizon.
Interest rates sold off in February reflecting increased inflation concerns, and spread performance varied by sector, with agency MBS spreads widening while most securitized credit spreads tightened during the month. New issue securitized supply remains very low as loan origination in both residential loans and commercial loans declined substantially. Securitized fundamental credit remains stable – delinquencies are rising slowly, but remain low from a historical basis, and do not appear to be threatening the thick levels of structural credit protection for most securitized assets. U.S. home prices have fallen ~5% from the peak in June.7
We expect home prices to fall another 5-10% for the remainder of 2023. U.S. residential credit remains our favorite sector, despite our expectations of home price declines, with 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, which continues to be negatively impacted in the post-pandemic world and could also be impacted by a recession. We meaningfully moved away from European versus U.S. exposure as risk-adjusted opportunities looked more compelling in the U.S., but as spreads have normalized and economic conditions have improved, we have become less concerned with European opportunities.