Insights
Annus Horribilis
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Global Fixed Income Bulletin
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May 30, 2022
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Annus Horribilis
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May 30, 2022
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Annus Horribilis
Annus Horribilis |
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If March was a tough month, April was literally off the charts! Returns across the asset spectrum were dire, except of course if your asset included ‘commodity’ in its name. Rising yields and widening spreads were the name of the game. April was also the month when equities caught up to fixed income and now have worse returns year-to-date (S&P 500 down 13.3%). While a bunch of problems in the world can be blamed on the Russian/Ukrainian situation, it is not the primary driver anymore. The reason for the carnage: inflation, inflation, inflation! And of course, what central banks are doing and planning to do about it.
Inflation shows no sign of significantly abating. U.S. inflation may have peaked, but that is a hollow victory when headline inflation is 8.5% (highest since 1982). Central banks, particularly the U.S. Federal Reserve (Fed), are now on a warpath to get rates up quickly or “expeditiously” using Chairman Powell’s parlance. Markets have priced in rapid rate hikes generally everywhere, but most importantly in the U.S. where the economy appears to be overheating the most outside of Eastern Europe. With labor markets still firm if not too firm central banks will be in no mood to lift the slow pace of tightening until policy gets to at least neutral. Interestingly, for the first time in a while the U.S. yield curve steepened, with U.S. Treasury 2-year yields up only 38 basis points (bps) while U.S. Treasury 10-year yields rose 60 bps, suggesting the Fed is not doing enough to contain inflation risks, despite the fact that expectations of year-end 3-month rates rose 45 bps.
The combination of the rise in yields, heightened worries of tighter policy AND a horrible performance of equities undermined credit and emerging markets. While the U.S. Treasury market returned -3.1% in April, investment-grade corporates returned -5%, high yield -3.6% and emerging markets -5.9%. The sharp fall in equities, bodes ill for high yield, the most equity sensitive part of fixed income. The risk-off environment in April also boosted the U.S. dollar. It rose anywhere from 2% against the Singapore dollar to 6.5% versus the Japanese yen to over 7% against the South African rand, a negative development for the global economy.
Note: USD-based performance. Source: Bloomberg. Data as of April 30, 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 April 30, 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 April 30, 2022.
Note: Positive change means appreciation of the currency against the USD. Source: Bloomberg. Data as of April 30, 2022.
Source: Bloomberg, JPMorgan. Data as of April 30, 2022.
Source: Bloomberg, JPMorgan. Data as of April 30, 2022.
Fixed Income Outlook
Developments in April did not deviate materially from the trajectory established earlier this year. Inflation continues to be a source of concern which, combined with tight labor markets, will—in our view—keep central banks on their tightening trajectory. Commodities, particularly food prices are likely to firm further, exacerbating the central bank’s inflation problem. The Fed does not plan to letup in tightening until at least policy is back to neutral, a level Chairman Powell has identified as a broad 2-3% range, giving them significantly leeway to up the pace this year if inflation does not improve. Another 150 bps of hikes this year looks taking U.S. Fed funds to the middle of the neutral range. Global yields remain biased to rise further.
As time passes, it becomes clearer and clearer that monetary policy was kept too easy for too long. We are talking about ALL central banks save the ones in China and Japan. Monetary policy everywhere, not just in the U.S., is in a race to catch up to “neutral” or move to a restrictive stance. But the gap between inflation and interest rates remains wide in most countries, indicating that unless inflation falls materially or is expected to fall materially in the months ahead, more rate hikes are coming. If inflation does not fall enough (yet to be defined, but probably no higher than the Fed’s current end of year forecast), expect additional unexpected tightening next year, i.e., a higher terminal Fed funds rate. This would raise the probability of a recession in 2023 and undermine credit assets.
The primary reason for unremitting central bank hawkishness is growth remains firm despite all the challenges thrown at it this year. Although inflation is acting as a tax on households and businesses and yields are moving higher, labor markets and corporate profitability are strongly supporting spending. For example, financial balances among households and corporations (big and small) are strong in surplus. It is estimated that the household sector has a surplus of 0.8% of GDP larger than pre-pandemic AND has accumulated approximately $3 trillion of excess savings. Moreover, corporate excess savings across the entire corporate universe are also high, equating to about 3% of GDP. What this means is that the probability of achieving a soft landing, a reduction of inflation to target AND no recession is much higher.
On the negative side, an economy with strong private sector balance sheets AND income generating capabilities will be harder to slow down, meaning the Fed may have to raise rates by more than is expected to get the requisite slowdown in demand to bring inflation to target. Thus, given the current level and trajectory of yields, we do not anticipate a recession either this year or next. The earliest it could happen based on our analysis is 2024. This is a long way off and supports a more 1994 interpretation of this year’s rate hiking cycle as one that will slow things down enough to contain inflation without throwing the U.S. or global economy into a recession. We must keep in mind that the global economy is decelerating from a very high level with little risk of near-term economic downturn.
Corporate profitability is likely to be varied. The energy, commodities, and defense sectors are likely to benefit; Healthcare and Telecoms will be least affected, and for Utilities it will depend on their exact regulatory and commodity exposure. Both industrial 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. Spreads are now materially wider than at the beginning of the year, with notable underperformance of Europe.
Credit fundamentals are mixed. Credit quality is mixed in terms of profitability, earnings growth has likely peaked, and leverage and margins are plateauing. But balance sheets, liquidity and debt servicing capacity remain exceptionally strong, in our opinion. And, importantly spread widening as nominal and yields rise and economic data slows. It will be important to differentiate those companies who can continue to thrive in such an environment. Active management is likely to be key to performance. We do maintain a preference at the margin for high yield over investment grade but that is very idiosyncratic and industry specific and of late have been reducing credit risk in general.
EM outperformance has ended as global yields surged. Inflation problems tied to food and other commodities make many EM central banks biased to continue to raise rates as fast or faster than in developed countries. With several frontier economies on the verge of restructuring, risk remains there as well. Country level analysis will be vital to uncover value as we expect markets to place an emphasis on differentiation amongst countries and credits. EM is likely to struggle as long as DM central banks remain on their current hawkish trajectory and China struggles. A signal that things are turning will be a softening in the U.S. dollar. Although it has risen substantially in April and is likely to consolidate, there is no sign yet that its strength is coming to an end.
Developed Market Rate/ Foreign Currency
MONTHLY REVIEW
In April, yields continued their upward trend as markets priced in even more hawkish central bank policy. While economic data was more mixed, it continued to remain strong overall and on average was better than economists expected, allowing central banks to emphasize curbing inflation rather than having to support growth. Risk assets in general performed poorly as investors worried about the impact of tighter monetary policy and rising costs.1
OUTLOOK
Central banks have a challenging task in front of them: to curb inflation without hurting growth too much. Inflationary pressures remain very strong, but downside growth risks have also increased. The war in Ukraine continues, causing higher energy and commodity prices, which are already reducing consumer confidence and discretionary spending power. COVID remains impactful, with outbreaks in China sustaining supply chain disruptions. While a lot of hikes have already been priced in, neutral policy rate expectations are still modest vs. history, suggesting yields could rise further. Regarding foreign exchange, the U.S. dollar is likely to remain a beneficiary of tighter Fed policy and growing global growth concerns, while the yen may weaken further due to Japanese monetary policy being more accommodative than everywhere else.
Emerging Market Rate/ Foreign Currency
MONTHLY REVIEW
Emerging Markets Debt (EMD) continued to be challenged along with the broader risk markets in April. Russia’s invasion of Ukraine persisted with their focus concentrated on the eastern region. The annual spring meetings of the International Monetary Fund (IMF) occurred in Washington D.C. and in person for the first time since 2019. The overall tone was somewhat pessimistic as global growth was revised down for 2022 and 2023 and inflation projections increased.2 The three major EMD indices (U.S. dollar-denominated corporate debt,3 local sovereign debt,4 and U.S. dollar-denominated sovereign debt)5 were negative for the month.
OUTLOOK
We are optimistic on EMD as valuations appear to be well-compensating investors for the risk. The Russia/Ukraine war will continue to drive headlines and may continue for quite some time. Fundamentals are mixed, and while Fed tightening is a concern, markets appear to be pricing that in somewhat aggressively. The growth and inflation dynamic remains critical. Country level analysis will be vital to uncover value as we expect markets to place an emphasis on differentiation amongst countries and credits.
Corporate Credit
MONTHLY REVIEW
Credit spreads widened in April with general market volatility elevated once again amidst heightened macro uncertainty. News in the month continued to be dominated by the conflict between Russia/Ukraine where no progress was made towards a resolution. Credit markets saw weak technicals with demand limited by the negative price action in fixed income as risk free yields rose. Supply in April was significantly down.6
The high yield market was particularly weak in April. Over the month, the average yield climbed and the average spread grew significantly amidst a sharp jump in Treasury yields and weak technical conditions. Growing concern over the eventual economic impact from aggressive tightening of monetary conditions and the potential for an eventual “hard landing” prompted investors to reassess exposure to the lowest-rated segments of the high yield market. The top performing sectors for the month were transportation, other industrial and basic industry.7
Global convertibles fell the most in two years as concerns over inflation, interest rates and corporate earnings rattled markets. Convertibles, however, did outperform both of its underlying components. The convertibles market is now priced far closer to bonds than stocks as a lot of paper trades below par with less equity delta and more yield to maturity.8
OUTLOOK
We see spreads likely to be rangebound. Markets are supported by more attractive valuations and strong corporate results yet constrained by the macro uncertainties and weak technicals given the lack of demand while market volatility remains high. We are cautious on the high yield market, which has experienced significant pockets of volatility this year and there is little to suggest the environment for high yield will be become materially more supportive over the near term.
Securitized Products
MONTHLY REVIEW
April was another challenging month for securitized markets. Agency MBS underperformed again in April. Current coupon agency MBS spreads widened as the market is pricing in the end of quantitative easing (QE) and likely the beginning of quantitative tightening (QT). Agency MBS spreads could widen further as the Fed continues to reduce its purchases and possibly sell MBS. U.S. Non-agency RMBS spreads were significantly wider across all residential sectors in April, as nearly all risk assets cheapened given concerns about inflation, central bank policies and geo-political events. U.S. ABS spreads were also wider in April, but fundamental credit performance remains strong.9
OUTLOOK
We believe the securitized market still offers a unique combination of low durations, attractive yields, and solid credit fundamentals. We remain constructive on securitized credit. We remain cautious on agency MBS and interest rate risk.