Insights
Are we there yet?
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Global Fixed Income Bulletin
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July 14, 2023
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Are we there yet?
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July 14, 2023
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Are we there yet?
Are we there yet? |
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June saw volatility continue to dissipate, which bolstered the market’s demand for riskier assets. The VIX ended the month with a 13 handle and most major stock indices ended the month in positive territory. Developed market yields were higher over the month, emerging market yields fell, and credit spreads tightened. Economic data continued to show resiliency, inflation numbers showed signs of turning over, and a general risk-on sentiment blanketed the market.
Developed market (DM) yields were broadly higher over the month as central banks continued to play catch up to their emerging market counterparts. The European Central Bank (ECB), Reserve Bank of Australia (RBA), Bank of Canada (BoC), Bank of England (BoE), and Norges Bank all hiked during their meetings. The Fed decided to pause its rate hiking cycle, which briefly signaled to the market that the end may be near. The reprieve was only short-lived, as hawkish rhetoric and the dot plot they released towards the end of the month signaled more hikes are coming soon.
On the EM side, June was a relatively positive month for returns in both the local and external markets. EM external and corporate spreads were largely tighter over the month and local debt performed well as the USD fell 1.4% vs a basket of currencies. Hungary began cutting rates and both Chile and Brazil signaled that they are ready to cut rates in the not-so-distant future as the countries have seen inflation begin to rollover.
Corporate credit spreads tightened over the month, with the US outperforming Europe, and high yield outperforming investment grade (IG). Most of the tightening can be attributed to the resilience of the US economy and tighter than expected labor markets. In the securitized space, current coupon spreads of agency MBS tightened 14 bps over the month, bringing year-to-date performance ahead of IG corporates and US Treasuries. Securitized credit spreads remained largely unchanged.
Fixed Income Outlook
Despite central bank behavior and rhetoric remaining focused on too high inflation, inflation data improved significantly. Disinflationary momentum is a major change from last year’s massive inflation shock, when high and rising inflation undermined both equities and bonds. Indeed, records were broken regarding the magnitude and correlation of negative asset price moves: a generational inflation shock triggered a once-in-a-generation asset price shock. This year the opposite has happened. Significant inflation deceleration has supported strong asset price appreciation: equities up double digits and high yield bonds returning over 5% through mid-year, despite continued central bank tightening.
A key driver of this “goldilocks light” environment with all assets (save a few challenged sectors like commercial office) performing well has been continued economic growth. Markets have been on recession alert for over six months with expectations having centered on a second half 2023 arrival. It has not happened and forecasts keep pushing it forward. The resiliency of economic growth during a historically unprecedented monetary tightening cycle has been one of the big surprises in 2023. We can expect risk assets (equities, high yield, emerging markets) to continue avoiding major selloffs if economies, particularly the US and Europe, avoid meaningful recession, defined as significant rises in unemployment. So far so good. But crunch time will arrive later in 2023 as the cumulative effects of central bank tightening continue to bite and residual strength from pandemic fiscal policy support wanes if not disappears. Recession risks remain, but in our view remain overblown in terms of their likely severity.
Many of the difficulties in navigating financial markets relate to the peculiarities of this economic cycle. Economies are still equilibrating post pandemic. Manufacturing output is very weak. Using US data from the ISM survey, it is in recession. On the other hand, service sector spending remains strong with the ISM service survey remaining in expansionary territory. This combination is unusual. The question is how long it can last. Recent US data on the consumer has begun to show some weakness: restaurant spending is down, credit card and loan delinquencies are rising (although still low), bank lending is slowing as is consumer durable purchases. We believe the good news is that this bodes well for inflation because if consumer spending does not slow, neither will inflation. Policy is working. Is it enough?
The major risk for bonds going forward is inflation does not fall fast enough for central banks, necessitating higher policy rates and additional economic weakness, potentially leading to recession. Markets, having resisted central bank forecasts of ever-rising policy rates, have had to give into the reality that central banks mean what they say, and show no signs of stopping raising rates. The Fed paused in June, but it emphasized it was a skip and not an indication that they were done. In the UK, high inflation has pushed the expected terminal policy rate over 6%! The highest since the turn of the century. Of course, inflation has not been this high for an even longer time.
A major challenge for policymakers and investors is knowing how high is high enough. To answer the question two things must be known. First, the target. We know that. Most country’s central banks have a 2% inflation target using some variation of core inflation. They seem intent on getting back to it. Second (more challenging), over what time frame and at what cost do they want to get to 2%. Each central bank probably has different preferences depending on their specific circumstances. The more willing a central bank is to lengthen the time frame in getting back to target means lower probability of recession and less chance of a policy overshot. We believe most central banks, including the Fed and ECB, are NOT in a rush to crush their economies to get inflation to target by end 2024. Both central banks forecast targeting inflation to be ABOVE target at end 2024, suggesting patience. Medium term risks of an economic slowdown remain, with the impact of tighter lending conditions, tight monetary policy and a slowing labor market picture still to be fully felt by consumers and corporates. We envision a moderate recession in 2024 with no dramatic rise in defaults or risk premium - maybe a semi-soft landing?
Government bond yields are getting more attractive. US Treasury 2-year yields moved back over 5% in early July, the highest they have been since 2006. Real interest rates, as measured by US TIPS, are also at decade plus highs. Indeed, one measure of monetary policy success is how much real yields have risen. They are now up almost 3% from March 2022 lows. Fed policy is working. US nominal 10-year yields breached 4% once again in early July. Not quite at their 2022 peak, but meaningfully higher. Similar moves occurred in other developed markets. Currently, our strategy is to remain modestly underweight interest rate risk, as evidence that labor markets are loosening enough to slow economies sufficiently remains scant. That said, we are analyzing data carefully for evidence that policy rates are high enough. On the other hand, emerging markets have performed very well in recent months, and we expect their outperformance versus developed markets to continue. But, if higher real yields are required to break the back of developed country inflation, lower EM yields may have to wait.
Our strategy remains one of taking risk where opportunities suggest adequate yield to compensate for unexpected volatility or surprising bad news, whether geopolitical, economic or policy induced. Corporate bonds both IG and high yield had a strong second quarter. We do not believe spreads will tighten further in the third quarter. However, we do not see risk of a meaningful sell-off in IG bonds. Given the broader economic headwinds, but still positive momentum, we see carry rather than capital appreciation as the likely driver of IG corporate returns in the second half of 2023. High yield bond’s strong performance year to date suggests that with economic headwinds likely increasing in the second half of the year, their performance is likely to deteriorate. We are taking a more idiosyncratic approach to high yield, avoiding lower spread, more generic credits.
The securitized credit outlook has also modestly deteriorated as US household balance sheets come under more pressure and excess savings are run down. We still think it offers the most compelling opportunities. We are trying to take advantage of higher yields on higher quality issuers to achieve our target returns, rather than venture down the risk/rating spectrum. Our favorite category of securitized credit remains non-agency residential mortgages, despite challenging home affordability. Somewhat surprisingly, US housing looks like it may have bottomed out.
Recent upwards movements in yields and incipient Eurozone economic weakness have not helped the U.S. dollar. We continue to like being underweight the U.S. dollar, over the longer term, versus a basket of mostly emerging market currencies. However, given EM’s strong year to date performance, we are not in a rush to increase exposure. We also continue to like emerging market local government bonds versus hard currency debt and developed market government bonds.
Developed Market Rate/Foreign Currency
Monthly Review
Developed market rates were broadly higher in June with curves sharply flattening as hawkish central banks continued to emphasize that the hiking cycle was not yet over. 10-year US Treasury bonds were up 19 bps, 10-year German bunds were up 11 bps, 10-year UK gilts were up 20 bps, and Australian 10-year bonds underperformed, up 42 bps. The US 2/10s yield curve inverted ~30 bps, beyond –100 bps once again. Central banks fought back against market pricing of near-term rate cuts and highlighted that rates would have to go higher. The Fed at the June meeting opted to pause or “skip”, deciding to keep the policy rate the same, but also indicating in the dot plot and subsequent speeches that it expected that one or more hikes would be required later in 2023. The ECB hiked 25 bps as expected but was hawkish in its messaging. Other central banks were more aggressive in their policy decisions. The BoC surprised markets, hiking 25b ps after pausing since January 2023. The RBA similarly surprised markets again, hiking for the second consecutive meeting after pausing in March. Likewise, in Europe, the BoE and Norges Bank surprised markets, hiking 50 bps versus expectations for 25 bps.1
Outlook
Overall, the story was broadly similar in June: economies were surprisingly resilient, inflation was still elevated, and labor markets (while likely past peak tightness) were still tight. As a result, central banks reacted now or highlighted a hawkish narrative to prevent getting further behind the curve. The risk of a hard landing recession has not completely gone away. Central banks have now hiked rates considerably and monetary policy may have lagged impacts which have not yet been fully felt. Further, while the banking sector crisis in the US has largely receded, credit conditions are still tight and may tighten even further, putting increased pressure on borrowers. Given the uncertainty, it is difficult to concretely express an outright view on interest rates. We continue to recommend patience, awaiting further clarification while taking advantage of more relative dislocations. In terms of foreign exchange, the U.S. dollar weakened slightly during June. We have thought and still believe that the U.S. dollar should weaken, although tactically have made adjustments where attractive.
Emerging Market Rate/Foreign Currency
Monthly Review
Emerging Markets debt delivered positive returns for June. Hungary cut rates and Chile is signaling they will start cutting next month. China’s economic rebound is materializing to be disappointing as the recovery has been shallow and short-lived. In Russia, the Wagner advance on the capital was the most significant event to happen for Russia since the war began. This could be a destabilizing event and has had a positive effect on Ukraine. Sovereign and corporate spreads compressed month- over-month and outflows from the asset class continued.2
Outlook
We remain cautiously optimistic on the asset class. The US Fed has turned slightly more hawkish following the June meeting, but many EM central banks have started to cut rates or are still in a position to cut rates. Interest rate differentials have compressed a bit but performance continued to be positive in the second quarter. There was positive progress for debt restructuring in Suriname, Zambia, and Sri Lanka during the quarter. Divergence between countries and credits is still wide so bottom-up analysis is critical.
Corporate Credit
Monthly Review
US IG spreads outperformed Euro IG spreads again this month amidst a credit market rally driven by numerous factors. Firstly, there were several economic data surprises (particularly in the U.S.), exceeding weak expectations with the labour markets remaining strong and inflation starting to fall. Secondly, corporate news was in general bondholder friendly. Finally, general risk sentiment improved as there were no major geo-political escalations, risks of a recession accompanied by a spike in defaults receded, and equity market volatility fell to pre-Covid levels.3
June was a strong month for global high yield markets, characterized by material outperformance of the higher-beta, more distressed segments of the market, particularly in the U.S. The technical conditions in high yield improved in June amid a slowdown in activity in the primary market and robust demand. The lower quality segments of the market generally outperformed again in June, after also outperforming in April and May.4
Global convertibles participated in the broad-based rally in June, with the Refinitiv Global Convertibles Focus Index rising 3.92%.5
Outlook
We foresee a summer squeeze driven by light supply and continued demand for yield followed by a stormier winter as tighter monetary policy, tighter lending conditions and lower profit margins impact sentiment resulting in attractive carry, but limited capital gains. While an economic slowdown seems likely, the magnitude and impact on downgrades/defaults is likely low as a combination of strong employment and conservative corporate management support markets.
We are reaffirming our cautious stance on the high yield market as we enter the third quarter of 2023. Over the short-term, it appears the average spread in the high yield market could grind lower driven by temporarily supportive technical conditions. However, we anticipate the market will contend with periods of elevated stress and volatility over the near-to-intermediate term due to several factors.
For Convertibles, volatility is currently low and is far more likely to increase than decrease, which should benefit the converts market as the option component of converts tends to become more valuable as volatility increases.
Securitized Products
Monthly Review
Within securitized, fundamental credit conditions remain stable despite recession risks. Although delinquencies across many asset classes are increasing slowly, overall delinquencies remain low from a historical perspective, and we believe delinquency and default levels will remain non-threatening to the large majority of securities. Agency MBS spreads tightened, while securitized credit spreads were generally unchanged. New issue and secondary trading activity was steady in June, but overall, 2023 volumes have been well below 2022 levels. The Bloomberg MBS Index returned -0.43% in June and is now up 1.87% year-to-date in 2023. US non-agency RMBS spreads were largely unchanged in June and remain wide by historical comparison. US ABS spreads tightened slightly in June, for both consumer and business-oriented ABS, but still lagged the broader spread tightening across fixed income during the month. The European securitized market remained active in June, primarily in RMBS and ABS. Supply continues to be met with healthy demand and European spreads remained stable.6
Outlook
We remain concerned about global economic conditions, and we expect employment rates to decline and households to experience greater stress. We have moved up in credit quality over the past few months, reducing credit risk while taking advantage of wider spreads for highly-rated securities. We continue to believe that the fundamental credit conditions of residential mortgage markets remain sound, but also believe that higher risk premiums are warranted across all credit assets given projected economic weakness. Securitized yields remain at historically wide levels, and we believe these wider spreads offer more than sufficient compensation for current market risks. Our favorite sector remains residential mortgage credit, despite our expectation that US home prices will likely fall another 5-10% in 2023. We remain more cautious on commercial real estate, especially office, which continues to be negatively impacted in the post-pandemic world.