Perspectivas
Déjà vu? No, 2022 Will Not Look Like 2021
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Global Fixed Income Bulletin
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enero 15, 2022
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Déjà vu? No, 2022 Will Not Look Like 2021
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enero 15, 2022
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Déjà vu? No, 2022 Will Not Look Like 2021
Déjà vu? No, 2022 Will Not Look Like 2021 |
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Financial markets had a good December despite Covid infections rising rapidly at the end of the month as the more contagious Omicron variant took over. Equities rallied, credit spreads tightened and even emerging markets had a good month, reversing much, if not all, of the sell offs in equities and credit in the second half of November. Government bond yields did rise, and have continued to rise further in January, in some countries substantially, but the increases in Europe and the U.S. did not dent the overall bullish economic outlook and merely returned yields to the ranges prevailing for most of the second half of 2021. The economic outlook brightened meaningfully in the fourth quarter as manufacturing output improved significantly as supply constraints began to ease and inventories are being restocked.
However, the end of 2021 looks very different from how it began. The year began positively: vaccines and massive fiscal stimulus were coming and, importantly, inflation was well contained, with the market and U.S Federal Reserve (Fed) projecting no changes in monetary policy until at least mid-2023. Currently the world faces a highly contagious variant, a very hawkish Fed with multiple 2022 rate hikes priced in, U.S fiscal policy in limbo and surging inflation. So, while on the surface things in early 2022 look like early 2021, it is not déjà vu by any stretch of the imagination.
Three questions need to be answered. First, how impactful, economically speaking, will Omicron be? Second, how much should markets fear the Fed? Third, will inflation slow?
The Omicron wave has pushed global infections to record highs before it has even hit Asia. This is likely to negatively impact growth. Our working assumption is that the Omicron wave will burn itself out relatively quickly due to its greater contagiousness, reduced virulence and high levels of vaccinations so that economic activity will take a hit in the first quarter, but it should not be too large. It should also impact services (increased cautiousness, reduced mobility) more than goods. Its impact on inflation is somewhat ambiguous as it will hit services supply (reduced) and demand (reduced) with goods output relatively unaffected.
Fed behavior in 2022 is likely to have a more long-lasting impact than Omicron (we truly hope!). The Fed has turned decisively hawkish. There appears to be minimal to no dissent to raising rates multiple (two to four) times in 2022, starting as soon as May, accelerating tapering, ending quantitative easing (QE) in March/April, and beginning quantitative tightening (a.k.a. shrinking the balance sheet), potentially also by mid-year. Crucially, what the Fed has not done, at least not yet, nor the market, is raise the expected terminal Fed funds rate. The market thinks it is in the 1.75% - 2.00% range and the Fed is at 2.25% - 2.50%. Two possibly non-mutually exclusive bearish things can happen: the market increases its pricing to be in line with the Fed’s forecast, which would push longer maturity yields higher, and the Fed could find itself fighting a stubborn inflation wave whereby it might increase its terminal rate forecast higher yet. This reduction in liquidity in 2022 and higher rates (market has already priced in 3+ hikes this year) will support higher bond yields. Quantitative tightening (QT) may be the trigger for a steeper yield curve in 2022. However, the biggest risk to financial markets is how the Fed manages its balance sheet. The market knows how to price rate hikes; it is much more uncertain as to what to do with potentially rapid balance sheet shrinkage.
Lastly, the inflation outlook is of paramount importance as the unexpectedly large global inflation shock is what is driving tighter monetary policy in so many countries, not just in the U.S but also many emerging markets, Canada, UK, Australia, Norway and New Zealand. The good news, we believe, is that inflation will come off the boil in the first quarter as energy inflation subsides. This will be the first drop in this expansion. Unfortunately, this drop in headline inflation does not mean that core inflation will drop. The trajectory of core inflation has been buffeted by both supply and demand shocks. Core inflation should stabilize at a minimum and hopefully fall, if only marginally. But the good news is that for the first time in over a year the markets will likely see inflation fall. The question is, will it fall enough to prevent central banks from tightening more than expected?
In terms of market views, we have generally been reducing portfolio risk into year-end given the uncertain outlook. We remain long risky assets (corporate credit, securitized credit, emerging markets) because of the positive economic outlook (slower but still strong growth/lower inflation) and expectations that Omicron will leave economies relatively unscathed. We expect developed economy government bond yields to continue to move higher but, as we have seen multiple times in the past, they remain at the mercy of risky asset performance, shifting/unstable risk preferences, and Covid.
Note: USD-based performance. Source: Bloomberg. Data as of December 31, 2021. 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 December 31, 2021. 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 December 31, 2021.
Note: Positive change means appreciation of the currency against the USD. Source: Bloomberg. Data as of December 31, 2021.
Source: Bloomberg, JPMorgan. Data as of December 31, 2021.
Source: Bloomberg, JPMorgan. Data as of December 31, 2021.
Fixed Income Outlook
December turned out very well for most asset markets, both in absolute terms and relative to what happened in November, when markets performed poorly. The flattening of yield curves slowed a bit but still flattened. Government bond yields generally rose, giving back much of the November rally. Interestingly, the English-speaking country bond markets outperformed even though their respective central banks are the most hawkish.1 Impressively, high yield bonds recouped all they lost in November with investment grade not far behind, not completely recovering all that was lost in the second half of November.2 The downside to this December rally in credit markets is it reduces 2022 expected returns, especially given the Fed’s decisive turn to hawkishness.
How the Omicron infection wave plays out will have a significant impact on economies and markets. Given its behavior to date, our assumption is that it will not disrupt underlying economic trends or policy reactions significantly. For sure, certain sectors of the economy will be impacted in the short run, but it is expected to be short-lived, and we can expect underlying trends to remain robust. Those trends look supportive for growth and corporate cash flow and, unfortunately, above target inflation. 2022, like 2021, should be another year of above trend growth with the U.S achieving full employment (however defined) and most other countries recouping or surpassing previous levels of output and employment. Unfortunately, high and persistent levels of inflation have also triggered changes in monetary policy expectations. The trend of central banks globally reducing accommodation is intensifying relative to what was expected just a month ago. How this is executed will be a defining event in 2022.
One of the biggest surprises in 2021 was the decline in real yields. Developed economies boomed, unemployment rates fell significantly, wages rose more than expected and inflation roared back. Indeed, 2021 was a year of large upside surprises in inflation, the first in over 20 years of undershooting expectations and forecasts. Despite this very strong macroeconomic backdrop, nominal yields surprisingly fell over the last three quarters of the year and pushed real yields deep into negative territory. Current market pricing is for real yields across the yield curve to stay negative far into the future. This is a very pessimistic forecast and one unlikely to be true if secular stagnation does not return (although we cannot completely dismiss the possibility). The depressed state of real yields is a function of a variety of factors that should dissipate in importance, like all-time easy monetary policy. The Fed needs real yields to rise to slow inflation. How high they need to go will depend on the financial market’s reaction. The more long-term yields rise, the less tightening required. The expected move to begin QT adds an element of uncertainty as markets do not have much experience in handicapping a higher rates/QT combo (nor does the Fed). Real yields led by the U.S. are already moving higher in anticipation of these events. Therefore, nominal and real yields should move higher in 2022 as liquidity is withdrawn and inflation falls.
One important factor keeping longer maturity yields low (outside of massive global liquidity) is, in our view, expectations that terminal rates, i.e., the peak in policy rates, will not reach new highs. Indeed, current market expectations are that peak rates this cycle will be meaningfully lower than last cycle (2015-2018). The risk to bond valuations comes more from the length of the hiking cycle and the eventual terminal policy rate rather than the pace or start date (although they matter for the shape of the yield curve). With inflation proving to be stubborn, there is a danger expected terminal rates will be moved higher by both the market and Fed. That said, we believe inflation will fall in 2022, growth in output and employment will slow, and the Fed will calibrate its tightening cycle as more information arrives. It may be true that this is just an inflation scare. By mid-year, when we know more about how fast inflation is falling, the Fed will be able to slow down its tightening. Of course, the opposite is true as well!
Other central banks will be reinforcing the Fed’s message with the Bank of Canada (BoC) primed to raise rates soon (beating the Fed to the starting line), while the Bank of England (BoE), Reserve Bank of New Zealand (RBNZ) and Norges Bank have already started hiking. Most emerging market (EM) central banks have been raising rates, aggressively in many cases, for most of the last 12 months. While we can expect more hikes if inflation keeps rising, given their head start, it is likely that they will be able to stop hiking rates even with the Fed in rate hiking mode if their economies should weaken and inflation rates fall. The European Central Bank (ECB) is going at a slower pace, given it is not yet convinced inflation will not fall below its target level again after the inflation shock is over, but it will significantly reduce, and possibly end, QE this year, which should prevent yields from falling. Even in Japan, inflation is turning out higher than expected and with no changes in Bank of Japan (BoJ) policy priced in, this could be a source of policy surprise in 2022. Only in China is monetary policy diverging from the Fed. Their zero Covid strategy and attempts to balance growth objectives with deleveraging is going to keep the Chinese central bank in accommodative mode in 2022.
Credit investors have also become more nervous recently, causing credit spreads to widen; we think this is mainly reflective of how tight spreads became, rather than any meaningful increase in default risk or deteriorating fundamentals. Further widening could be a buying opportunity. EM risk remains predominantly on the local side. Very hawkish central banks, with inflation pressures still evident, make it premature, despite significant rate hikes in recent months, to get bullish. The Fed moving to a less accommodative posture in the months ahead is also likely to be a challenge. Politics in several countries is taking its toll.
Where does this leave our views on markets? In general, we remain overweight the riskier, cyclical sectors but less so than several months ago. We think high yield, securitized credit and floating-rate loans will outperform government bonds, agency mortgage-backed securities (MBS) and investment grade credit, but by less than in 2021. We think low expected terminal rates and highly negative real yields make longer-maturity bonds relatively unappealing. However, this outcome is contingent on the Fed not overdoing it, either on purpose or by accident. If markets sense recession risks rising, performance rankings will flip with investment grade and government bonds expected to outperform. Local EM looks interesting given how much central banks raised rates. Examples include Mexico, Brazil, South Africa, and Russian local bonds. On the external side, we are more selective, but do expect high yielding sovereign bonds to reverse their 2021 underperformance. Once inflation peaks, substantial risk premiums should fall. Shorter maturity bonds are more interesting due to much higher risk premiums now priced in. How China manages their zero-Covid strategy will also be impactful both on the demand and supply sides. And, of course, Omicron remains a risk as does the risk of another unknown variant showing up.
Developed Market Rate/Foreign Currency
Monthly Review
Two key storylines drove rates in developed markets in December: the Omicron variant and central bank policy meetings. Overall, although the month began with rates briefly falling following a flight-to-safety given Omicron fears, developed market rates for the most part ended the month higher. The U.S. dollar did not move significantly in December, while emerging market currencies were mixed.
Outlook
Monetary policy and Covid circumstances will continue to drive DM rate movements. We see the risks skewed towards higher inflation, leading to a hawkish central bank bias and higher rates as well as steeper yield curves. Overall, we see value in many EM currencies versus G10.
Emerging Market Rate/Foreign Currency
Monthly Review
EM debt returns were positive in December. Hard currency sovereigns performed well driven by tighter spreads, although partially offset by higher U.S Treasury yields.3 EM corporate returns were positive for the month, with high yield outperforming investment grade corporates.4 Local currency bonds posted positive returns, primarily due to stronger EM currencies against the U.S. dollar.5
Outlook
We moved from a cautious to an opportunistic outlook for EM debt. Though tighter global monetary policy, elevated inflation, and uncertainty over the Omicron variant may limit scope for a sizable rally in risky assets, global growth remains solid and commodity prices recovered during the month. In such a backdrop, there is room for high yield EM credit to outperform investment grade. On the local side, some currencies look substantially cheap and could outperform in a scenario where uncertainty subsides. In local rates, we prefer yield curves that are already pricing in aggressive monetary policy tightening.
Corporate Credit
Monthly Review
Corporate credit spreads tightened meaningfully in December as risky assets in general rallied. Corporate news in the month was limited due to the holidays, but M&A remained a constant theme with the cheap debt and expected economic rebound in 2022 driving deals.
The high yield market recorded a strong return in December, despite volatility remaining sharply elevated, led by lower credit quality.
Global convertibles underperformed both equity and credit for the second consecutive month in December, led largely by asset class underweights to the best-performing equity sectors: Energy, Financials, Real Estate and Materials.
Outlook
We see little change in the base case credit outlook with valuations looking full but fundamentals well supported. We expect some volatility in early 2022 given the current uncertainty and lack of appetite for risk positioning.
Floating-Rate Loans
Monthly Review
Robust investor demand for floating-rate assets fuelled the senior loan market’s rebound in December. Fundamentals continued to showcase healthy credit conditions and quality-level themes followed the familiar Covid-era risk-on form: lower-rated loans outperformed.
Outlook
We expect continued strong technicals and fundamentals. The healthy credit picture and investors’ ongoing search for yield will drive continued flows to the sector. Additionally, above trend economic growth, strong credit metrics and low default rates will create a strong fundamental environment.
Securitized Products
Monthly Review
Mortgage and securitized markets were generally quiet in December, both in terms of trading activity and pricing volatility. Securitized new issuance volumes set post-financial crisis records for 2021, despite a slower December. Spreads were slightly tighter in agency MBS.6 Agency MBS demand remains robust as the Fed is still net buying MBS and reinvesting prepayments (despite reducing the size of net buying) and U.S banks continue to increase their holdings. Non-agency RMBS, CMBS and ABS spreads were generally wider during the month, however performance varied significantly by sub-sector.7
Outlook
Overall, we believe the securitized market offers an attractive combination of low duration and attractive yields with solid credit fundamentals. We remain constructive on securitized credit and are modestly overweight. We remain cautious on agency MBS and interest rate risk, and we continue to manage portfolios with relatively short durations.
RISK CONSIDERATIONS
Diversification neither assures a profit nor guarantees against loss in a declining market.
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 a portfolio. 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. Certain U.S. government securities purchased by the strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. High-yield securities (junk bonds) are lower-rated securities that may have a higher degree of credit and liquidity risk. Sovereign debt securities are subject to default risk. 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. The currency market is highly volatile. Prices in these markets are influenced by, among other things, changing supply and demand for a particular currency; trade; fiscal, money and domestic or foreign exchange control programs and policies; and changes in domestic and foreign interest rates. Investments in foreign markets entail special risks such as currency, political, economic and market risks. The risks of investing in emerging market countries are greater than the risks generally associated with foreign investments. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, and correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). Due to the possibility that prepayments will alter the cash flows on collateralized mortgage obligations (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 portfolio could sustain a loss.