Analyses
And the Beat Goes On …
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Global Fixed Income Bulletin
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décembre 15, 2021
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And the Beat Goes On …
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décembre 15, 2021
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And the Beat Goes On …
And the Beat Goes On … |
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November continued where October left off: heightened volatility, hawkish (or less dovish) central bank rhetoric, rising yields and flattening yield curves. However, around mid-month things changed. The discovery of the Omicron variant and its uncertain impact in conjunction with hawkish central banks upended credit and equity markets. After making new highs on November 18th, the S&P 500 Index fell almost 3% over the remainder of the month. Credit spreads, after gently widening over the previous two months, widened significantly. But longer maturity U.S. Treasury yields and other risk-free government bond yields fell sharply (German yields fell more than U.S. Treasury yields) and yield curves flattened in response to sell-offs in equities and credit, worries about growth, and the worry that the Fed would be accelerating tightening into an uncertain post-Omicron world.1
It seems like only yesterday hopes were high that vaccines would allow the world to normalize and get back to where things were pre-pandemic. In terms of economics, many countries are getting there; e.g., recovering lost output and getting back to full employment. But it is happening at a cost: higher inflation. How will Omicron impact the growth/inflation nexus? If the world is lucky, it will prove to be a milder version, less lethal, less virulent in terms of its negative health implications. If so, it could accelerate the process of moving to a more normal world. Strong growth, higher inflation, higher interest rates is probably okay for credit and equity markets. On the other hand, suppose it is a more transmissible Delta-like variant? Maybe more resistant to existing vaccines? Will growth weaken? Will inflation worsen? Will economies weaken due to intensified supply side issues? And/or will it constrain demand as mobility decreases once again? And how will it impact monetary policies?
For now, we think the best working assumption is that Omicron will not cause any radical changes in health outcomes or economic behavior. If true, the biggest risk for financial markets is inflation and how central banks react. We are seeing today probably the greatest dispersion in central bank policies (current and prospective) in many years. Most importantly, the Fed has changed its tune most aggressively: from believing inflation was predominantly transitory, it now believes it is likely to be persistent, necessitating a change in policy. Tapering of QE is likely to accelerate so that it ends before July; Chairman Powell has stated as much in recent comments. This opens the door to rate hikes sooner, possibly as soon as the second quarter. Other central banks are more sanguine on the inflation outlook: the European Central Bank (ECB), People’s Bank of China (PBOC), Bank of Japan, Swedish Riskbank, and the Reserve Bank of Australia. On the other hand, many central banks, primarily in emerging markets, are tightening policy aggressively. Amongst developed countries, the UK, Canadian and New Zealand central banks look set to raise rates before the Fed or, in the case of New Zealand, continue to raise them.
A key question for financial markets will be to what extent central banks follow through on their current plans. Clearly, if a central bank was dovish prior to Omicron, it is likely to be more dovish post. For example, the Swedish central bank is adamant that essentially all the inflation spike is transitory and therefore there is no need to raise rates before 2024! On the other hand, the UK -- not too distant from Sweden -- seems quite keen to raise rates immediately, although recent comments suggest there could be advantages to waiting for more evidence on the impact of Omicron. Regarding the Fed, there appears to be no impediment to accelerating tapering. This was an emergency program to deal with the initial impact of the pandemic. With inflation where it is and growth and employment strong, why should QE exist? It should not. Fortunately, for the Fed, the decision to raise rates can be postponed for several months while QE is tapered, allowing more time to evaluate the impact of the Omicron variant and the path of inflation. All in all, we expect central banks to proceed cautiously in the near future.
In terms of our market views, we have generally been reducing portfolio risk given the uncertain outlook. We remain long risky assets (corporate credit, securitized credit, emerging markets), a bit less than last month, because of the positive economic outlook and strong fundamentals. We expect government bond yields to reverse at least some of their Omicron related fall but meaningful rises will depend on three things: equity market stabilization, Fed hawkishness, and volatility. But it will be a “long and winding road”.
Note: USD-based performance. Source: Bloomberg. Data as of November 30, 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 November 30, 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 November 30, 2021.
Note: Positive change means appreciation of the currency against the USD. Source: Bloomberg. Data as of November 30, 2021.
Source: Bloomberg, JPMorgan. Data as of November 30, 2021.
Source: Bloomberg, JPMorgan. Data as of November 30, 2021.
Fixed Income Outlook
November looked like a repeat of October until the Omicron variant was uncovered. Central banks continued to talk and act hawkishly. Yields were rising and curves were flattening. And volatility was up. But then the Omicron variant arrived or, more precisely, was uncovered. This, in conjunction with demanding valuations and Fed hawkishness, hit credit and equity markets. Until mid-month the S&P 500 was making new highs. Over the remainder of the month, it lost almost 3%. Investment grade spreads widened approximately 12 basis points (bps) (a big move for this market) and high yield 50 bps -- moves that far from qualify as a bear market, but a meaningful correction nonetheless given underlying solid corporate fundamentals. Given the absence of any meaningful corrections in these markets for over a year, maybe one was overdue and a healthy development given the somewhat exuberant state of financial markets in recent months.
Looking into the future, our assumption is that the Omicron variant (and/ the residual effects of Delta variant) will not derail the underlying economic story underpinning financial markets. Yes, the pandemic will continue to find ways to act as a headwind; and yes, central banks and policymakers in general (outside of China) are dialing back support for economies, but household and corporate fundamentals look solid enough to generate above-trend growth, and, unfortunately, above-target inflation in 2022. Inflation remains a problem for most countries while growth outlooks remain resilient despite pandemic headwinds (i.e., mobility constraints and drags from energy prices). Global growth should accelerate in the fourth quarter with little abatement of inflation pressures, which do not seem to have peaked with the Omicron variant likely to not be helpful in terms of reducing inflation pressures. Unfortunately, this means that inflation concerns are likely to remain and central banks, like the Fed, will remain on a course of reducing accommodation.
Despite a lot of inflation angst, we expect central banks to move slowly and deliberately, particularly with the Omicron variant out there. We must keep in mind that, although the Fed is now firmly in the reduce-accommodation camp, the other three big central banks are clearly not: ECB, PBOC, BoJ. Global monetary policy in the more advanced economies is unlikely to tighten much in 2022. Emerging Market (EM) central banks are on a different trajectory, especially in Latin America and CEMEA. For those central banks moving to tighten, they are very likely to move slowly and will avoid doing anything to suggest policy needs to be “tight” rather than just “less easy”. But it must be said, with the Fed likely to end QE in the first half of 2022 and countenancing rate hikes in 2022, it will be easier for other central banks to follow.
This relatively sanguine monetary policy outlook is not without risk. Inflationary pressures are not abating, or at least not fast enough. Worries about second round effects and surging housing markets worry central banks. The most recent surge has come from higher energy prices (especially European natural gas prices), but the pressure is more broad-based: many other commodities (e.g., food, a particular concern for EM central banks) are also at multi-year highs; COVID-induced bottlenecks continue to cause shortages in many consumer goods supply chains, and there are widespread reports of labor shortages across developed economies. Omicron may in fact exacerbate some of these issues. It is currently unclear just how persistent, or permanent, many of these issues are, but what is certain is that the current surge in inflation is expected to last longer than previously thought. Thus, the need for central banks to play defense and engage risk mitigation strategies, which imply reduced accommodation.
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). But if the market starts expecting a more normal central bank cycle, then we believe yields should rise further. Credit investors have also become more nervous recently, causing credit spreads to widen; we think this is mainly reflective of how tight spreads have become 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 also taking its toll.
Where does this leave our views on markets? In general, we remain overweight the riskier, cyclical sectors but we have been reducing our exposure at the margin given valuations and increased volatility/uncertainty. On government bonds, we expect yields to move higher, but this is likely to be a long process given high global liquidity/savings and a likely slow tightening cycle. That said, we think low expected terminal rates and highly negative real yields make longer-maturity bonds relatively unappealing. Shorter maturity bonds are more interesting due to much higher risk premiums now priced in. The danger is those expectations of tightening could increase if inflation remains stubbornly elevated in December and early 2022. And, of course, Omicron remains an unknown. We remain overweight corporate credit (although less so than last month) and securitized products, particularly lower quality investment grade bonds and selective high yield (avoiding too much market beta); we are overweight in selective emerging markets, where there are, in our view, idiosyncratic reasons to be bullish.
Developed Market (DM) Rate/Foreign Currency (FX)
Monthly Review
November was full of volatility in the developed markets. Initially, strong economic data, inflation concerns, and hawkish beliefs drove rates up, inflation expectations higher, and yield curves steeper. In the end, however, that story was overshadowed by COVID concerns, which reversed the prior movements. The initial increases in rates were reversed into overall rate declines and yield curves to their flattest levels of the year.2
Outlook
If Omicron has a significantly negative impact on the economic outlook, then government bonds could remain well supported at current levels for some time. However, repeated upside inflation surprises, and some signs of inflation persistence, are pressuring central banks to normalize monetary policy quicker. We expect most DM central banks to have started hiking rates in 2022 (if they haven’t already), with the ECB, RBA and BoJ being notable exceptions. In currency markets, we see value in many emerging markets vs. G10. However, negative risk sentiment and greater macro risks mean EM FX could continue to trade cheap for some time. Amongst G10 currencies, we see limited valuation differences and hence are relatively neutral on our currency positioning.
Emerging Market (EM) Rate/FX
Monthly Review
EM debt returns were negative in November, with hard currency sovereigns -1.8%, on wider spreads, partially offset by a rally in U.S. Treasuries.3 EM Corporates returns were negative for the month with high yield underperforming investment grade corporates. Local currency bonds posted negative returns, primarily due to weaker EM currencies against the U.S. dollar. From a broad market perspective, Malaysia, Morocco, Hungary and China were the best performers in November, while bonds from Lebanon, Ethiopia and El Salvador were laggards. From a sectoral perspective, Diversified and Infrastructure companies led the market, while those in the Oil & Gas, Metals & Mining and Real Estate sectors lagged.4, 5
Outlook
We have a cautious stance towards Emerging Market debt at present on the back of tighter global monetary policy in the face of rising inflation, as well as uncertainty over the transmissibility of the new Omicron variant and its potential impact on global growth and inflation. Notwithstanding cheap valuations, high-yield sovereigns may continue to underperform investment-grade credits in the near term. Similarly, on the local side, EMFX may face near term challenges if dollar strength persists. In local rates, we prefer yield curves that are already pricing in aggressive monetary policy tightening.
Credit
Monthly Review
Credit spreads widened meaningfully in November on the risk-off sentiment. Sector and corporate news were dominated by Q3 earnings reports that confirmed performance was healthy and the impact of cost increases on margins was less than expected.6 The high yield market came under pressure in November amidst elevated volatility across global risk markets. The average credit spread widened by more than a half-percent by month-end.7 Global convertibles underperformed both equity and credit in November as the Refinitiv Global Convertibles Focus Index fell.8 Loan prices steadily firmed for much of November’s opening three weeks. Record-setting investor demand and an overall supply-deficit technical condition remained the catalysts. Loan prices later softened from November highs after the holiday however, as virus headlines took their toll on investor psyches and ultimately capital markets.9
Outlook
Looking forward we see little changed in the base case credit outlook with valuations looking full but fundamentals well supported by the four pillars of (1) expectations financial conditions will remain easy supporting low default rates (2) economic activity that is expected to rebound as vaccinations allow economies to reopen (3) strong corporate profitability with conservative balance sheet management as overall uncertainty remains high (4) demand for credit to stay strong as excess liquidity looks to be invested. We expect some volatility into year-end given the current uncertainty and lack of appetite for risk positioning.
Securitized Products
Monthly Review
Securitized markets remained choppy in November with performance largely driven by liquidity and depth of sponsorship rather than specific credit concerns. New issuance and secondary activity both remained high, and larger and more-liquid sectors outperformed more esoteric sectors.10 Agency MBS underperformed meaningfully in November, impacted by the flattening curve and potentially accelerated Fed taper expectations.11 U.S. Non-agency RMBS spreads were mixed, but generally either flat or wider across most residential sectors. Non-agency RMBS new issuance remained high, putting supply pressure on some parts of the markets.12 U.S. ABS spreads were also generally wider, with both more liquid sectors (auto and credit card) and less liquid sectors (aircraft, consumer loans, etc) experiencing spread widening.13 U.S. CMBS spreads also widened.14 European RMBS, CMBS and ABS activity remained high, and European spreads remained steady. European securitized spreads remain relatively tight compared to comparable U.S. securitized assets, despite talk of the ECB potentially reducing its asset purchases.15
Outlook
We expect market activity to slow in December. Higher rates, wider spreads and approaching year-end could cool overall activity levels. Credit fundamentals should remain healthy, especially for residential and consumer assets. European securitized markets should remain well supported by the historically low rates in Europe and by the asset purchase programs and lending programs of the ECB and BOE, although these purchase programs could also be reduced in the coming months.
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.