Western Asset’s base case outlook is for an elongated, U-shaped global economic recovery. We expect the battle against COVID-19 will take time; however, we are encouraged by signs of progress in the global race for a vaccine and the decline in global mortality rates. Forceful policy action to date has buoyed global economic activity and restored market functioning. We expect central banks to remain extraordinarily accommodative, especially in light of subdued global inflation pressures, and to remain so to support the recovery. That stated, we continue to be wary of the upcoming US presidential election, post-Brexit trade negotiations, US-China trade discussions and geopolitical tensions as these all have the potential to disrupt economic and financial market activity. Given these uncertainties, we aim to position our portfolios to withstand further market volatility, yet remain flexible enough to capture exceptional value opportunities as they appear. Here, we provide a summary of the key drivers behind our global outlook and describe where we see value across global fixed-income markets.

KEY DRIVERS
US: Recovery Proceeding

The US economy has made steady and impressive progress in 3Q. It is uncontestable that the economy is still suffering from the effects of the Covid-induced shutdowns and related strictures on business operations. However, the remaining softness is either confined to sectors that are still laboring under severe shutdown constraints or else is the lagged effects of weak demand some months ago.

Both consumer and business demand for merchandise has rebounded fully back to and through their pre-Covid levels. Goods production is rising nicely, but has not bounced as sharply as demand, as producers have been cautious to see whether the restored demand would sustain. The difference was accommodated by a sharp reduction in inventories. Inventories are showing signs of rebounding, restored demand is continuing and we believe it is just a matter of time before goods production fully reaches pre-shutdown levels.

The situation is even more positive for construction. There, new-home sales are much higher than their pre-Covid levels, and it is merely pipeline issues that have so far kept construction spending below pre-Covid levels. This will likely change very soon, as builders catch up with demand. In service sectors, however, shutdowns and consumer fears have kept passenger travel, accommodations and recreation sectors from achieving anything more than a token bounce, though health care and restaurants have rebounded more strongly.

A full recovery in these sectors most probably awaits the introduction of a credible COVID-19 vaccine. Until then, it will be a bifurcated economy, with near-complete recovery in some sectors, but only partial recovery in those sectors most affected by social distancing. Both the Fed’s monetary policy and governments’ fiscal policy are likely to key off those sectors still suffering.

Europe: A Strong Rebound Is Getting a Bit Less Strong

Our growth expectations for the eurozone in 2020—contraction of around 9%—remains unchanged. However, we now believe that the better-than-expected economic rebound underway in Q3 will run into more significant headwinds during Q4, mainly as the result of (local) restrictions to contain the second waves of Covid-19 infections and also due to fading fiscal policy support. Looking into 2021, we believe that some economies might recover to end-2019 GDP levels next year whereas the harder-hit ones will only do so in 2022.

At a national level, fiscal stimuli have averaged around 4% to 5% of GDP, but supplementary measures including government guarantees have varied widely, ranging from close to 0% to essentially open-ended. European economies are likely to end 2020 with fiscal deficits in the 7% to 12% range, with debt-to-GDP ratios increasing between 10% and 20%. As the focus shifts to next year’s budgets, there will be a transition from stop-gap measures to those promoting longer-term policy priorities. In addition, the fiscal measures taken at the European level in May and July will provide support over the next few years, although the impact will only be felt later in 2021 and beyond.

While the ECB’s Targeted Longer-Term Refinancing Operations (TLTRO) continue to provide ample liquidity at very favorable rates to European banks, the ECB has slowed down its purchases under the €1.35 trillion Pandemic Emergency Purchase Program (PEPP) as market dislocations and fragmentation risk have receded. In fact, government bond yields have trended lower and are close to historic lows in some jurisdictions. With eurozone inflation already starting to drift below the most recent—not particularly optimistic—projections, the ECB is now more likely to extend and upsize the PEPP, which is currently set to end in June 2021. In addition, a return of pandemic-related adverse conditions in asset markets could make the need for a higher purchase pace even more obvious.

In the UK, the Bank of England has started some preparatory work to potentially push policy rates into negative territory, but has denied that this is an option in the near term. That said, monetary policy might have to step up again, including by potentially increasing the size of the quantitative easing (QE) envelope, as some fiscal policy support measures are expected to run out in Q4 and negotiations with the EU over a post-Brexit trade relationship have just been extended into October and are so far inconclusive. Our base case remains that both sides will reach an accord on some form of free-trade agreement that would be better than the WTO fallback.

Asia: A Brighter Path to Recovery

Per its latest growth estimate, the Asian Development Bank expects Asia as a region to decline by 0.7% in 2020. This will be the first regional contraction since 1962, and only China is expected to buck the contraction malaise with a growth rate of 1.8%. However, in the aftermath of Covid, growth for developing Asia is expected to rebound by a strong 6.8% in 2021 led by China (+7.7%), India (+8.0%) and Indonesia (+5.3%). For now, Asia’s recovery continues to be led by exports out of North Asia, driven primarily by inventory restocking as well as medical-related demand. Containment fatigue is setting in, with governments correspondingly losing their appetite to continue with mobility curbs or lockdowns. The challenge will be the strain on healthcare systems even if mortality broadly remains low. While there are early signs of progress on vaccines, COVID-19 will likely remain a lingering concern. It will be some time before social and business travel return to normal. Market confidence, though, will be fundamentally underpinned by policymakers having demonstrated their willingness to do whatever it takes to prop up their economies.

For now, Asian economies continue to benefit from both fiscal and monetary policy space with the only exception being India and Malaysia, which have higher public-debt ratios than their peers. While core inflation remains subdued in most Asian countries, headline inflation might see a spike due to oil price inflation. Asian central banks are expected to keep policy rates at current levels heading into the end of the year, even though there is clearly room for further easing with most countries having low foreign currency debt and strong current account surpluses. The policy pause is also driven by the increasing challenges with monetary policy transmission as well as the intent to maintain monetary policy space if growth conditions deteriorate.

US: Recovery Proceeding
US Recovery

The US economy has made steady and impressive progress in 3Q. It is uncontestable that the economy is still suffering from the effects of the Covid-induced shutdowns and related strictures on business operations. However, the remaining softness is either confined to sectors that are still laboring under severe shutdown constraints or else is the lagged effects of weak demand some months ago.

Both consumer and business demand for merchandise has rebounded fully back to and through their pre-Covid levels. Goods production is rising nicely, but has not bounced as sharply as demand, as producers have been cautious to see whether the restored demand would sustain. The difference was accommodated by a sharp reduction in inventories. Inventories are showing signs of rebounding, restored demand is continuing and we believe it is just a matter of time before goods production fully reaches pre-shutdown levels.

Shutdowns and consumer fears have kept passenger travel, accommodations and recreation sectors from achieving anything more than a token bounce. Double O Small Icon

The situation is even more positive for construction. There, new-home sales are much higher than their preCovid levels, and it is merely pipeline issues that have so far kept construction spending below pre-Covid levels. This will likely change very soon, as builders catch up with demand. In service sectors, however, shutdowns and consumer fears have kept passenger travel, accommodations and recreation sectors from achieving anything more than a token bounce, though health care and restaurants have rebounded more strongly.

A full recovery in these sectors most probably awaits the introduction of a credible COVID-19 vaccine. Until then, it will be a bifurcated economy, with near-complete recovery in some sectors, but only partial recovery in those sectors most affected by social distancing. Both the Fed’s monetary policy and governments’ fiscal policy are likely to key off those sectors still suffering.

Europe: A Strong Rebound Is Getting a Bit Less Strong
Europe Rebound

Our growth expectations for the eurozone in 2020—contraction of around 9%—remains unchanged. However, we now believe that the better-than-expected economic rebound underway in Q3 will run into more significant headwinds during Q4, mainly as the result of (local) restrictions to contain the second waves of Covid-19 infections and also due to fading fiscal policy support. Looking into 2021, we believe that some economies might recover to end-2019 GDP levels next year whereas the harder-hit ones will only do so in 2022.

At a national level, fiscal stimuli have averaged around 4% to 5% of GDP, but supplementary measures including government guarantees have varied widely, ranging from close to 0% to essentially open-ended. European economies are likely to end 2020 with fiscal deficits in the 7% to 12% range, with debt-to-GDP ratios increasing between 10% and 20%. As the focus shifts to next year’s budgets, there will be a transition from stop-gap measures to those promoting longer-term policy priorities. In addition, the fiscal measures taken at the European level in May and July will provide support over the next few years, although the impact will only be felt later in 2021 and beyond.

Looking into 2021, we believe that some economies might recover to end-2019 GDP levels next year whereas the harder-hit ones will only do so in 2022. Double O Small Icon

While the ECB’s Targeted Longer-Term Refinancing Operations (TLTRO) continue to provide ample liquidity at very favorable rates to European banks, the ECB has slowed down its purchases under the €1.35 trillion Pandemic Emergency Purchase Program (PEPP) as market dislocations and fragmentation risk have receded. In fact, government bond yields have trended lower and are close to historic lows in some jurisdictions. With eurozone inflation already starting to drift below the most recent—not particularly optimistic—projections, the ECB is now more likely to extend and upsize the PEPP, which is currently set to end in June 2021. In addition, a return of pandemic-related adverse conditions in asset markets could make the need for a higher purchase pace even more obvious.

In the UK, the Bank of England has started some preparatory work to potentially push policy rates into negative territory, but has denied that this is an option in the near term. That said, monetary policy might have to step up again, including by potentially increasing the size of the quantitative easing (QE) envelope, as some fiscal policy support measures are expected to run out in Q4 and negotiations with the EU over a post-Brexit trade relationship have just been extended into October and are so far inconclusive. Our base case remains that both sides will reach an accord on some form of free-trade agreement that would be better than the WTO fallback.

Asia: A Brighter Path to Recovery
Open Sign Chinese
Growth for developing Asia is expected to rebound by a strong 6.8% in 2021. Double O Small Icon

Per its latest growth estimate, the Asian Development Bank expects Asia as a region to decline by 0.7% in 2020. This will be the first regional contraction since 1962, and only China is expected to buck the contraction malaise with a growth rate of 1.8%. However, in the aftermath of Covid, growth for developing Asia is expected to rebound by a strong 6.8% in 2021 led by China (+7.7%), India (+8.0%) and Indonesia (+5.3%). For now, Asia’s recovery continues to be led by exports out of North Asia, driven primarily by inventory restocking as well as medical-related demand. Containment fatigue is setting in, with governments correspondingly losing their appetite to continue with mobility curbs or lockdowns. The challenge will be the strain on healthcare systems even if mortality broadly remains low. While there are early signs of progress on vaccines, COVID-19 will likely remain a lingering concern. It will be some time before social and business travel return to normal. Market confidence, though, will be fundamentally underpinned by policymakers having demonstrated their willingness to do whatever it takes to prop up their economies.

Asian economies continue to benefit from both fiscal and monetary policy space with the only exception being India and Malaysia. Double O Small Icon

For now, Asian economies continue to benefit from both fiscal and monetary policy space with the only exception being India and Malaysia, which have higher public-debt ratios than their peers. While core inflation remains subdued in most Asian countries, headline inflation might see a spike due to oil price inflation. Asian central banks are expected to keep policy rates at current levels heading into the end of the year, even though there is clearly room for further easing with most countries having low foreign currency debt and strong current account surpluses. The policy pause is also driven by the increasing challenges with monetary policy transmission as well as the intent to maintain monetary policy space if growth conditions deteriorate.

The Big Picture

Developed Market Rates: Relative Value by Region

CANADA: Provincial and corporate spreads should resume tightening after recent softness. 30-year real return bonds remain compelling with breakeven inflation rates at 1.30%, below underlying inflation trends. We remain wary of energy exposure after Canadian energy prices rebounded sharply in Q2 and have been flat to down since.
US: We expect rates to remain low and range-bound; duration could serve as a valuable risk-off hedge. As the yield curve has steepened over the past months, we see value in the back end of the curve.
UK:We continue to expect a few more bumpy months in terms of headlines. Intensified trade talks with the EU should provide some temporary relief for the pound, but we still expect pound weakness over the medium term. UK fixed-income markets could benefit from another round of monetary policy support.
EUROPE: While we still see some room for spread compression in select markets, the overall opportunity set is shrinking as massive policy support—especially via the ECB—has produced a rapid rebound in fixed-income markets. We also expect the news flow to become less positive into year-end, but view the European policy response to Covid as a very significant step forward.
JAPAN: We expect a steeper yield curve, especially in the super-long end as the front end and intermediate parts of the curve are likely to stay low under the yield curve control (YCC) framework by the BoJ.
AUSTRALIA: We remain active in the mid to long part of the curve; we also remain overweight semi-government and SSA bonds given their appeal to foreign investors on a yield and hedging cost basis.
See Relative Value by Sector section for the Emerging Markets outlook.
US The economy is still suffering from the effects of the Covid shutdowns and related strictures on business operations. While the goods sector is recovering nicely, the services sector (away from health care and restaurants) continues to be weighed down by shutdowns and consumer fears. We see a bifurcated economy as we move into 2021.
Canada The Canadian rebound in household demand is likely to be more robust than in the US due to the ongoing household income support into 2021. The risks seen earlier to Canadian real estate have been pushed aside, with Canada now experiencing a broad upswing in real estate demand. The economic rebound is now widespread though it is slowing, as it is elsewhere, but the pandemic infection rates are also rising again. However, Canada appears relatively well-placed to ensure its economic recovery continues.
Europe As the continent rebounds from the H1 recession, the need for coordinated fiscal support is higher than ever to avoid fragmentation between countries with fiscal space and those without. The decisions taken already will also lead to a sizable pool of supranational safe-haven assets in the context of the recovery fund. Having deployed or enhanced several highly effective tools to combat the COVID pandemic in a timely fashion, the ECB is, for now, in a wait-and-see position, and will be watching inflation developments carefully.
UK We expect increased volatility into year-end as fiscal policy is being tightened and trade negotiations with the EU were just extended, but are required to conclude by the end of the year. The outlook for monetary policy has become more subjugated to events on the fiscal and trade side, which could lead to another round of monetary easing in an adverse outcome.
Japan We expect the Japanese economy to continue recovering from the Covid crisis on the back of its unprecedented policy response. New Prime Minister Suga is likely to maintain the current flexible fiscal stance to support the recovery. Also, we continue to believe that the BoJ will keep interest rates very low for a long period of time with a steepening bias toward the Japanese yield curve.
Australia The broader economy is showing a solid recovery and with the harsh lockdown rules in Victoria starting to show results, a full opening of the economy is likely by mid-Q4. The RBA continues to tinker with its support packages for bank funding and this has driven liquidity to record levels, with the funding rates reaching record lows. The upcoming budget in October is expected to deliver a substantial fiscal expansion, which would allow the RBA to focus on QE.

Relative Value by Sector

Investment-Grade (IG) Corporate Credit
US
Outlook While the direction for fundamentals is uncertain and subject to the path of the virus, we are cautiously optimistic for an eventual recovery. Valuations remain somewhat attractive even as they have meaningfully recovered from the crisis lows. The technical backdrop remains supportive for IG credit as demand remains robust.
Relative Value + We remain overweight in the near term, especially through higher-quality issuers with robust franchises, solid balance sheets and the wherewithal to survive an extended period of uncertainty.
Europe
Outlook Earnings continue to be challenged in Covid-related names, although some of the most exposed issuers have now fallen into HY. Companies continue to be proactive in addressing liquidity needs. IG remains well supported by the sizeable ECB program and a market starved of yield.
Relative Value +/– Valuations are not cheap in a historical context, but we think still offer some opportunity. Bank stocks remain under pressure, but we continue to like bank credit given balance sheet strength.
Australia
Outlook Demand for IG credit, particular bank paper, remains strong on the back of the Australian economy reopening from the lockdowns and ongoing RBA funding which suggests limited new issuance well into 2021. Primary markets were alive over the quarter with most deals well oversubscribed.
Relative Value + We remain overweight the IG sector, taking comfort from sound balance sheets and improving local sentiment. The technical bid remains particularly strong in local credit as the chase for yield continues.
High-Yield (HY) Corporate Credit
US
Outlook Q3 was a strong quarter for the HY market as the risk-on trade was in full-swing in July and August. Flows and new issuance remained strong. During the quarter, we took advantage of our ability to help structure certain high-quality secured transactions, largely in cyclical sectors, and anticipate this will continue moving forward.
Relative Value + We continue to position for a “reopening trade” and remain overweight certain cyclical sectors (airlines, cruise lines and retail) complemented by a higher-quality bias in those less cyclical subsectors providing ballast in the portfolios.
Europe
Outlook Q3 returns across all ratings bands were fairly consistent. The market has gone from focusing on corporate liquidity to balance sheet sustainability and deleveraging potential. Supply has been focused on higher-rated BB companies with hardly any CCC issuance. We believe that as we move toward 2021, with expected fiscal stimulus and ultimately an improvement in economic growth, HY continues to look attractive versus lower yielding asset classes.
Relative Value + Within HY, we favor BB and B credits with a focus on defensive industries (e.g. health care, telecom and cable) and industrials that should benefit from increased fiscal stimulus. We remain selective on consumer-related companies which are more likely to experience Covid-related headwinds.
Bank Loans
US
Outlook While September saw a flurry of transactions, we expect Q4 to be a light issuance period. On the demand front, the CLO cost of financing has tightened to pre-Covid levels, which will drive incremental CLO issuance during the quarter. As a result, we expect demand to outstrip supply and continue to drive the loan market higher into year-end (post November election volatility).
Relative Value + Defensive higher-quality names will continue to grind higher as ramping CLOs look to purchase in the secondary. We have been able to selectively purchase certain names at very attractive levels that we believe have the appropriate liquidity runway and business profile to weather the pandemic.
Collateralized Loan Obligations (CLOs)
US
Outlook The CLO market will likely take its cue from the underlying credit markets (bank loans and HY), as well as from supply technicals. While spreads have recovered materially since the March lows, IG-rated CLO spreads still remain attractive. However, the direction of spreads in the early part of Q4 will depend on the large current supply backdrop eventually clearing.
Relative Value + We retain our view that AAAs will continue to perform well in either a bearish or bullish scenario with plenty of opportunities across the entire AAA term structure. BBB and select BB CLOs offer compelling total return at current valuations.
Structured Credit
Agency MBS
Outlook We are neutral on mortgages based on current valuations and continued support from Fed purchases.
Relative Value +/– We favor TBA in production coupons and specified pools in higher coupons.
Non-Agency Residential MBS (NARMBS)
Outlook While uncertainty surrounding the Covid crisis remains, housing was in a strong position going into the crisis. The response from regulators and the Fed has been swift and effective at preventing a spike in foreclosures and keeping capital flowing into the housing market.
Relative Value + We are positive on legacy NARMBS/new-issue re-performing loan deals as many of these borrowers have already withstood similar disruptions (e.g., the GFC and hurricanes) and are proven performers.
Non-Agency Commercial MBS (CMBS)
Outlook As broad market sentiment improved in May, CMBS markets saw better demand and continued to recover. It is unclear how long it will take for commercial real estate markets to fully recover from the pandemic. We expect the fundamental outlook to be uneven across property types and markets as the impact of COVID-19 on each property type and geography varies.
Relative Value +/– We are positive on short-duration, well-structured single-borrower securitizations and loans. We remain selective and prefer bonds that can better withstand a period of reduced operating income and forbearance and provide good risk/reward.
Asset-Backed Securities (ABS)
Outlook We are cautious on consumer fundamentals and watchful of credit performance on consumer ABS sectors due to the impact of COVID-19 on the economy and the uncertain pace of recovery.
Relative Value +/– We favor well-protected senior ABS classes from high-quality sectors with low Covid disruption impact.
Inflation-Linked
US
Outlook A rebound in Core CPI still leaves inflation running below 2019 levels. Energy prices are expected to have modest upside through year-end, though significant inventories do represent downside risk. The Fed’s policy shift to average inflation targeting will struggle to get inflation to 2.0%, given no change in policy implementation or new tools.
Relative Value + TIPS have underperformed nominal USTs across the curve. We remain focused on longer-dated breakeven trades that should still benefit from the new inflation targeting regime.
Europe
Outlook Inflation may remain subdued relative to historic levels but should move above the levels implied by the current very low breakeven inflation rates once it becomes apparent that economic recovery has begun. ECB purchases of index-linked bonds should provide support in the near term.
Relative Value + In index-linked and global portfolios, we maintain exposure to French and Italian real yields and breakeven inflation spreads.
Japan
Outlook Japanese breakeven inflation spreads have sunk below 0%. Considering the embedded floor options, Japanese inflation-linked bonds are significantly undervalued.
Relative Value + We maintain an overweight in Japanese real yields against nominal yields.
Municipals
US
Outlook Municipalities will continue to grapple with acute budget stress associated with the economic implications of the pandemic, compounded by fading federal stimulus expectations. While the majority of the municipal market maintains the budgetary resiliency to employ austerity measures to meet obligations, we anticipate that a fraught election season, pandemic-related headlines and increasing muni supply could drive short-term market volatility.
Relative Value + We continue to favor lower IG revenue-backed securities versus higher-quality General Obligation-backed liens. Within the revenue sector, we are increasing exposure to transportation and health care sectors on improved demand and attractive risk-adjusted returns.
Emerging Market (EM) Debt
EM Sovereigns (USD)
Outlook USD sovereign issuance continues at a healthy pace with EM countries seeking to take advantage of low rates to fund fiscal programs in order to blunt economic damage induced by the pandemic. Given EM nations’ limitations to implement significant monetary and fiscal programs versus that of DMs, we believe the crisis may linger longer in EMs.
Relative Value +/– We continue to favor select IG-rated EM USD-denominated sovereigns from both a carry and total-return standpoint, and exercise caution toward debt issued by lower-rated frontier sovereign countries that face an uphill road ahead.
EM Local Currency
Outlook The real rate differential between the US and EM countries is a dynamic that should benefit prospective EM capital and portfolio flows. Many EM central banks continue to be in accommodative mode in contrast to past crises. EM FX continues to play its role as the pressure relief valve in periods of stress.
Relative Value +/– We continue to find local rates attractive given high real yields, while thoughtful on EM currencies that continue to be subject to volatility. With still-high real rates relative to DM, we view local rates as carry rather than total return.
EM Corporates
Outlook EM corporates are comparatively defensive within the global credit universe, however deteriorating global and sovereign-level growth weigh on fundamentals. EM corporates have relatively clean maturity schedules and liquidity positions, which companies have been bolstering with cost cuts, revolver borrowings and opportunistic new issuance.
Relative Value +/– We see value in high-quality EM corporate bonds. We continue to be cautious about single B rated EM corporates with cyclical/commodity exposure or domiciles with elevated macroeconomic and/or political vulnerability to COVID-19.
Outlook Relative Value
Investment-Grade (IG) Corporate Credit
US While the direction for fundamentals is uncertain and subject to the path of the virus, we are cautiously optimistic for an eventual recovery. Valuations remain somewhat attractive even as they have meaningfully recovered from the crisis lows. The technical backdrop remains supportive for IG credit as demand remains robust. + We remain overweight in the near term, especially through higher-quality issuers with robust franchises, solid balance sheets and the wherewithal to survive an extended period of uncertainty.
Europe Earnings continue to be challenged in Covid-related names, although some of the most exposed issuers have now fallen into HY. Companies continue to be proactive in addressing liquidity needs. IG remains well supported by the sizeable ECB program and a market starved of yield. +/– Valuations are not cheap in a historical context, but we think still offer some opportunity. Bank stocks remain under pressure, but we continue to like bank credit given balance sheet strength.
Australia Demand for IG credit, particular bank paper, remains strong on the back of the Australian economy reopening from the lockdowns and ongoing RBA funding which suggests limited new issuance well into 2021. Primary markets were alive over the quarter with most deals well oversubscribed. + We remain overweight the IG sector, taking comfort from sound balance sheets and improving local sentiment. The technical bid remains particularly strong in local credit as the chase for yield continues.
High-Yield (HY) Corporate Credit
US Q3 was a strong quarter for the HY market as the risk-on trade was in full-swing in July and August. Flows and new issuance remained strong. During the quarter, we took advantage of our ability to help structure certain high-quality secured transactions, largely in cyclical sectors, and anticipate this will continue moving forward. + We continue to position for a “reopening trade” and remain overweight certain cyclical sectors (airlines, cruise lines and retail) complemented by a higher-quality bias in those less cyclical subsectors providing ballast in the portfolios.
Europe Q3 returns across all ratings bands were fairly consistent. The market has gone from focusing on corporate liquidity to balance sheet sustainability and deleveraging potential. Supply has been focused on higher-rated BB companies with hardly any CCC issuance. We believe that as we move toward 2021, with expected fiscal stimulus and ultimately an improvement in economic growth, HY continues to look attractive versus lower yielding asset classes. + Within HY, we favor BB and B credits with a focus on defensive industries (e.g. health care, telecom and cable) and industrials that should benefit from increased fiscal stimulus. We remain selective on consumer-related companies which are more likely to experience Covid-related headwinds.
Bank Loans
US While September saw a flurry of transactions, we expect Q4 to be a light issuance period. On the demand front, the CLO cost of financing has tightened to pre-Covid levels, which will drive incremental CLO issuance during the quarter. As a result, we expect demand to outstrip supply and continue to drive the loan market higher into year-end (post November election volatility). + Defensive higher-quality names will continue to grind higher as ramping CLOs look to purchase in the secondary. We have been able to selectively purchase certain names at very attractive levels that we believe have the appropriate liquidity runway and business profile to weather the pandemic.
Collateralized Loan Obligations (CLOs)
US The CLO market will likely take its cue from the underlying credit markets (bank loans and HY), as well as from supply technicals. While spreads have recovered materially since the March lows, IG-rated CLO spreads still remain attractive. However, the direction of spreads in the early part of Q4 will depend on the large current supply backdrop eventually clearing. + We retain our view that AAAs will continue to perform well in either a bearish or bullish scenario with plenty of opportunities across the entire AAA term structure. BBB and select BB CLOs offer compelling total return at current valuations.
Structured Credit
Agency MBS We are neutral on mortgages based on current valuations and continued support from Fed purchases. +/– We favor TBA in production coupons and specified pools in higher coupons.
Non-Agency Residential MBS (NARMBS) While uncertainty surrounding the Covid crisis remains, housing was in a strong position going into the crisis. The response from regulators and the Fed has been swift and effective at preventing a spike in foreclosures and keeping capital flowing into the housing market. + We are positive on legacy NARMBS/new-issue re-performing loan deals as many of these borrowers have already withstood similar disruptions (e.g., the GFC and hurricanes) and are proven performers.
Non-Agency Commercial MBS (CMBS) As broad market sentiment improved in May, CMBS markets saw better demand and continued to recover. It is unclear how long it will take for commercial real estate markets to fully recover from the pandemic. We expect the fundamental outlook to be uneven across property types and markets as the impact of COVID-19 on each property type and geography varies. +/– We are positive on short-duration, well-structured single-borrower securitizations and loans. We remain selective and prefer bonds that can better withstand a period of reduced operating income and forbearance and provide good risk/reward.
Asset-Backed Securities (ABS) We are cautious on consumer fundamentals and watchful of credit performance on consumer ABS sectors due to the impact of COVID-19 on the economy and the uncertain pace of recovery. +/– We favor well-protected senior ABS classes from high-quality sectors with low Covid disruption impact.
Inflation-Linked
US A rebound in Core CPI still leaves inflation running below 2019 levels. Energy prices are expected to have modest upside through year-end, though significant inventories do represent downside risk. The Fed’s policy shift to average inflation targeting will struggle to get inflation to 2.0%, given no change in policy implementation or new tools. + TIPS have underperformed nominal USTs across the curve. We remain focused on longer-dated breakeven trades that should still benefit from the new inflation targeting regime.
Europe Inflation may remain subdued relative to historic levels but should move above the levels implied by the current very low breakeven inflation rates once it becomes apparent that economic recovery has begun. ECB purchases of index-linked bonds should provide support in the near term. + In index-linked and global portfolios, we maintain exposure to French and Italian real yields and breakeven inflation spreads.
Japan Japanese breakeven inflation spreads have sunk below 0%. Considering the embedded floor options, Japanese inflation-linked bonds are significantly undervalued. + We maintain an overweight in Japanese real yields against nominal yields.
Municipals
US Municipalities will continue to grapple with acute budget stress associated with the economic implications of the pandemic, compounded by fading federal stimulus expectations. While the majority of the municipal market maintains the budgetary resiliency to employ austerity measures to meet obligations, we anticipate that a fraught election season, pandemic-related headlines and increasing muni supply could drive short-term market volatility. + We continue to favor lower IG revenue-backed securities versus higher-quality General Obligation-backed liens. Within the revenue sector, we are increasing exposure to transportation and health care sectors on improved demand and attractive risk-adjusted returns.
Emerging Market (EM) Debt
EM Sovereigns (USD) USD sovereign issuance continues at a healthy pace with EM countries seeking to take advantage of low rates to fund fiscal programs in order to blunt economic damage induced by the pandemic. Given EM nations’ limitations to implement significant monetary and fiscal programs versus that of DMs, we believe the crisis may linger longer in EMs. +/– We continue to favor select IG-rated EM USD-denominated sovereigns from both a carry and total-return standpoint, and exercise caution toward debt issued by lower-rated frontier sovereign countries that face an uphill road ahead.
EM Local Currency The real rate differential between the US and EM countries is a dynamic that should benefit prospective EM capital and portfolio flows. Many EM central banks continue to be in accommodative mode in contrast to past crises. EM FX continues to play its role as the pressure relief valve in periods of stress. +/– We continue to find local rates attractive given high real yields, while thoughtful on EM currencies that continue to be subject to volatility. With still-high real rates relative to DM, we view local rates as carry rather than total return.
EM Corporates EM corporates are comparatively defensive within the global credit universe, however deteriorating global and sovereign-level growth weigh on fundamentals. EM corporates have relatively clean maturity schedules and liquidity positions, which companies have been bolstering with cost cuts, revolver borrowings and opportunistic new issuance. +/– We see value in high-quality EM corporate bonds. We continue to be cautious about single B rated EM corporates with cyclical/commodity exposure or domiciles with elevated macroeconomic and/or political vulnerability to COVID-19.