KEY TAKEAWAYS
- Global inflation pressures arising in 2022 have pushed yields sharply higher in all fixed-income asset classes.
- Unfortunately, diversification has had no benefits with regard to returns.
- We expect correlations to normalize later this year and into 2023.
- Given current valuations, over time we expect GMS portfolios are likely to benefit and recapture the recent performance drawdown.
- Looking ahead, we believe GMS portfolios are well positioned to benefit from opportunities available in the various liquid global bond market sectors by drawing upon Western Asset’s best ideas in a risk-controlled framework.
Background
As we entered 2022, our outlook was for global growth to decelerate from the robust levels seen in 2021. A reduction in global fiscal stimulus, less monetary accommodation and ongoing secular headwinds including rising global debt burdens, aging demographics and technology displacement were anticipated to help slow global growth as the world began to return to post-Covid normality. Inflation pressures, despite being more persistent than anticipated, were expected to recede during 2022 as global supply-chains pressures eased and growth moderated. Corporate fundamentals were in sound shape, with leverage below the post-Covid spike, healthy balance sheet liquidity and anticipated passive deleveraging. In addition, technical conditions for the credit markets were also positive. High-yield credit offered a good risk/reward profile given positive growth, minimal default rates and positive ratings trends. Select emerging market (EM) bonds offered value with higher real yields and stronger macroeconomic fundamentals than when the Federal Reserve (Fed) last began to withdraw monetary stimulus in 2013. Additionally, many EM countries and companies would benefit from exports of energy and commodities supported by positive global growth.
Global Multi Sector (GMS) portfolios were positioned to take advantage of this environment, diversified across developed market (DM) global investment-grade and high-yield corporate bonds, EM bonds and currencies, plus some exposure to floating-rate debt via bank loans. For diversification and risk control against an unanticipated slowdown in growth, where risk assets would be vulnerable, GMS portfolios maintained some modest interest-rate exposure, principally in the US with overall duration just below the midpoint of its typical range of 3-7 years. Ex-ante risk was below that of the strategy’s longer-term target, reflecting fairly tight credit spreads and reasonably low levels of government bond yields.
What Happened
As the first half of 2022 progressed, inflation continued to increase globally—far exceeding central bank and market expectations. The combination of higher food and energy prices and ongoing supply-chain issues as a result of the Russian invasion of Ukraine and further Covid-related lockdowns in China forced major central banks to move to a more hawkish stance to rein in inflation. This led to a global upward repricing of interest rates. At the same time, credit spreads widened as markets began to price in slower growth, declining corporate profitability and higher default rates. EM countries were also negatively impacted by geopolitical issues and lower real incomes although some Latin American currencies including the Mexican peso and Brazilian real held up well given the strength in commodities.
Impact on GMS Portfolios
With the exception of 2018, over a 25-year history the GMS strategy has always benefited from diversification when considering its exposure across high-yield, EM and higher quality assets as represented by Global Aggregate bonds (e.g., government bonds and investment-grade credit and mortgage issues). In any economic or credit environment, there is normally at least one asset class that benefits and helps dampen volatility to cushion some of the downside.
For example, during the global financial crisis (GFC) of 2008, high quality global aggregate bonds benefited from the flight to quality. During the Fed’s tapering of its balance sheet during 2013, high-yield performed relatively well. EM outperformed high-yield during 2015 when oil collapsed and the Fed raised rates at the end of the year. Only in 2018 were all of the major fixed-income asset classes highly correlated when the Fed was raising rates and risk assets underperformed due to a slowdown in Chinese growth and concerns over a global trade war. But returns in 2019 were very strong as the Fed reversed course and global growth improved.
During the extreme conditions of 2008, 2015 and 2018, we focused on our long-term value approach—we revisited the fundamentals and tied those into market pricing, and rotated the portfolio’s assets toward the asset classes we felt offered the best risk/reward opportunities. Over 3-year periods that included these years of challenging performance GMS generated attractive returns, as market conditions normalized, we captured the improvement in value and generated even greater positive returns the following year. This is demonstrated in Exhibit 3 which shows the GMS strategy’s 3-year rolling returns. Indeed, GMS has provided positive absolute returns in 97% of the monthly observations (264 of 273 months) since inception in 1996.
We now face a similar situation where financial conditions have tightened and diversification has offered limited protection from negative total returns. Even bank loans, which typically benefit from floating-rate interest payments, have come under pressure over concerns of the future interest-rate burden on companies’ cashflows.
Negative returns across all fixed-income asset classes and high correlations so far this year have resulted in a performance drawdown for GMS portfolios commensurate with the GFC of 2008 and the spring of 2020 when Covid broke out on a global basis. However, to put returns into perspective, GMS portfolios, which have an average investment-grade rating (BBB), have a return so far this year that is less negative than US investment-grade corporate bonds.
Where We Go From Here
The key to an improved tone and more stability in the fixed-income markets is a moderation in inflation. Our base case is that the supply chains will slowly begin to normalize. This trend, combined with the Fed and other major central banks around the world tightening monetary policy along with negative real incomes slowing consumption, should see inflation moderate. There are signs that the housing market is beginning to slow as higher mortgage rates begin to bite and there is anecdotal evidence from corporates that inventories are normalizing and demand is softening. Therefore, we anticipate inflation to peak in 3Q22 and decline into 2023. The Fed, however, is expected to raise interest rates in the short term at a faster pace until it sees inflation start to fall toward its 2% target. Markets have largely priced in this more aggressive action by the Fed and currently Treasury yields are significantly higher than the 2% inflation target.
In terms of growth, we anticipate a moderation toward trend growth of around 1.5%-2.0%. There is a risk that monetary policy is tightened in the face of higher short-term inflation readings or that real rates increase even as inflation declines, which in turn would cause growth to slow more sharply. In that case, the Fed is likely to be more cautious in its monetary-policy deliberations—which should be positive for higher quality bond sectors. We believe that credit markets are already pricing in risks of a sharply slower global growth profile, based on market-implied forward credit default rates.
The yield-to-maturity of GMS portfolios is currently in excess of 7%. The negative scenarios surrounding growth and inflation over the next 12 months are largely priced. The more balanced nature of these risks should mean a reversion to the negative correlations of US Treasuries and risk assets in times of market stress.
If inflation does begin to show signs of peaking and coming down then that should provide stability to rates markets. Anything less than a hard landing/recession should see credit spreads stabilize and potentially contract—this outcome should be very beneficial to GMS portfolios and their ability to recapture recent performance drawdowns.
Of course, there are risks to our base case—both in terms of ongoing inflation pressures and downside growth risks. We are cognizant of these risks and will adjust GMS portfolio positioning as appropriate to navigate those scenarios.
We have had the benefit and privilege of managing GMS portfolios for over 25 years through numerous interest-rate, economic and credit cycles. Each challenge that presents itself is different, but as long-term value investors building portfolios with multiple diversified strategies, we believe that the GMS strategy is well positioned to capture future returns especially as traditional asset class relationships are re-established.
View the Performance and Risk Disclosures for Global Multi-Sector.