Market Insights at a Glance
Despite the backdrop of elevated stress, we think spread sectors are still attractive though the outlook is clouded by macro risk. The following summary is intended to aggregate the Firm’s current overall views and present an at-a-glance dashboard.*
- Banking turmoil in the US and Europe suggests the potential for systemic risk, which we believe is unlikely to happen
- Our view is that the banking system as a whole is extraordinarily sound, with equity capital ratios at multi-decade highs
- We continue to expect US growth to slow this year, but not necessarily into recession
- In China, with the reversal of Covid restrictions and an improving property market, growth of 5%-6% is likely for 2023
- The Fed seems to be relying on lagging indicators of inflation, but those should catch up to demonstrate that inflation indeed is moderating
- The Fed’s base case (to get inflation back to 2%) is still the prevalent narrative; however, the risk case is that inflation persists and growth slows dramatically
- We maintain an underweight position in the front end of the yield curve where we see the most volatility
- We favor an overweight position to the long end of the curve, in support of our disinflationary view
- In the US, we think the Fed now has the opportunity to pause, perhaps after one more 25-bp hike in May
- In Europe, the Bank of England and European Central Bank (ECB) face a very serious challenge in that UK and European inflation is climbing higher as the economies are worsening, with consumer confidence at all-time lows
- Global fiscal stimulus is turning into global fiscal drag, as Covid-related support is now reversing very meaningfully around the globe
- China is cutting its reserve requirement once again in an effort to make sure credit is flowing in. We think this is a very stimulative action and suggests that the property market will do even better as the year progresses
As of March 31 2023*
Will 2023 Break the Banks? We Think Not.
This has been a daunting period to navigate. For investors who are positioning portfolios based on the long-term disinflationary trend, assuming Covid was a historic one-off, the conversation was always, “where can I find safe yield?” One benefit of this volatile period is that bond yields and valuations have been restored—now, investors are likely to find plenty of opportunities for safer yield. This is why we are going up in quality in our portfolios, trimming high-yield and bank loans, adding to agency MBS and maintaining our investment-grade and EM positions. We are taking advantage of normalization given the disinflationary trend, but recognize that there may be risks to the downside. We favor duration in the long end of the curve where disinflation has the most effect. Those positioning for the “dark cloud” so-called hard landing would find a tremendous position in front-end rates and no spread exposure. We just don’t see that happening. Our expectation is that the disinflation process will continue to unfold, with central banks taking their foot off the brakes, which should be beneficial for fixed-income across the board.
As the first quarter approached its end, financial markets were jolted by bank failures in both the US and Europe. Fears of systemic contagion spread, sparking a massive rally of front-end rates as risk assets sold off in a classic flight to safety. Our immediate reaction to the US bank failures of Silicon Valley Bank (SVB) and Signature Bank on March 15 was that they were isolated incidents involving banks with unique characteristics, and not representative of the banking system at large (and we maintain that view). Just a few days later, European banks were in the spotlight with Switzerland’s Credit Suisse (CS) also facing insolvency. To address the situation and forestall a crisis of confidence, the Swiss government, central bank and market regulator orchestrated the state-backed takeover of Credit Suisse by UBS for 3 billion Swiss francs ($3.3 billion). As part of the resolution, the Swiss government made the unprecedented announcement to write down in full $17 billion of CS’s AT1 capital-contingent debt thus subordinating a bond to common equity in the capital structure. This decision to subordinate debt to equity sent initial shockwaves through the market across all subordinated banking debt as the Swiss government’s move defied international expectations of capital structure treatment. Even given this development, we remain convinced that large banks in the US and Europe continue to be attractive investments for bondholders, and that active management prioritizing sound fundamentals continue to be a critical component.
Falling Inflation Should Bolster Recovery
Exhibit 1 shows the expectation of the median Federal Open Market Committee (FOMC) member versus market expectations on short-term interest rates. As you can see from the chart, the Fed anticipates achieving a higher terminal policy rate and maintaining that rate for a longer period of time versus market expectations. Put simply, market pricing suggests a combination of lower inflation and/or a “hard landing,” which would cause the Fed to ease rates sooner than currently anticipated. We push back against the “hard landing” scenario, but believe inflation will continue to come down.
Western Asset Investment Themes
|Asset Class||Our View|
|Overall Risk Assets||Spread sectors are still attractive, although they have been shadowed by the possibility of a policy mistake and of course persistent geopolitical risks.|
|Investment-Grade||Spreads have widened as the cloud of macro risk continues to permeate, not unlike how they behaved amid the S&L crisis (circa 1990). Investors are being paid for default risk versus what’s reasonably expected, but US spreads relative to other countries look compelling.|
|High-Yield||We believe the market is pricing in pessimism that is out of line with current fundamental metrics. Although cracks are emerging for the most levered companies, the ability to service debt remains supportive of lower than average defaults.|
|Bank Loans||With interest coverage remaining near decade highs as EBITDA and interest rate expenses rose, bank loan fundamentals remain supportive of the asset class|
|Structured Product||Fundamentals and valuations look attractive for agency mortgage-backed securities (MBS), with spreads having widened significantly as the Fed and bank support diminished.|
|EM Debt||Adjusted for inflation, we think emerging market (EM) yields are attractive. A weaker US dollar and China coming off of its draconian Covid lockdowns also bode well for EM. Of course, issue selection remains key.|