Market Insights at a Glance
We remain cautious given risks of slowing growth and central bank overtightening but believe current spreads adequately compensate investors. The following summary is intended to aggregate the Firm’s current overall views and present an at-a-glance dashboard.*
- US growth is slowing but still resilient, and we expect the US will avoid a recession
- Global growth is broadly downshifting but is aided by factors such as the reopening of supply chains in China and a weaker dollar, which bodes well for EM
- US inflation remains “sticky” but should continue to decline
- Inflation in Europe, especially in the UK, continues to remain prevalent
- Tailwinds coming out of the Covid pandemic that had been fueling inflation have either abated or even turned into headwinds
- Interest rates are likely to trend lower once the Fed achieves its terminal policy rate
- The yield curve has flattened due to policy tightening and recession fears
- In the US, the Fed hiked another 25 bps in July as expected; with US inflation continuing to moderate, this may be the Fed’s final hike of this cycle
- In Europe, the ECB also hiked rates by 25 bps in July as expected, citing elevated inflation—but with two more inflation releases before the September ECB meeting, future hikes are far from certain
- Fiscal stimulus and government spending during Covid drove economic demand, contributing to inflation
- Covid-related support is now reversing very meaningfully around the globe
- Large US banks are in good shape given their balance sheet strength and regulatory scrutiny
- We expect large banks to grow stronger while weaker regional banks will likely consolidate
*As of June 30, 2023
**As of July 27, 2023
Looking Ahead With Cautious Optimism
The period since the onset of Covid has been tumultuous to say the least. Last year, rising inflation drove markets and policy, stoking fears of recession. Now disinflation is well underway, uneven yet welcome, as central banks appear nearly done tightening—though risks remain of having gone too far as some cracks emerge. Stress persists in banking, but immediate disaster seems avoided, as systemic risks have abated. US and global growth are broadly slowing following the initial post-Covid rebound, but the former may skirt recession if policy steadies.
Supply chains have improved in China and a weaker US dollar aids other nations, especially developing ones hammered when the flight to safety bid the dollar up and Fed rate cuts sent capital home. Yet central bankers often cannot help reacting to each data point, keeping volatility high and trust in their judgment shaken when actions follow words but consequences prove still some ways behind.
Global growth is broadly downshifting but is aided by factors such as the reopening of supply chains in China and a weaker dollar, which bodes well for EM. But central bank overtightening is still a meaningful risk. Central bankers talk about the long and variable lags that need to be considered but they often can’t help overreacting to monthly inflation prints. This will continue to keep volatility and uncertainty high. Even with this backdrop, we are encouraged by the higher yields in fixed-income and our view is that investors are best served by higher-quality credits.
We all know how we got here. Inflation came in strongly with all the Covid-related stimulus. Unprecedented monetary and fiscal policy experiments kept the wheels churning until DM economies acquired vaccines and moved to reopen, essentially restarting the business cycle, which was a major demand shock amid tight supply constraints. The Russia/Ukraine War made matters worse, driving up energy prices and disrupting supply chains, as did China’s zero-Covid policy. The tailwinds to inflation have largely abated or turned into headwinds. Fiscal policy has been muted although still considered stimulative given the large deficit.
These headwinds to inflation should be cause for caution among central banks. Fed members are talking about the need to pause, citing the long and variable lags to its policy playing out. Inflation is clearly trending lower but continues to be uneven. Core CPI has been sticky, but continues to decline as seen in June readings. Generally, US and global inflation data have been surprising sharply to the downside. All DM central banks are tightening together, with the lags and feedback loops all hitting at the same time. This has meaningfully changed the projection of global inflation going forward, further fueling our optimism.
Reinforcing the Case for Fixed-Income
Valuations Have Been Restored
- One benefit following the recent rough patch is that bond yields and valuations have been restored—investors are now much more likely to find opportunities for enhanced yield in fixed-income (Exhibit 2).
- More attractive valuations amid falling inflation sets the table for a more promising investment environment.
- With valuations in better shape, inflation slowing and volatility down, the case for fixed-income today is very strong.
The Case for High-Quality Credit
- With higher yields overall in 2023, we favor higher-quality credit.
- Investment-grade corporate bonds and agency mortgage-backed securities (MBS) are high quality sectors that now have substantially more yield than they have over the past decade.
- While we expect to avoid a recession in the US, there remains the possibility of a hard landing. In that environment, higher quality spread product should perform better than lower quality.
Western Asset Investment Themes
|Asset Class||Our View|
|Overall Risk Assets||While tight monetary policy risks inducing more market volatility, high yields likely compensate investors if inflation ebbs as expected. Short-term bonds may shelter risks but curb returns, and risk tolerance determines comfort moving out the curve. We favor moving up in quality.|
|Investment-Grade||Spreads suggest muted upside but policy mistakes could introduce threats, so higher-quality issues are preferred for balance, especially given the attractive yields. Investment-grade remains attractive, but may face downside risks if recession yet hits.|
|High-Yield & Bank Loans||Distressed credits pose landmines, yet bargains may be identified through careful issue selection; with recession unlikely, lower-rated credit’s higher yields may be attractive but pose increase risks.|
|Structured Product||Residential credit has a cushion but commercial markets continue to struggle, and while mortgages are always complex, success relies on deep dives identifying strong credits and terms. Easy profits won't emerge but housing should remain stable, so values may be found in select agency RMBS.|
|EM Debt||Declining inflation should give central banks room to pause or even ease as global activity stabilizes, which could be a boon for EM where monetary policy could shift from a headwind to a tailwind.|