Keeping an Eye on the Big Picture

Q: The first quarter of the calendar year has been extremely difficult in the fixed-income space, with returns hard to come by and excess carry failing to cushion wider spreads in all instances. Furthermore, there have been a lot of developments on the macro front. With all of this in mind, what is Western Asset’s current outlook for the broader global economy? As rates start to move in the US and across most Western economies as higher inflation starts to bite, where and how are you positioning portfolios for performance?

A: It’s important to keep in mind how quickly we’ve arrived at this moment when markets are completely fixated on inflation worries. At the end of last year, global growth was on the mend after almost two years of Covid-related headwinds. There were some rumblings then about inflation pressure in the US due to lingering supply-chain bottlenecks and some inflation concerns in Europe due to gas-supply disruptions boosting energy prices, but really nothing out of the ordinary was anticipated.

Our view as we entered 2022 was that the global recovery would continue marching on, but without any real inflation momentum as supply-chain bottlenecks eased over time. We were also cognizant that since then, there continue to be long-standing secular factors working behind the scenes, such as the high debt loads across countries, aging demographics and ongoing technological displacement; all of these factors generally help temper inflation pressure and keep long-term rates range-bound.

However, in the span of just four to five months, we’ve experienced two major events that have further accentuated the inflation narrative while simultaneously delivering a body blow to global growth prospects: Russia’s invasion of Ukraine in February (which has pushed oil and agricultural prices to new highs) and, more recently, the complete lockdown of major manufacturing cities in China due to rising Covid cases (which has exacerbated the supply-chain problem).

The combination of these developments and other idiosyncratic factors forced the major central banks such as the Federal Reserve (Fed), European Central Bank (ECB), Bank of England (BoE) and the Reserve Bank of Australia to sharply pivot away from their very accommodative stances and to jump in front of the inflation train. These sudden moves, the associated pessimism and the headlines looking to sensationalize every single macro data release together explain why global bond markets and risk assets have repriced so aggressively in such a short amount of time.

With this current context in mind, our outlook on global growth through year-end is a bit more benign than the consensus view, which at the moment is considerably more pessimistic on growth and inflation. We think central banks are very cognizant of the inflation risks and are using all the tools at their disposal (in particular, forward guidance) to address it, while being careful to not jeopardize economic growth. While some countries such as the US have turned down the dial on fiscal stimulus over the past year, we could see new forms of stimulus in China and the euro area. Bear in mind that myriad conditions in each country are quite different, of course, so how our macro base case for each plays out will depend a lot on inflation trajectories, how rising rates and elevated prices impact growth and, in turn, how each nation’s policymakers react.

At a high level, the main markets we’re focused on today are the US, Europe and the UK where active duration and yield-curve management are key to generating outperformance. If we’re right about global growth and inflation moderating as we move closer to year-end, that backdrop will be supportive for emerging markets (EM), which have been shaken by the sharp rise in rates and a strengthening US dollar as well as credit markets, which have softened a bit over the past few weeks.

As of late, we’ve been opportunistically adding to shorter-dated investment-grade credit where valuations have become much more attractive and to rising star stories, which we believe have strong total return prospects. These are select high-yield BB rated names that have the potential to move back to investment-grade status over the next 12-18 months.

Q: Fed Chair Powell has said the Federal Open Market Committee (FOMC) would not hesitate to push rates above neutral if necessary. The neutral rate in the US has been estimated to be somewhere between 2% and 3%. In your view, what do you believe the neutral cash rate would be?

A: We have to acknowledge at the outset that there’s still an ongoing debate over what the term “neutral” means. A few years ago, neutral meant the level of yields that was consistent with steady long-run growth and inflation. What we observed was that bond yields ended the last economic expansion at levels well below what Fed models estimated that neutral should be. Today, neutral refers to the level of rates above which inflation would start to decline. If you think about it, that’s a level well above the old definition of neutral.

Some pundits, like Larry Summers (who believes that 5% inflation is entrenched) think rates need to be well above 5% in order to start to curb inflation. Others who think 5%+ inflation is an aberration and that the economy is calibrated for an ongoing inflation rate of 3% or lower believe that rates near 3% make more sense. The bottom line is that there are so many opinions on both sides that it’s difficult to truly know what the consensus on the neutral rate really is. Given all this, the best we can say is that markets look to be priced for a neutral rate of around 3%, and we would be comfortable with that level or the Fed’s long-run estimate of about 2.5%.

Q: Policy risk has been a widely discussed topic. Aside from the Fed (and potentially other central banks) getting its tightening strategy and timing wrong, what are the prime risks that we need to remain cognizant of now with investing in these asset classes?

A: One risk that seems to have been pushed aside with all of the rate hike, inflation and Russia headlines is Covid, and the possibility of another major outbreak. Variants are still morphing out there and one could prove severe enough that more countries, not just China, begin to reintroduce mobility restrictions or lockdowns that slow the global economy more than anticipated. Such a scenario would certainly cool inflation fears and bring rates down, but slower than expected growth or a widespread recession that threatens to impair corporate earnings would also weigh heavily on equity markets and pressure credit spreads wider.

Another surprise scenario is that the Ukraine crisis is resolved sooner than expected due to a sudden turn of events out of Russia (for example, some form of regime change). That could result in a sharp repricing of inflation to the downside and growth expectations to the upside and push risk assets sharply higher. We can’t dismiss a scenario such as this, either.

Q: Given the volatility across markets and the disparity in policy responses across different regions, where do you see the best opportunities to add value? Are there any sectors or regions that stand out over the next 12 months, for example, EM?

A: This is a great question. In a market dislocation such as the one we’re currently experiencing, there’s often a knee-jerk tendency to look at higher-yielding asset classes to find potential sources of excess returns. But we have to bear in mind that there’s still plenty of macro uncertainty in the air, so it wouldn’t be prudent to just reach for yield.

We think the best opportunities will come from beat-up areas such as global government bonds and higher-quality corporate credit where valuations don’t make sense (to us) based on underlying fundamentals. Remember that pricing anomalies or inefficiencies typically pop up when securities are indiscriminately sold during market sell-offs to raise liquidity either to meet margin calls or redemptions. As an active manager, our job is to identify and exploit these inefficiencies.

To recap and add a bit more detail to our high conviction calls, consider the following. In the US, we believe that we’ve likely seen the peak in headline inflation. The Fed will be facing both weaker growth and prices as it considers tighter monetary policy in the second half of the year; with that in mind, we believe the Fed is unlikely to raise rates more than what’s currently priced in by year-end.

In Europe, the growth and inflation picture is much cloudier due to the potential disruption of natural gas from Russia. Even though we think the ECB is still determined to stop asset purchases, the hurdle for the bank to hike rates aggressively, e.g., by more than the 80 bps priced in by year-end, seems high to us.

The UK situation is also pretty interesting. With four rate hikes already in the bag, the BoE is ahead of the Fed and ECB in tightening monetary policy, but its latest inflation projections point to a significant undershoot versus the target if it hikes in line with market expectations. In other words, we think the BoE will likely pause for a while and take stock of the impact that inflation is having on consumer confidence and spending before considering any further hikes.

As noted earlier, each central bank is at slightly different stages and this provides opportunities for us. We’ve been cautious on the US, but have recently started adding to front-end exposure. In the EU, we think too many hikes are priced and have been further trimming our duration underweight as German bund yields approached 1%. In the UK, we’ve built a long duration position on the view that the BoE will be cautious in tightening policy further in the coming months. In some ways the BoE will serve as an interesting “test case” for other major central banks.

If central banks end up having to back off and not tighten as much as currently priced, this should be supportive for developed market (DM) rates and spread sectors. The key will be how quickly and by how much growth slows. If it’s a gentle glide lower, then EM and lower-rated credit should do well. If it’s a sharper slowdown, then rates should rally hard, but credit and EM will be challenged. We positioned for the former, but have to admit that the risks of the latter are growing.

Q: Finally, what is Western Asset’s expectation for returns of the asset class over the next one to two years given that bond yields are now substantially higher when compared to pre-Covid levels?

A: We believe inflation will be contained and move lower by year-end, in which case it’s reasonable to think that US Treasuries (USTs)—which most investors are focused on given their higher yields relative to other global government bonds—could drift back near pre-2022 levels. If this transpires, returns for USTs and higher quality credit would at least match current yield levels. For longer-duration assets, returns would likely be much greater.

For riskier asset classes such as high-yield credit, future returns depend not just on government bond yields moving back to year-ago levels, but also on credit spreads remaining contained in this environment and grinding tighter over time. This combination would require that the Fed is successful in containing inflation without triggering a recession. We think this is a reasonable prospect based on our assessment of the macro environment and how committed the Fed and other central banks are in attacking inflation and managing downside growth risks.