Executive Summary
- We expect to see a meaningful pickup in global growth in the sec ond half of 2021 as economies continue to reopen; however, we are cautious about extrapolating short-term cyclical boosts into a presumption of a higher secular trend rate of growth or inflation.
- In the US, we expect growth in the service sectors to continue to disappoint relative to consensus expectations; meanwhile, growth in the manufacturing and construction sectors will be muted as the recovery there is already complete.
- We expect the European growth rebound to kick into high gear in the second half of the year as the vaccination drives across the continent approach herd immunity toward the end of the third quarter and workers currently on furlough and related schemes rejoin the labor market.
- Having been boosted by an early recovery post-Covid, we expect growth in China to trend back to its long-term average.
Western Asset expects that the second half of the year should see very strong growth in global GDP as the world economy reopens. That stated, we are cautious about extrapolating short-term cyclical boosts into a presumption of a higher secular trend rate of growth or inflation. The secular challenges that have kept US and global growth to a moderate pace at best over the last several decades persist. These include the stagnation of Western societies’ middle-class wages, aging demographics and rising global debt burdens. Moreover, the small and medium-sized business destruction in many countries not seen since the Great Depression may take years to repair. Given this backdrop, Western Asset expects central banks to remain extraordinarily accommodative for the foreseeable future. We aim to position our portfolios to withstand further market volatility, yet remain flexible enough to capture 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.
| US: Recovery Continuing but Falling Short of Consensus Expectations |
|---|
The US economy in recent months has performed in line with our expectations as set out a few months ago. Growth has moderated in the manufacturing and construction sectors, now that these have achieved essentially complete recovery from the Covid-induced shutdown recession of 1Q20. Meanwhile, growth in the service sectors has been decent, but not spectacular and not suggestive of a quick return to pre-Covid norms. Much of this relatively sluggish rebound in services reflects the fact that a general reopening of the service sectors has been occurring only in the last few weeks. Still, growth has moderated in the restaurant and medical care sectors—the reopenings occurring in various states in late-June and after are not quite "full" reopenings, and residual fears of Covid among some cohorts will likely be an ongoing restraining factor as well. As a result of these factors, we would expect growth in the service sectors to continue to disappoint relative to consensus expectations and that growth in manufacturing and construction sectors will be muted as the recovery there is already complete. There is enough "slack" remaining in service sectors to single-handedly drive US GDP growth of 7% or so for a number of quarters yet. Instead, however, would expect growth in a 2% to 5% range: not bad, but, again, lower than what seems to be already baked into consensus accounts. While market and media rhetoric are still trumpeting an inflation flare-up, we see most of the run-up in reported inflation in recent months as reflecting: a) adverse comparisons to especially low CPI prints in April and May 2020 and b) rebounds in prices of a number of services where reopening is occurring to some extent (and where prices are still well below pre-Covid levels even with the recent run-up). Treasury markets have already reacted to these developments, pulling the 10-year yield down from a high of 1.74% in April to the low 1.40s range recently. We don’t expect further significant declines in term yields, but we would expect yields to remain in the trading range of the last three months, with a lot of time spent toward the lower end of that range. |
| Europe: Growth Full Steam Ahead; Rising Inflation a Distraction (For Now) |
We expect the European growth rebound to kick into high gear in the second half of the year as the vaccination drives across the continent approach herd immunity toward the end of the third quarter and workers currently on furlough and related schemes rejoin the labor market. Higher-frequency, forward-looking activity indicators are reaching new highs but the momentum is clearly slowing. The main risk to our outlook is a further delay due to Covid variants. We believe the growth momentum can continue into 2022 as we see less of a fiscal cliff risk compared to elsewhere given that EU fiscal rules will remain suspended and a politically driven business cycle with two major elections in continental Europe later this year and next. The Next Generation EU (NGEU) recovery fund has started to issue marketable securities and first disbursements to member states are bound to flow in Q3. These flows will play a much larger role in 2022 outcomes and can be quite sizeable in certain economies. Inflation in the eurozone will be on a rising trend in Q3, peak in Q4, but fall back soon thereafter, mostly due to significant base and special effects. Beyond that, however, inflation in the eurozone is likely to remain muted over the medium term, as there is still little sign of wage pressures, significant credit expansion or rising longer-term inflation expectations. That said, we do expect markets to become more concerned about inflation in the second half of this year as inflation prints in selected jurisdictions might be close to 4% in H2. While potential spillovers into expectations will have to be monitored, they are still below the inflation target for all time horizons and are therefore less of a concern compared to some other developed markets. Even aside from that, the European Central Bank (ECB) will have a busy quarter: in addition to implementing the results of the just-concluded Strategy Review with regard to simplified communications, we expect the ECB to start tapering in September by reducing the amount it purchases under the Pandemic Emergency Purchase Programme (PEPP) facility as long as sovereign yields rise gradually and in line with the improving economic outlook. If that reduction takes place, there is no need to increase the overall envelope for this facility and we expect that to be wound down early next year as planned, but the September ECB meeting will be a key stepping stone to refocus monetary policy for the post-pandemic period. The UK has delayed the last step of its economic reopening into July as Covid cases have surged, driven by the spread of the delta variant. With about half of the UK’s population fully vaccinated, the speed of the inoculation drive has already slowed significantly. As European Covid responses are becoming more coordinated, travel restrictions between the UK and the EU should ease in Q3, benefitting tourism sectors everywhere. Thorny issues around the implications of the Northern Ireland protocol in the context of the UK’s Withdrawal Agreement with the EU have been adjourned, but we expect trade between the UK and the EU to continue to remain below pre-Brexit levels for an extended period of time. The Bank of England continues to look through inflation (and output) volatility even as headline inflation is above the inflation target. In addition, with the most hawkish voices leaving the Monetary Policy Committee (MPC), we expect the asset purchase program to be wound down this year as planned but no other hawkish signals for the time being. |
| China: Slowing Momentum With a Focus on Risks |
Having been boosted by an early recovery post-Covid, growth in China looks set to trend back to its long-term average. At the recently concluded Lujiazui forum, People’s Bank of China (PBoC) governors noted that China’s growth is slowing down; there are no concerns over economic overheating or an inflation overshoot, which points to the efficacy of prudent and flexible monetary policy. That stated, the China Banking and Insurance Regulatory Commission continues to signal a tough stance on shadow banking and rising credit risks. Moving into the second half of the year, policymakers will want to sustain growth so that employment remains strong even as they seek to manage excessive credit growth. Also, China’s monetary stance will continue to be domestically oriented. On the COVID-19 front, expectations are building onshore that China’s policymakers seem intent on keeping quarantines and border closures in place until at least after the Beijing Winter Olympics in February 2022. This should have a limited domestic impact on China growth as $250 billion of annual overseas spending would be kept at home, but there would be negative spill over to countries dependent on China tourism. The “Covid-zero” approach is independent of vaccination rates, which remain high at 20 million does per day and are currently on track to achieve a 100% completion rate for China’s eligible population by year-end. |
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US: Recovery Continuing but Falling Short of Consensus Expectations
 |
The US economy in recent months has performed in line with our expectations as set out a few months ago. Growth has moderated in the manufacturing and construction sectors, now that these have achieved essentially complete recovery from the Covid-induced shutdown recession of 1Q20. Meanwhile, growth in the service sectors has been decent, but not spectacular and not suggestive of a quick return to pre-Covid norms. Much of this relatively sluggish rebound in services reflects the fact that a general reopening of the service sectors has been occurring only in the last few weeks. Still, growth has moderated in the restaurant and medical care sectors—the reopenings occurring in various states in late-June and after are not quite “full” reopenings, and residual fears of Covid among some cohorts will likely be an ongoing restraining factor as well.
We expect growth in the service sectors to continue to disappoint relative to consensus expectations and that growth in manufacturing and construction sectors will be muted as the recovery there is already complete.
As a result of these factors, we would expect growth in the service sectors to continue to disappoint relative to consensus expectations and that growth in manufacturing and construction sectors will be muted as the recovery there is already complete. There is enough “slack” remaining in service sectors to single-handedly drive US GDP growth of 7% or so for a number of quarters yet. Instead, however, would expect growth in a 2% to 5% range: not bad, but, again, lower than what seems to be already baked into consensus accounts. While market and media rhetoric are still trumpeting an inflation flare-up, we see most of the run-up in reported inflation in recent months as reflecting: a) adverse comparisons to especially low CPI prints in April and May 2020 and b) rebounds in prices of a number of services where reopening is occurring to some extent (and where prices are still well below pre-Covid levels even with the recent run-up). Treasury markets have already reacted to these developments, pulling the 10-year yield down from a high of 1.74% in April to the low 1.40s range recently. We don’t expect further significant declines in term yields, but we would expect yields to remain in the trading range of the last three months, with a lot of time spent toward the lower end of that range. |
|---|---|
|
Europe: Growth Full Steam Ahead; Rising Inflation a Distraction (For Now)
 |
We expect the European growth rebound to kick into high gear in the second half of the year as the vaccination drives across the continent approach herd immunity toward the end of the third quarter and workers currently on furlough and related schemes rejoin the labor market. Higher-frequency, forward-looking activity indicators are reaching new highs but the momentum is clearly slowing. The main risk to our outlook is a further delay due to Covid variants. We believe the growth momentum can continue into 2022 as we see less of a fiscal cliff risk compared to elsewhere given that EU fiscal rules will remain suspended and a politically driven business cycle with two major elections in continental Europe later this year and next. The Next Generation EU (NGEU) recovery fund has started to issue marketable securities and first disbursements to member states are bound to flow in Q3. These flows will play a much larger role in 2022 outcomes and can be quite sizeable in certain economies. Inflation in the eurozone will be on a rising trend in Q3, peak in Q4, but fall back soon thereafter, mostly due to significant base and special effects. Beyond that, however, inflation in the eurozone is likely to remain muted over the medium term, as there is still little sign of wage pressures, significant credit expansion or rising longer-term inflation expectations. That said, we do expect markets to become more concerned about inflationn in the second half of this year as inflation prints in selected jurisdictions might be close to 4% in H2. While potential spillovers into expectations will have to be monitored, they are still below the inflation target for all time horizons and are therefore less of a concern compared to some other developed markets. Even aside from that, the European Central Bank (ECB) will have a busy quarter: in addition to implementing the results of the just-concluded Strategy Review with regard to simplified communications, we expect the ECB to start tapering in September by reducing the amount it purchases under the Pandemic Emergency Purchase Programme (PEPP) facility as long as sovereign yields rise gradually and in line with the improving economic outlook. If that reduction takes place, there is no need to increase the overall envelope for this facility and we expect that to be wound down early next year as planned, but the September ECB meeting will be a key stepping stone to refocus monetary policy for the post-pandemic period.
We expect the ECB to start tapering in September by reducing the amount it purchases under the PEPP.
The UK has delayed the last step of its economic reopening into July as Covid cases have surged, driven by the spread of the delta variant. With about half of the UK’s population fully vaccinated, the speed of the inoculation drive has already slowed significantly. As European Covid responses are becoming more coordinated, travel restrictions between the UK and the EU should ease in Q3, benefitting tourism sectors everywhere. Thorny issues around the implications of the Northern Ireland protocol in the context of the UK’s Withdrawal Agreement with the EU have been adjourned, but we expect trade between the UK and the EU to continue to remain below pre-Brexit levels for an extended period of time. The Bank of England continues to look through inflation (and output) volatility even as headline inflation is above the inflation target. In addition, with the most hawkish voices leaving the Monetary Policy Committee (MPC), we expect the asset purchase program to be wound down this year as planned but no other hawkish signals for the time being. |
|
China: Slowing Momentum With a Focus on Risks
 |
Having been boosted by an early recovery post-Covid, growth in China looks set to trend back to its long-term average. At the recently concluded Lujiazui forum, People’s Bank of China (PBoC) governors noted that China’s growth is slowing down; there are no concerns over economic overheating or an inflation overshoot, which points to the efficacy of prudent and flexible monetary policy. That stated, the China Banking and Insurance Regulatory Commission continues to signal a tough stance on shadow banking and rising credit risks. Moving into the second half of the year, policymakers will want to sustain growth so that employment remains strong even as they seek to manage excessive credit growth. Also, China’s monetary stance will continue to be domestically oriented.
China's policymakers seem intent on keeping quarantines and border closures in place until at least after the Beijing Winter Olympics.
On the COVID-19 front, expectations are building onshore that China’s policymakers seem intent on keeping quarantines and border closures in place until at least after the Beijing Winter Olympics in February 2022. This should have a limited domestic impact on China growth as $250 billion of annual overseas spending would be kept at home, but there would be negative spill over to countries dependent on China tourism. The “Covid-zero” approach is independent of vaccination rates, which remain high at 20 million does per day and are currently on track to achieve a 100% completion rate for China’s eligible population by year-end. |
Developed Market Rates: Relative Value by Region
| US | We expect growth in the service sectors to continue to disappoint relative to consensus expectations; meanwhile, growth in manufacturing and construction sectors will be muted, as the recovery there is already complete. |
|---|---|
| Canada | The recovery downshifted early in Q2 due to restrictions, but growth was better than expected. Rate hike expectations have accelerated, though we think the BoC will emphasize patience as core inflation remains below the top of the 1% to 3% range under circumstances of uncertainty. |
| Europe | National fiscal support to continue into next year, albeit at a slowing pace compared to this year, increasingly requiring economies to build momentum. We see NGEU support slowly building over the next few years, while increasing the pool of supranational safe-haven assets. Monetary support is likely to slow as the ECB may reduce asset purchases into the ongoing rebound, but the Strategy Review is a focal point over the next months. |
| UK | The UK is very likely to end pandemic restrictions in Q3 but we expect only a comparatively limited marginal impact on the economy from that. The main risks are a higher inflation trajectory than currently envisaged by the Bank of England driven by a rapid absorption of currently furloughed workers and continued uncertainty in the UK’s relationship with continental Europe. |
| Japan | We expect that the Japanese economy will continue to recover as the vaccine rollouts have finally accelerated. The BoJ’s commitment to the easy monetary policy and the Japanese government’s flexible fiscal stance to support the recovery remain intact. |
| Australia | As a result of strict Covid-related restrictions, the economy has outperformed most developed countries with both employment and growth now above pre-pandemic levels. A delay in securing vaccines could crimp the current pace of growth. The RBA and government remain committed to supporting the economy through super easy monetary policy and fiscal support until inflation and, importantly, wage growth returns. |
Relative Value by Sector
| Investment-Grade (IG) Corporate Credit |
|---|
| US |
| Outlook We are optimistic on near-term credit fundamentals, but remain vigilant of shareholder-friendly activity (e.g., LBOs and M&A). While favorable technicals endure, valuations have already returned to pre-Covid, and even pre-financial crisis, levels for many sectors. |
| Relative Value +/– We are maintaining overweights to banking, select reopening industries and rising-star candidates where allowed. |
| Europe |
| Outlook Most sectors are demonstrating fundamental improvement with travel and leisure still impacted. Private equity cash and low borrowing costs have led to concerns of re-leveraging in certain names and sectors, with a potential LBO in the UK supermarket space. |
| Relative Value – Low government bond yields and ECB corporate purchases continue to drive demand for IG bonds. However, valuations are no longer compelling with spreads close to historic tights. We find some opportunities in subordinated financials and REITs. |
| Australia |
| Outlook Credit markets supported by the lack of new supply and a strong demand for yield due to the low underlying returns caused by yield-curve control and a record-low setting of the cash rate that the RBA still believes they will hold until 2024. |
| Relative Value + We remain overweight the IG sector. REITs and infrastructure sectors still remain relatively more attractive than financials due to the funding programs by the RBA that limited supply in this sector and forced spreads in. |
| High-Yield (HY) Corporate Credit |
| US |
| Outlook HY spreads were 42 bps tighter in 2Q21, a continuation from last quarter as the vaccine rollout accelerated along with strong reopening trends in place. We continue to position for a “reopening trade” and remain overweight certain cyclical sectors including airlines, cruise lines and select retail segments complemented by a higher quality bias in less cyclical subsectors. |
| Relative Value + Issue selection and asset class allocation remain the key drivers for portfolios. We will look to add selectively (away from LBO issuance and credits lacking catalysts) for total return/spread compression given valuations. |
| Europe |
| Outlook As earnings recover, we anticipate credit rating profiles to improve. Supply has increased, surpassing annual 2019/2020 levels already but is being absorbed by widespread demand. |
| Relative Value + Spreads are back to late-2017/early-2018 levels, but still 50 bps wider than the tightest levels we saw back then. We anticipate range-bound markets over the next quarter. |
| Bank Loans |
| US |
| Outlook With close to 90% of the $700 billion CLO market expected to end its respective non-call periods by year-end, supply will continue to remain the central theme for 2021. Demand has been steady out of US banks, asset managers and insurance companies, and deals have been clearing without any material spread widening. |
| Relative Value + We believe outperformance will come from carry, avoiding problem credits and owning select names where fundamentals and liquidity remain intact and there is still real price convexity in the credit. |
| Collateralized Loan Obligations (CLOs) |
| US |
| Outlook Given current valuations, a constructive fundamental outlook and where the JPY/USD cross-currency basis resides, the market is anticipating overseas demand to create another strong tailwind for the CLO market. With default rates at lows, any widening in the CLO market should be viewed as a buy opportunity. |
| Relative Value + We retain our view that AAAs will continue to perform well in either a bearish or bullish scenario. We expect supply to remain heavy which will lead to opportunities to add lower-rated CLOs at attractive levels in the coming months. |
| Europe |
| Outlook With €66bn of institutional issuance (source: S&P LCD), H1 2021 was the busiest first half of any year for loan primary since the GFC. As more M&A -related deals are expected, the recent slowdown in CLO creation might cause mild loan spread widening in the short term due to an element of oversupply. However, we expect stable carry-driven returns through year-end. |
| Relative Value + With recovery in European economies expected to gather pace, single-B rated loans provide attractive returns. We focus on credits in that category with potential to convert the post-pandemic rebound into strong free cash flows that will alleviate the pressure of highly levered capital structures. |
| Mortgage and Consumer Credit |
| Agency MBS |
| Outlook At current valuations, we believe there are more downside risks to spread widening in agency MBS over the next year as taper discussions increase, supply remains elevated and convexity risk is unappealing. |
| Relative Value – We have been reducing agency MBS exposure relative to benchmarks, while actively repositioning coupon and collateral selection. We continue to focus on agency CMBS and allocations to high quality non-agency sectors for portfolio diversification. |
| Non-Agency Residential MBS (NARMBS) |
| Outlook Housing has performed strongly over the past year with national home prices increasing 14.6% YoY. Positive housing fundamentals continue to support further home price appreciation. |
| Relative Value + We are positive on GSE credit risk transfers as well as legacy NARMBS/new-issue re-performing loan deals. |
| Non-Agency Commercial MBS (CMBS) |
| Outlook In the near term, we remain cautious as it is uncertain how long it will take for commercial real estate markets to fully recover from the negative impacts of the pandemic. |
| Relative Value +/– We are positive on short-duration, well-structured single-borrower securitizations and loans. |
| 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 the pandemic on the economy and 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 While the news media focuses on price increases now due to bottleneck pressures, we think longer-dated inflation expectations will be limited by the same forces that capped inflation in the pre-pandemic period. |
| Relative Value – Our expectation is that short- and medium-maturity TIPS will underperform comparable nominal USTs in the second half of 2021. |
| Europe |
| Outlook In the second half of 2021 we expect a short-lived period of high inflation in the eurozone as VAT cuts drop out of the yearly numbers and the hump in goods prices overlaps with service sector price normalization. |
| Relative Value +/– We are currently neutral in eurozone inflation-linked bonds. But would likely add on weakness. |
| Japan |
| Outlook We believe that Japanese inflation-linked bonds remain undervalued, assuming the expected recovery of the Japanese economy. The balance between issuances and buybacks continues to be supportive. Inflation-linked bonds issued total JPY200 billion, while buybacks total JPY330 billion on a quarterly basis. |
| Relative Value + We maintain an overweight to Japanese real yields against nominal yields. |
| Municipals |
| US |
| Outlook Better than expected state and local revenues, combined with direct federal aid measures that will continue to be rolled out, should bolster municipal credit over the cyclical horizon. Supply technicals will be in focus amid possibilities for additional taxable or tax-exempt supply incentives.. |
| Relative Value + We continue to favor those issuers and sectors that would benefit from a recovery, particularly among transportation, health care and select HY issuers. |
| Emerging Market (EM) Debt |
| EM Sovereigns (USD) |
| Outlook We anticipate continued robust USD sovereign issuance by EM countries to fund fiscal programs and mitigate ongoing economic damage induced by the pandemic. |
| Relative Value +/– We continue to favor select IG-rated EM USD-denominated sovereigns and exercise caution toward lower-rated frontier sovereign debt. |
| EM Local Currency |
| Outlook EM local rates and flows should continue to benefit from the attractive real rate differential between the US and EM countries. Asia stands to benefit given a resumption of global trade. |
| Relative Value +/– We remain biased toward, but highly selective on, local rates for their relatively attractive real yield and more favorable risk/reward characteristics. |
| EM Corporates |
| Outlook EM corporates have low leverage and conservative financial policies despite loosening DM credit standards, while technicals remain extremely strong given a lack of net supply and increased investor interest in the asset class. |
| Relative Value + We continue to take advantage of primary issuance from short- and intermediate-dated IG and HY EM corporates. |
| Outlook | Relative Value | ||
|---|---|---|---|
| Investment-Grade (IG) Corporate Credit | |||
| US | We are optimistic on near-term credit fundamentals, but remain vigilant of shareholder-friendly activity (e.g., LBOs and M&A). While favorable technicals endure, valuations have already returned to pre-Covid, and even pre-financial crisis, levels for many sectors. | +/– | We are maintaining overweights to banking, select reopening industries and rising-star candidates where allowed. |
| Europe | Most sectors are demonstrating fundamental improvement with travel and leisure still impacted. Private equity cash and low borrowing costs have led to concerns of re-leveraging in certain names and sectors, with a potential LBO in the UK supermarket space. | – | Low government bond yields and ECB corporate purchases continue to drive demand for IG bonds. However, valuations are no longer compelling with spreads close to historic tights. We find some opportunities in subordinated financials and REITs. |
| Australia | Credit markets supported by the lack of new supply and a strong demand for yield due to the low underlying returns caused by yield-curve control and a record-low setting of the cash rate that the RBA still believes they will hold until 2024. | + | We remain overweight the IG sector. REITs and infrastructure sectors still remain relatively more attractive than financials due to the funding programs by the RBA that limited supply in this sector and forced spreads in. |
| High-Yield (HY) Corporate Credit | |||
| US | HY spreads were 42 bps tighter in 2Q21, a continuation from last quarter as the vaccine rollout accelerated along with strong reopening trends in place. We continue to position for a “reopening trade” and remain overweight certain cyclical sectors including airlines, cruise lines and select retail segments complemented by a higher quality bias in less cyclical subsectors. | + | Issue selection and asset class allocation remain the key drivers for portfolios. We will look to add selectively (away from LBO issuance and credits lacking catalysts) for total return/spread compression given valuations. |
| Europe | As earnings recover, we anticipate credit rating profiles to improve. Supply has increased, surpassing annual 2019/2020 levels already but is being absorbed by widespread demand. | + | Spreads are back to late-2017/early-2018 levels, but still 50 bps wider than the tightest levels we saw back then. We anticipate range-bound markets over the next quarter. |
| Bank Loans | |||
| US | With close to 90% of the $700 billion CLO market expected to end its respective non-call periods by year-end, supply will continue to remain the central theme for 2021. Demand has been steady out of US banks, asset managers and insurance companies, and deals have been clearing without any material spread widening. | + | We believe outperformance will come from carry, avoiding problem credits and owning select names where fundamentals and liquidity remain intact and there is still real price convexity in the credit. |
| Collateralized Loan Obligations (CLOs) | |||
| US | Given current valuations, a constructive fundamental outlook and where the JPY/USD cross-currency basis resides, the market is anticipating overseas demand to create another strong tailwind for the CLO market. With default rates at lows, any widening in the CLO market should be viewed as a buy opportunity. | + | We retain our view that AAAs will continue to perform well in either a bearish or bullish scenario. We expect supply to remain heavy which will lead to opportunities to add lower-rated CLOs at attractive levels in the coming months. |
| Europe | With €66bn of institutional issuance (source: S&P LCD), H1 2021 was the busiest first half of any year for loan primary since the GFC. As more M&A -related deals are expected, the recent slowdown in CLO creation might cause mild loan spread widening in the short term due to an element of oversupply. However, we expect stable carry-driven returns through year-end. | + | With recovery in European economies expected to gather pace, single-B rated loans provide attractive returns. We focus on credits in that category with potential to convert the post-pandemic rebound into strong free cash flows that will alleviate the pressure of highly levered capital structures. |
| Mortgage and Consumer Credit | |||
| Agency MBS | At current valuations, we believe there are more downside risks to spread widening in agency MBS over the next year as taper discussions increase, supply remains elevated and convexity risk is unappealing. | – | We have been reducing agency MBS exposure relative to benchmarks, while actively repositioning coupon and collateral selection. We continue to focus on agency CMBS and allocations to high quality non-agency sectors for portfolio diversification. |
| Non-Agency Residential MBS (NARMBS) | Housing has performed strongly over the past year with national home prices increasing 14.6% YoY. Positive housing fundamentals continue to support further home price appreciation. | + | We are positive on GSE credit risk transfers as well as legacy NARMBS/new-issue re-performing loan deals. |
| Non-Agency Commercial MBS (CMBS) | In the near term, we remain cautious as it is uncertain how long it will take for commercial real estate markets to fully recover from the negative impacts of the pandemic. | +/– | We are positive on short-duration, well-structured single-borrower securitizations and loans. |
| Asset-Backed Securities (ABS) | We are cautious on consumer fundamentals and watchful of credit performance on consumer ABS sectors due to the impact of the pandemic on the economy and uncertain pace of recovery. | +/– | We favor well-protected senior ABS classes from high-quality sectors with low Covid disruption impact. |
| Inflation-Linked | |||
| US | While the news media focuses on price increases now due to bottleneck pressures, we think longer-dated inflation expectations will be limited by the same forces that capped inflation in the pre-pandemic period. | – | Our expectation is that short- and medium-maturity TIPS will underperform comparable nominal USTs in the second half of 2021. |
| Europe | In the second half of 2021 we expect a short-lived period of high inflation in the eurozone as VAT cuts drop out of the yearly numbers and the hump in goods prices overlaps with service sector price normalization. | +/– | We are currently neutral in eurozone inflation-linked bonds. But would likely add on weakness. |
| Japan | We believe that Japanese inflation-linked bonds remain undervalued, assuming the expected recovery of the Japanese economy. The balance between issuances and buybacks continues to be supportive. Inflation-linked bonds issued total JPY200 billion, while buybacks total JPY330 billion on a quarterly basis. | + | We maintain an overweight to Japanese real yields against nominal yields. |
| Municipals | |||
| US | Better than expected state and local revenues, combined with direct federal aid measures that will continue to be rolled out, should bolster municipal credit over the cyclical horizon. Supply technicals will be in focus amid possibilities for additional taxable or tax-exempt supply incentives.. | + | We continue to favor those issuers and sectors that would benefit from a recovery, particularly among transportation, health care and select HY issuers. |
| Emerging Market (EM) Debt | |||
| EM Sovereigns (USD) | We anticipate continued robust USD sovereign issuance by EM countries to fund fiscal programs and mitigate ongoing economic damage induced by the pandemic. | +/– | We continue to favor select IG-rated EM USD-denominated sovereigns and exercise caution toward lower-rated frontier sovereign debt. |
| EM Local Currency | EM local rates and flows should continue to benefit from the attractive real rate differential between the US and EM countries. Asia stands to benefit given a resumption of global trade. | +/– | We remain biased toward, but highly selective on, local rates for their relatively attractive real yield and more favorable risk/reward characteristics. |
| EM Corporates | EM corporates have low leverage and conservative financial policies despite loosening DM credit standards, while technicals remain extremely strong given a lack of net supply and increased investor interest in the asset class. | + | We continue to take advantage of primary issuance from short- and intermediate-dated IG and HY EM corporates. |