Executive Summary
- With further distortions/disruptions from the war in Ukraine muddying the inflation waters, the risk is that the Fed—or the markets—will overdo the increases in yields, slowing the US economy more than would otherwise occur.
- In Europe, we expect economic growth to slow more drastically than previously assumed, while still remaining above potential growth this year and next on the back of very strong momentum and continued policy support.
- In the UK, post-pandemic normalization continues to play out faster than on the continent, with a tight labor market and significant inflationary pressures expected to peak in the second quarter.
- In China, weaker economic data in the next few months should provide a window for policy easing to support the economy and asset markets.
The investment landscape faces enormous uncertainty following the Russian invasion of Ukraine. The long slog to a post-Covid world has been meaningfully derailed. Energy and soft commodity prices are likely to remain high. The case for developed market (DM) government bond yields is less clear given current elevated inflation readings but the traditional desire for such a global safe haven is likely to be powerful. Our view remains that the global economic recovery from the Covid pandemic will be underpinned by responsible central bank policy that recognizes the detrimental effect that elevated energy prices and the uncertain situation in Eastern Europe will have on global growth. We have seen a rapid re-pricing of monetary policy expectations. While tensions in Ukraine are pushing up short-term energy prices and inflation, the medium- to long-term impacts have yet to be determined. Western Asset’s view is that while data on inflation and labor markets will likely lead to accelerated tightening schedules across a number of key DM central banks, the fundamental headwinds to global growth and inflation remain. These include the reduction of global fiscal stimulus, the withdrawal of monetary policy accommodation and the persistence of secular-related headwinds such as global debt burdens, aging demographics and technology displacement. 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: Growth Outlook Complicated by Fed’s Changed Stance |
|---|
Economic growth has largely dovetailed with our outlook. Consumer spending growth has been only moderate, with a shift in spending from goods to services, leaving goods demand flat for the last 11 months. Flat goods demand opposite gradually rising domestic production and a sharp increase in goods imports has led to an extremely strong increase in US inventories. This served to overstate 4Q21 GDP growth, but it is also serving to moderate price pressures in goods markets. The two problems are that first, the Fed has come under increasing pressure from financial markets to actively subdue inflation, and, second, the crisis in Ukraine has intensified pressures on headline inflation measures. The Fed’s shift to a more aggressive tightening stance has been met by sharp increases in US yields across the board, but especially at short maturities, so that the yield curve is vastly flatter and higher than was the case just three months ago. We have been skeptical that Fed policy has been effective in stimulating either the economy or inflation, and our take has been that price pressures mostly reflect imbalances in the economy in view of ongoing Covid restrictions in some sectors, only recently removed disincentives to work and supply pipeline disruptions. None of these are disturbances that call for a monetary response. But with impatient investors both domestically and globally, Fed action is likely necessary anyway, and with the further distortions/disruptions from the war in Ukraine muddying the inflation waters, the risk is that the Fed—or the markets—will overdo the increases in yields, slowing the US and global economies more than would otherwise occur. The upside outlook is that growth is more widely perceived to be modest and that the markets see through headline inflation measures—held up by Ukraine issues—and recognize that core inflation measures should be coming down with the assuagement of supply problems in goods sectors (and reopening/de-restricting of service sectors given declining Covid risks). Under these developments, we are likely at or already above a peak in term-maturity yields, and Fed hiking efforts likely will not have to be as extensive as presently expected. A downside outlook is that war-induced increases in energy prices feed through to core inflation measures, terminating the apparent moderation of the last two months and thereby intensifying pressures on the Fed to follow through with or even intensify its hiking regimen. Such developments would clearly be negative for economic growth, but any downward effects of that on yields would be postponed until markets are assured that inflationary risks are being effectively dealt with. |
| Europe: The Outlook Is Darkening Quickly |
Europe continues to suffer from two major shocks: the escalation of energy prices as well as inflation more broadly and, relatedly, the Russian invasion of Ukraine. Higher energy costs and inflationary pressures are making a significant dent in real disposable income of households, hampering consumption. The war has added to inflationary pressures via commodities and supply-chain issues, but it has also had a negative impact on consumer and business confidence. Most countries have eliminated Covid omicron-related restrictions, but another wave toward next winter constitutes a downside risk to economic activity, especially if triggered by a new variant. Employment has continued to rebound and remains only marginally below pre-pandemic levels but the outlook is becoming a bit more mixed. Taken together, we expect economic growth to slow more drastically than previously assumed, while still remaining above potential growth this year and next on the back of very strong momentum and continued policy support. We do see, however, significant downside risks to this outlook if imports of natural gas from Russia were to decrease markedly. The impact on manufacturing in Germany and Italy—but really continental Europe as a whole—could result in flat growth this year. That said, we do believe that fiscal support would be forthcoming in such an environment, possibly even at the European level. Even if there is no new European fiscal package, we believe that there won’t be any binding fiscal rules this year and next. Consequently, national governments will increase support to the economy and households, reducing fiscal drag to a minimum. Disbursements from the Next Generation EU (NGEU) recovery fund to most countries have been sizeable already, pre-financing a large number of projects across the continent. Finally, the economic outlook for France after its presidential elections will also depend on the outcome of its parliamentary elections in June. A parliamentary majority that does not align with the president could result in a lasting stalemate. Inflation in the eurozone has escalated further over the past months. The path forward continues to be driven by energy-related commodities, which depend, in turn, on the hostilities in Ukraine and associated policy measures. In particular, an embargo escalation could push headline inflation in the eurozone into double-digits. This is a significant risk at this point but not our baseline as base effects will become ever stronger in the second half of the year. Underlying inflation (excluding food and energy) in the eurozone has also risen and broadened, and inflation expectations are likely to drift higher. There are still no tangible indications of wage inflation picking up, but the key bargaining negotiations will only take place later this year. As inflation continues to drift higher, we believe that the ECB will stop its remaining asset purchase program soon, likely by early- to mid-3Q. The outlook for rate hikes, however, is less clear. While the market expects interest rates to no longer be in negative territory by the end of the year, we think that hikes are only likely if domestic demand is holding up, either because the hostilities end and energy-related inflation recedes somewhat or because of additional fiscal support to households and corporates that neutralizes uncertainty and the fiscal drag. Post-pandemic normalization in the UK continues to play out faster than on the continent, with a tight labor market and significant inflationary pressures expected to peak in the second quarter. This progress is most clearly visible in the context of monetary policy. The Bank of England (BoE) stopped its asset purchases already in December 2021 and has already hiked three times. Households’ disposable income is negatively affected by the increase of contributions to national insurance and the spring budget announcement saw very limited measures to alleviate the inflation squeeze, leading to questions about the strength of real aggregate demand. As a consequence, the BoE has already moderated its language around the ongoing hiking cycle, indicating a slower pace. Brexit-related uncertainties around trade flows and foreign investment have been relegated for now to the background as joint interests regarding Ukraine and the inflation narrative take precedence. In the medium run, however, questions around regulatory alignment will resurface and gain in importance. |
| China: Challenged by Covid Response, Focus on Stability Is a Priority |
China’s Covid response will be challenged by the highly transmissible omicron variant even with targeted lockdowns and a more dynamic approach. In the aftermath of China equity markets capitulation, headwinds from Covid, housing market weakness and geopolitical tensions, China announced a number of initiatives to restore confidence, the most concerted effort since November 2018. They include more proactive monetary policy, an increase in stock holdings by long-term state institutional investors, a more risk-managed housing sector transition, increased transparency around the regulatory reset for big tech firms and more coordinated measures to avoid unilateral official actions that might weaken market sentiment. The overall intent is one of pro-growth and stability in a year of political reshuffling. The Financial Stability and Development Committee’s (FSDC) meeting makes it clear that growth support will not be achieved via monetary policy alone; for example, the property market cannot be expected to recover without a clear turnaround in policy or at the very least a clear path ahead given that 40% of bank assets in China are property-related. Weaker economic data in the next few months should provide a window for policy easing, echoing the FSDC’s guidance in mid-March that “monetary policy needs to be more proactive” to support the economy and asset markets. |
|
US: Growth Outlook Complicated by Fed’s Changed Stance
 |
Economic growth has largely dovetailed with our outlook. Consumer spending growth has been only moderate, with a shift in spending from goods to services, leaving goods demand flat for the last 11 months. Flat goods demand opposite gradually rising domestic production and a sharp increase in goods imports has led to an extremely strong increase in US inventories. This served to overstate 4Q21 GDP growth, but it is also serving to moderate price pressures in goods markets. The two problems are that first, the Fed has come under increasing pressure from financial markets to actively subdue inflation, and, second, the crisis in Ukraine has intensified pressures on headline inflation measures. The Fed’s shift to a more aggressive tightening stance has been met by sharp increases in US yields across the board, but especially at short maturities, so that the yield curve is vastly flatter and higher than was the case just three months ago.
The risk is that the Fed—or the markets—will overdo the increases in yields, slowing the US and global economies more than would otherwise occur.
We have been skeptical that Fed policy has been effective in stimulating either the economy or inflation, and our take has been that price pressures mostly reflect imbalances in the economy in view of ongoing Covid restrictions in some sectors, only recently removed disincentives to work and supply pipeline disruptions. None of these are disturbances that call for a monetary response. But with impatient investors both domestically and globally, Fed action is likely necessary anyway, and with the further distortions/disruptions from the war in Ukraine muddying the inflation waters, the risk is that the Fed—or the markets—will overdo the increases in yields, slowing the US and global economies more than would otherwise occur. The upside outlook is that growth is more widely perceived to be modest and that the markets see through headline inflation measures—held up by Ukraine issues—and recognize that core inflation measures should be coming down with the assuagement of supply problems in goods sectors (and reopening/de-restricting of service sectors given declining Covid risks). Under these developments, we are likely at or already above a peak in term-maturity yields, and Fed hiking efforts likely will not have to be as extensive as presently expected. A downside outlook is that war-induced increases in energy prices feed through to core inflation measures, terminating the apparent moderation of the last two months and thereby intensifying pressures on the Fed to follow through with or even intensify its hiking regimen. Such developments would clearly be negative for economic growth, but any downward effects of that on yields would be postponed until markets are assured that inflationary risks are being effectively dealt with. |
|---|---|
|
Europe: The Outlook Is Darkening Quickly
 |
Europe continues to suffer from two major shocks: the escalation of energy prices as well as inflation more broadly and, relatedly, the Russian invasion of Ukraine. Higher energy costs and inflationary pressures are making a significant dent in real disposable income of households, hampering consumption. The war has added to inflationary pressures via commodities and supply-chain issues, but it has also had a negative impact on consumer and business confidence. Most countries have eliminated Covid omicron-related restrictions, but another wave toward next winter constitutes a downside risk to economic activity, especially if triggered by a new variant. Employment has continued to rebound and remains only marginally below pre-pandemic levels but the outlook is becoming a bit more mixed. Taken together, we expect economic growth to slow more drastically than previously assumed, while still remaining above potential growth this year and next on the back of very strong momentum and continued policy support. We do see, however, significant downside risks to this outlook if imports of natural gas from Russia were to decrease markedly. The impact on manufacturing in Germany and Italy—but really continental Europe as a whole—could result in flat growth this year. That said, we do believe that fiscal support would be forthcoming in such an environment, possibly even at the European level. Even if there is no new European fiscal package, we believe that there won’t be any binding fiscal rules this year and next. Consequently, national governments will increase support to the economy and households, reducing fiscal drag to a minimum. Disbursements from the Next Generation EU (NGEU) recovery fund to most countries have been sizeable already, pre-financing a large number of projects across the continent. Finally, the economic outlook for France after its presidential elections will also depend on the outcome of its parliamentary elections in June. A parliamentary majority that does not align with the president could result in a lasting stalemate.
We expect economic growth to slow more drastically than previously assumed … inflation expectations are likely to drift higher.
Inflation in the eurozone has escalated further over the past months. The path forward continues to be driven by energy-related commodities, which depend, in turn, on the hostilities in Ukraine and associated policy measures. In particular, an embargo escalation could push headline inflation in the eurozone into double-digits. This is a significant risk at this point but not our baseline as base effects will become ever stronger in the second half of the year. Underlying inflation (excluding food and energy) in the eurozone has also risen and broadened, and inflation expectations are likely to drift higher. There are still no tangible indications of wage inflation picking up, but the key bargaining negotiations will only take place later this year. As inflation continues to drift higher, we believe that the ECB will stop its remaining asset purchase program soon, likely by early- to mid-3Q. The outlook for rate hikes, however, is less clear. While the market expects interest rates to no longer be in negative territory by the end of the year, we think that hikes are only likely if domestic demand is holding up, either because the hostilities end and energy-related inflation recedes somewhat or because of additional fiscal support to households and corporates that neutralizes uncertainty and the fiscal drag. Post-pandemic normalization in the UK continues to play out faster than on the continent, with a tight labor market and significant inflationary pressures expected to peak in the second quarter. This progress is most clearly visible in the context of monetary policy. The Bank of England (BoE) stopped its asset purchases already in December 2021 and has already hiked three times. Households’ disposable income is negatively affected by the increase of contributions to national insurance and the spring budget announcement saw very limited measures to alleviate the inflation squeeze, leading to questions about the strength of real aggregate demand. As a consequence, the BoE has already moderated its language around the ongoing hiking cycle, indicating a slower pace. Brexit-related uncertainties around trade flows and foreign investment have been relegated for now to the background as joint interests regarding Ukraine and the inflation narrative take precedence. In the medium run, however, questions around regulatory alignment will resurface and gain in importance. |
|
China: Challenged by Covid Response, Focus on Stability Is a Priority
 |
China’s Covid response will be challenged by the highly transmissible omicron variant even with targeted lockdowns and a more dynamic approach. In the aftermath of China equity markets capitulation, headwinds from Covid, housing market weakness and geopolitical tensions, China announced a number of initiatives to restore confidence, the most concerted effort since November 2018. They include more proactive monetary policy, an increase in stock holdings by long-term state institutional investors, a more risk-managed housing sector transition, increased transparency around the regulatory reset for big tech firms and more coordinated measures to avoid unilateral official actions that might weaken market sentiment. The overall intent is one of pro-growth and stability in a year of political reshuffling. The Financial Stability and Development Committee’s (FSDC) meeting makes it clear that growth support will not be achieved via monetary policy alone; for example, the property market cannot be expected to recover without a clear turnaround in policy or at the very least a clear path ahead given that 40% of bank assets in China are property-related. Weaker economic data in the next few months should provide a window for policy easing, echoing the FSDC’s guidance in mid-March that “monetary policy needs to be more proactive” to support the economy and asset markets. |
Global Market Rates: Relative Value by Region
| US | With the further distortions/disruptions from the war in Ukraine muddying the inflation waters, the risk is that the Fed—or the markets—will overdo the increases in yields, slowing the US economy more than would otherwise occur. |
|---|---|
| Canada | The Bank of Canada’s (BoC) rate-hiking cycle has begun and will likely move in line with the US Fed’s, though with CPI inflation running lower and the currency a bit stronger. While we remain concerned about the too-hot housing market, higher mortgage rates to date have had limited impact. With money market rates already pricing in 2.5% policy rates by end-2022, any slowing in the labor market or decline in reported inflation could lower market yields substantially. Meanwhile, we expect the BoC to match US policy rate hikes through Q3. |
| Europe | The war in Ukraine is threatening the outlook for both inflation and growth. We expect more fiscal support to come through in due course, and a fast end to the ECB’s asset purchases. At this point, however, it is far from clear whether there will be rate hikes on the continent in 2022. This will depend on the situation in Ukraine and the inflation trajectory but also on forthcoming fiscal support, which could put a floor under the downside risks to growth. |
| UK | The UK’s faster rebound has also led to a faster hiking cycle and earlier concerns about the strength of the economy. We believe that the BoE’s hiking cycle is likely to run out of steam sooner rather than later as inflation and fiscal pressures weaken household demand. |
| China | We expect growth to come in between 4% and 5% in 2022; with policymakers focused on stability with some growth upside, the COVID-19 omicron variant continues to challenge China’s approach to Covid. |
| Japan | We expect that the Japanese economy will continue to grow at 2.0% to 2.5% in 2022 and 1.5% to 2.0% in 2023, but at a slower pace than before because of greater uncertainties and higher prices in energies and foods due to Russia’s war. Japan has significant reliance on imports of energies and foods. The BOJ just announced its commitment to loosen monetary policy by capping the 10-year JGB yield at 0.25%. |
| Australia | The Reserve Bank of Australia (RBA) has remained relatively calm holding the cash rate at an emergency setting of 0.10%. With the 3%+ level for wages growth in sight with labour tightness abound, June now looks likely for lift-off, with a steady tightening approach likely to follow with a 1% cash level by year-end and 2% by end-2023. |
Relative Value by Sector
| Investment-Grade (IG) Corporate Credit |
|---|
| US |
| Outlook We remain cautiously optimistic about corporate fundamentals near-term given the strong starting position while overall domestic economic growth should still be supportive despite additional headwinds emanating from the Russia/Ukraine conflict. We remain vigilant of potential shareholder-friendly activity (e.g., share buy-backs, M&A, etc.), but outside of a few examples of bondholder-unfriendly behavior, we have continued to witness conservative balance sheet management. |
| Relative Value +/– Valuations temporarily repriced into attractive territory; however, overall spreads quickly retraced in the second half of March to levels that can be described as fair given the increased degree of uncertainty still remaining. We continue to maintain overweights to banking, select reopening industries and rising-star candidates where allowed. |
| Europe |
| Outlook Fundamentals in IG are strong with few pockets of concern, despite the war in Ukraine. M&A, LBOs, a stretched consumer and supply chains are all key risks we are focused on. Bank balance sheets remain in strong shape with higher rates supportive of profitability. |
| Relative Value +/– Yields have reached multi-year highs in euro-denominated IG bringing a surge in demand for high quality bonds from insurance companies. We expect IG spreads to perform, but with valuations less attractive than in 1Q and higher volatility, we do not expect a reversion to the 2021 tights. We find most value in subordinated financials and REITs. |
| Australia |
| Outlook We continue to see value; inflation will be an issue for some issuers but most have monopolistic or regulated resets that will protect their margins. Management has remained defensive which has protected balance sheets; with limited issuance YTD the demand for credit at primary remains strong. |
| Relative Value + We remain overweight the IG sector. Select REITs and infrastructure assets that have regulated resets or that are still enjoying growth as the economy opens up still remain relatively more attractive than financials. |
| High-Yield (HY) Corporate Credit |
| US |
| Outlook HY spreads remain relatively attractive given a supportive nominal economic growth and low default outlook. Credit quality continues to improve with much of the index rated BB and with declining CCC exposure compared to several years ago. Technicals have been negative YTD given outflows from fixed-income as interest rates have risen, but higher yields are beginning to attract new buyers. |
| Relative Value + We continue to position for a “reopening trade” and rising stars. We remain overweight certain cyclical sectors including airlines, cruise lines and select lodging credits, complemented by a higher quality bias in less cyclical subsectors. |
| Europe |
| Outlook Fundamentals have improved, but markets are now pricing in ongoing elevated input pricing pressure, lingering supply chain issues and gradual tightening of monetary policy by the ECB—but Covid-related headwinds should subside. Supply has decreased dramatically, supporting the technical picture. |
| Relative Value + Valuations are attractive in the context of lower-yielding, more interest-rate-sensitive European asset classes. We expect spreads to be range-bound. We favour telecom/cable sectors and have turned more cautious on some consumer-related sectors given a deterioration in disposable income. |
| Bank Loans |
| US |
| Outlook Fundamentals remain strong and minimal defaults are expected given the economic outlook. Issuance has been robust in recent years, driven by M&A and LBOs, but the supply of new issues has been met with demand for higher-yielding floating-rate securities from retail and institutional clients. |
| Relative Value + We believe outperformance will come from carry and avoiding problem credits. We are focused on select names where fundamentals remain intact and prices are at discounts to their call price. |
| Collateralized Loan Obligations (CLOs) |
| US |
| Outlook Any improvement in the CLO arbitrage or reduction of broader macro volatility is likely to be met with elevated CLO issuance keeping spreads relatively range-bound in the near term. Hedging costs for overseas investors have risen so far on the year but high-quality CLOs still screen attractive for overseas investors which should lead to demand. |
| Relative Value + We view AAA CLO debt at current levels as very attractive and retain our view that it will continue to perform well in either bullish or bearish bank loan spread environments given strong structural protections. IG-rated mezzanine tranches at current spreads and dollar prices are attractive as this part of the capital structure remains well insulated from credit losses. |
| Mortgage and Consumer Credit |
| Agency MBS |
| Outlook We believe there are more downside risks to spreads widening as Fed support diminishes, but valuations have become more reasonable. |
| Relative Value – We have been reducing our underweight, while actively repositioning coupon and collateral selection. |
| Non-Agency Residential MBS (NARMBS) |
| Outlook Housing has performed strongly over the past year with national home prices increasing 19.1% YoY. Positive housing fundamentals support home price appreciation, albeit at a slower pace as supply and demand normalize. |
| Relative Value + We are positive on GSE credit risk transfers as well as legacy non-agency and new-issue loan deals. |
| Non-Agency Commercial MBS (CMBS) |
| Outlook Fundamentals vary by sector with multifamily and industrial real estate showing recent signs of strength, but challenges in retail and office space remain. If coupons continue rising, cap rates could come under pressure and transactions may decline. We are constructive on fundamentals but cautious on spreads due to macro volatility and heavy supply potential. |
| Relative Value +/– We are constructive up the capital stack and opportunistic on mezzanine and below-IG credits. |
| Asset-Backed Securities (ABS) |
| Outlook While consumers are better positioned thanks to Covid relief, we are cautious on consumer fundamentals and watchful of credit deterioration due to the reduction of direct aid and the long-term structural challenges. |
| Relative Value +/– We favor well-protected ABS classes from higher quality sectors. |
| Inflation-Linked |
| US |
| Outlook Inflation peaked in March provided energy prices can stabilize, though the drop in core inflation now looks less steep as supply chains are only slowly clearing. Housing inflation will likely remain high this year though our forecasted decline in 2023 will be at risk if the rents continue to rise even as new supply is completed amid worsened affordability. |
| Relative Value – Our expectation is that medium-maturity TIPS are at risk of underperforming comparable nominal USTs in 2Q22 with markets now pricing substantially higher inflation into both 2023 and 2024. |
| Europe |
| Outlook Inflation has likely peaked in the eurozone but is expected to fall back only gradually this year. Volatility in energy prices remains high and any further Russian energy embargoes could hinder growth but keep inflation high. |
| Relative Value – We have a modest underweight in eurozone index-linked bonds, while remaining short in nominal bunds as the ECB responds to higher inflation via scaling back asset purchases and gently raising rates. |
| Japan |
| Outlook We keep a constructive view on inflation-linked JGBs. The current 10-year BEI is still below 2% of the BoJ’s inflation target as well as 1.5% of our CPI forecast this year. The balance between issuances and buybacks continues to be supportive. |
| Relative Value + We maintain an overweight to Japanese real yields against nominal yields. |
| Municipals |
| US |
| Outlook Fundamentals will continue to be supported with record revenue collections, reserve levels and unspent Covid relief funds that can be allocated into 2026. However, we anticipate challenged liquidity conditions stemming from mutual fund outflows to contribute to market volatility in the near term. |
| Relative Value +/– We maintain an overweight to higher-beta revenue sectors that would continue to benefit from an ongoing economic recovery. |
| Emerging Market (EM) Debt |
| EM Sovereigns (USD) |
| Outlook The unevenness of the post-pandemic recovery across regions and countries has led to a greater emphasis on idiosyncratic risks. The need to differentiate long-term credit themes across countries is of paramount importance. The anticipated recovery path presents a contrast with synchronized economic contractions in 2020. |
| Relative Value +/– IG-rated EM sovereigns look appealing from a carry standpoint, but will continue to be susceptible to UST volatility. Vigilance is warranted on lower-rated countries given the pandemic’s impact on sovereign credit quality. |
| EM Local Currency |
| Outlook EM growth challenges, heightened geopolitical risks and Fed tightening are historically not supportive of EM FX. In addition, inflation concerns continue to be a dominant theme for central banks. The aggressive approach to monetary tightening over the past year does provide some counterbalance, reflected in the higher cost of carry. |
| Relative Value +/– By region, Asia stands to benefit given stronger initial conditions. Currencies of weaker countries could be vulnerable to market swings. |
| EM Corporates |
| Outlook EM corporates continue to maintain discipline with lower leverage and conservative financial policies despite loosening DM credit standards. Generally speaking, near-term risks to EM corporates will emanate from sovereign dynamics rather than traditional balance sheet considerations. |
| Relative Value + We believe EM primary issuance priced at a concession to secondary and DM levels offers attractive relative value, while we continue to watch for more dislocated pockets of value in HY-rated corporate issuers. |
| Outlook | Relative Value | ||
|---|---|---|---|
| Investment-Grade (IG) Corporate Credit | |||
| US | We remain cautiously optimistic about corporate fundamentals near-term given the strong starting position while overall domestic economic growth should still be supportive despite additional headwinds emanating from the Russia/Ukraine conflict. We remain vigilant of potential shareholder-friendly activity (e.g., share buy-backs, M&A, etc.), but outside of a few examples of bondholder-unfriendly behavior, we have continued to witness conservative balance sheet management. | +/– | Valuations temporarily repriced into attractive territory; however, overall spreads quickly retraced in the second half of March to levels that can be described as fair given the increased degree of uncertainty still remaining. We continue to maintain overweights to banking, select reopening industries and rising-star candidates where allowed. |
| Europe | Fundamentals in IG are strong with few pockets of concern, despite the war in Ukraine. M&A, LBOs, a stretched consumer and supply chains are all key risks we are focused on. Bank balance sheets remain in strong shape with higher rates supportive of profitability. | +/– | Yields have reached multi-year highs in euro-denominated IG bringing a surge in demand for high quality bonds from insurance companies. We expect IG spreads to perform, but with valuations less attractive than in 1Q and higher volatility, we do not expect a reversion to the 2021 tights. We find most value in subordinated financials and REITs. |
| Australia | We continue to see value; inflation will be an issue for some issuers but most have monopolistic or regulated resets that will protect their margins. Management has remained defensive which has protected balance sheets; with limited issuance YTD the demand for credit at primary remains strong. | + | We remain overweight the IG sector. Select REITs and infrastructure assets that have regulated resets or that are still enjoying growth as the economy opens up still remain relatively more attractive than financials. |
| High-Yield (HY) Corporate Credit | |||
| US | HY spreads remain relatively attractive given a supportive nominal economic growth and low default outlook. Credit quality continues to improve with much of the index rated BB and with declining CCC exposure compared to several years ago. Technicals have been negative YTD given outflows from fixed-income as interest rates have risen, but higher yields are beginning to attract new buyers. | + | We continue to position for a “reopening trade” and rising stars. We remain overweight certain cyclical sectors including airlines, cruise lines and select lodging credits, complemented by a higher quality bias in less cyclical subsectors. |
| Europe | Fundamentals have improved, but markets are now pricing in ongoing elevated input pricing pressure, lingering supply chain issues and gradual tightening of monetary policy by the ECB—but Covid-related headwinds should subside. Supply has decreased dramatically, supporting the technical picture. | + | Valuations are attractive in the context of lower-yielding, more interest-rate-sensitive European asset classes. We expect spreads to be range-bound. We favour telecom/cable sectors and have turned more cautious on some consumer-related sectors given a deterioration in disposable income. |
| Bank Loans | |||
| US | Fundamentals remain strong and minimal defaults are expected given the economic outlook. Issuance has been robust in recent years, driven by M&A and LBOs, but the supply of new issues has been met with demand for higher-yielding floating-rate securities from retail and institutional clients. | + | We believe outperformance will come from carry and avoiding problem credits. We are focused on select names where fundamentals remain intact and prices are at discounts to their call price. |
| Collateralized Loan Obligations (CLOs) | |||
| US | Any improvement in the CLO arbitrage or reduction of broader macro volatility is likely to be met with elevated CLO issuance keeping spreads relatively range-bound in the near term. Hedging costs for overseas investors have risen so far on the year but high-quality CLOs still screen attractive for overseas investors which should lead to demand. | + | We view AAA CLO debt at current levels as very attractive and retain our view that it will continue to perform well in either bullish or bearish bank loan spread environments given strong structural protections. IG-rated mezzanine tranches at current spreads and dollar prices are attractive as this part of the capital structure remains well insulated from credit losses. |
| Mortgage and Consumer Credit | |||
| Agency MBS | We believe there are more downside risks to spreads widening as Fed support diminishes, but valuations have become more reasonable. | – | We have been reducing our underweight, while actively repositioning coupon and collateral selection. |
| Non-Agency Residential MBS (NARMBS) | Housing has performed strongly over the past year with national home prices increasing 19.1% YoY. Positive housing fundamentals support home price appreciation, albeit at a slower pace as supply and demand normalize. | + | We are positive on GSE credit risk transfers as well as legacy non-agency and new-issue loan deals. |
| Non-Agency Commercial MBS (CMBS) | Fundamentals vary by sector with multifamily and industrial real estate showing recent signs of strength, but challenges in retail and office space remain. If coupons continue rising, cap rates could come under pressure and transactions may decline. We are constructive on fundamentals but cautious on spreads due to macro volatility and heavy supply potential. | +/– | We are constructive up the capital stack and opportunistic on mezzanine and below-IG credits. |
| Asset-Backed Securities (ABS) | While consumers are better positioned thanks to Covid relief, we are cautious on consumer fundamentals and watchful of credit deterioration due to the reduction of direct aid and the long-term structural challenges. | +/– | We favor well-protected ABS classes from higher quality sectors. |
| Inflation-Linked | |||
| US | Inflation peaked in March provided energy prices can stabilize, though the drop in core inflation now looks less steep as supply chains are only slowly clearing. Housing inflation will likely remain high this year though our forecasted decline in 2023 will be at risk if the rents continue to rise even as new supply is completed amid worsened affordability. | – | Our expectation is that medium-maturity TIPS are at risk of underperforming comparable nominal USTs in 2Q22 with markets now pricing substantially higher inflation into both 2023 and 2024. |
| Europe | Inflation has likely peaked in the eurozone but is expected to fall back only gradually this year. Volatility in energy prices remains high and any further Russian energy embargoes could hinder growth but keep inflation high. | – | We have a modest underweight in eurozone index-linked bonds, while remaining short in nominal bunds as the ECB responds to higher inflation via scaling back asset purchases and gently raising rates. |
| Japan | We keep a constructive view on inflation-linked JGBs. The current 10-year BEI is still below 2% of the BoJ’s inflation target as well as 1.5% of our CPI forecast this year. The balance between issuances and buybacks continues to be supportive. | + | We maintain an overweight to Japanese real yields against nominal yields. |
| Municipals | |||
| US | Fundamentals will continue to be supported with record revenue collections, reserve levels and unspent Covid relief funds that can be allocated into 2026. However, we anticipate challenged liquidity conditions stemming from mutual fund outflows to contribute to market volatility in the near term. | +/– | We maintain an overweight to higher-beta revenue sectors that would continue to benefit from an ongoing economic recovery. |
| Emerging Market (EM) Debt | |||
| EM Sovereigns (USD) | The unevenness of the post-pandemic recovery across regions and countries has led to a greater emphasis on idiosyncratic risks. The need to differentiate long-term credit themes across countries is of paramount importance. The anticipated recovery path presents a contrast with synchronized economic contractions in 2020. | +/– | IG-rated EM sovereigns look appealing from a carry standpoint, but will continue to be susceptible to UST volatility. Vigilance is warranted on lower-rated countries given the pandemic’s impact on sovereign credit quality. |
| EM Local Currency | EM growth challenges, heightened geopolitical risks and Fed tightening are historically not supportive of EM FX. In addition, inflation concerns continue to be a dominant theme for central banks. The aggressive approach to monetary tightening over the past year does provide some counterbalance, reflected in the higher cost of carry. | +/– | By region, Asia stands to benefit given stronger initial conditions. Currencies of weaker countries could be vulnerable to market swings. |
| EM Corporates | EM corporates continue to maintain discipline with lower leverage and conservative financial policies despite loosening DM credit standards. Generally speaking, near-term risks to EM corporates will emanate from sovereign dynamics rather than traditional balance sheet considerations. | + | We believe EM primary issuance priced at a concession to secondary and DM levels offers attractive relative value, while we continue to watch for more dislocated pockets of value in HY-rated corporate issuers. |