Western Asset: 4Q22 Global Outlook

Executive Summary

In the US, consumer spending growth has slowed and US homebuilding activity has also pulled back substantially. Recession is still not inevitable, but the chances of avoiding it lessen each day that we do not see any indications that Fed hiking will let up.
In Europe, the cessation of Russian natural gas exports has forced eurozone energy prices substantially higher. This will push into recession those eurozone countries with greater Russian energy dependence and increased exposure to manufacturing.
In the UK, real disposable incomes will remain under increasingly acute pressure due to high food and energy prices as well as materially higher interest rates. We expect this to weigh heavily on economic activity.
In China, the economy continues to be weighed down by multiple tailwinds, from the destabilizing effects of zero-Covid disruptions, continuing slowdown in the property sector and slowing export demand.

The key to an improved tone and more stability in fixed-income markets is a moderation in inflation. In the US, there are signs that the labor market is softening, and the housing market is beginning to slow as higher mortgage rates begin to bite. Anecdotal evidence from corporates indicates inventories are normalizing and demand is softening. In Europe, higher energy costs and inflation are hampering consumption and negatively impacting business and consumer confidence. We anticipate inflationary pressures will peak in the coming months and decline as 2023 progresses. While global central banks are expected to raise interest rates further in the short term, we believe more aggressive action is already anticipated by the markets. 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. As growth and inflation moderate and the risks surrounding central bank policy become more balanced, so too should the market environment for fixed-income investors. Here, we provide a summary of the key drivers behind our global outlook and describe where we see value across global fixed-income markets.

KEY DRIVERS

The economic outlook has deteriorated somewhat in recent months due to the effects of rising prices on consumer and business finances. A more aggressive-than-expected Fed hiking regimen, along with the financial markets’ response to those pronouncements, have further clouded the outlook. Recession is not inevitable now, but it is a much higher probability outcome than was the case just a few months ago.

Concerning inflation, real incomes have been declining steadily over the last seven months, as wage growth and job growth have not been able to offset the effects of rising prices. This is a distinctly different development from how things occurred in the late-1960s, when the rise of inflation did not make a dent in household real incomes. We had thought that US inflation would moderate quickly and substantially enough to erase the drag on real incomes, but this has not been the case. Our perception is that these declines in real income portend accompanying declines in real consumer spending. To date, households have dipped into savings enough to keep real consumer spending merely flat, but even this is a substantial deceleration from the pace of six months ago, and eventually, consumers will react further.

Meanwhile, perhaps in response to the Fed’s stated hiking regimen or in response to observed inflation rates, financial markets have pushed term yields substantially higher over the past six months. While Treasury yields have appeared to stabilize in recent weeks, they remain elevated well above 2021 levels, and still-rising credit spreads have pushed private-sector borrowing rates even higher.

The best chances to avoid a recession would be either a swift subsidence in inflation that causes the Fed and financial markets to pull term yields below the 3% range they have lately taken, and/or a sufficient increase in consumer spending on services still restricted by Covid to allow some positive growth in GDP. In the latter event, declining consumer spending on goods would depress imports and likely “export” US softness abroad.

Under either development, however, US growth will likely be substantially slower than it looked a few months ago. Growth of 1% or less in coming quarters seems likely.

We see significant downside risks to eurozone growth if imports of natural gas from Russia were to decrease markedly. The impact on manufacturing in Germany and Italy especially—but 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.

Meanwhile, inflation in the eurozone continues to rise largely driven by energy-related commodities. An embargo escalation or decision by Russia to halt gas supplies 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 likely 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 remain elevated. There are still no tangible indications of excessive wage inflation in Europe, but key bargaining negotiations will only be completed later this year. As inflation has continued to drift higher, the European Central Bank (ECB) has ended net asset purchases and committed to interest rate hikes in July and September to end negative rates. The outlook for monetary policy beyond that, however, is highly uncertain. While further rate hikes are possible if domestic demand is holding up, either because the hostilities ease and energy-related inflation recedes somewhat or because of additional fiscal support to households and corporates that neutralizes uncertainty and the fiscal drag, the fragility of Europe’s energy supply poses a significant risk through the second half of the year.

Following the reduction of pandemic-related restrictions normalization in the UK played out faster than on the continent, with a tight labor market and significant inflationary pressures expected to persist through the remainder of this year. The Bank of England (BoE) was also earlier in its shift toward tighter monetary policy ending its asset purchases in December 2021, later halting the reinvestment of maturing bonds and hiking rates five times consecutively. Households’ disposable income is negatively affected by the increase of contributions to national insurance and rising living costs. Despite some fiscal measures to alleviate the inflation squeeze, questions remain about the strength of real aggregate demand and consumer sentiment is close to all-time lows. 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.

China’s zero-Covid policy and the omicron variant’s virulent nature continue to present key risks to growth prospects in 2022. Policy remains supportive in view of rising growth and unemployment risks though movement restrictions; however, uncertainty over the next outbreak dampens the effectiveness of policy. Consumption remains under pressure from continued restrictions and weaker sentiment, though production has been able to rebound more quickly. Meanwhile, exports, a key support for growth during the pandemic, are showing signs of slowing. Uncertainty persists and even small-scale flare-ups at regional levels could still dampen sentiment. Policy support has been boosted significantly since Q2, albeit in a targeted manner. On May 31, the State Council detailed an extensive stimulus package ranging from tax relief, fee reductions and deferment of debt repayment to ease financial burdens and expand infrastructure spending to prop up investment and jobs.

US: Inflation Headwinds Persist... For Now

Over the last three months, inflation has failed to moderate the way we anticipated, but consumer spending growth has slowed in line with our expectations, and US homebuilding activity has also pulled back substantially in line with our expectations. Meanwhile, the Fed has continued to ratchet short rates higher, and the lack of clear progress on inflation indicates that such hiking will proceed further than we were expecting three months ago. After holding steady for much of the (Northern-Hemisphere) summer, term yields have moved higher as well, presumably also in response to the diminished chances for a tapering of Fed rate hikes.

The ongoing Fed rate hikes should increase the chances for recession both in the US and globally.

The ongoing Fed moves higher should increase the chances for recession both in the US and globally. As yet, however, the only real sign of weakness in the US economy is the emerging sharp declines in residential construction spending. This measure had already been trending down since early 2021, but the downward pace has intensified in recent months—and also widened from multi-family to both multi- and single-family—as large inventories of unsold new homes have gotten oppressive. Meanwhile, manufacturing activity has decelerated, but is not declining. For services and sectors, consumer spending growth has slowed a bit lately, reflecting falling real incomes, but it is not (yet) declining.

Then again, the onerous pace of Fed hikes—and rising long-term yields—emerged only six months or so ago, and the yield increases seen as a result of the latest Fed increases are likely to have larger impact on economic activity in the months ahead. Recession is still not inevitable in the US, but the chances of avoiding it lessen each day that we do not see any indications that Fed hiking initiatives will let up. On the price front, there are a number of encouraging signs that inflation will slow markedly, but these indications have yet to bear tangible fruit.

Europe: On Edge

The cessation of Russian natural gas exports to the eurozone that we had feared became a reality in the third quarter, pushing eurozone energy prices substantially higher. This will likely push eurozone countries with greater Russian energy dependence and increased exposure to manufacturing into recession. In the eurozone, GDP should begin to contract marginally in Q3, but should see larger drops in 4Q22 and 1Q23. Pushing against this, governments have ramped up both fiscal support packages (supportive of growth) and voluntary policies designed to reduce power consumption (marginally negative for growth) over the winter and into 1Q23. Additionally, European-wide gas storage levels are nearing 90%, which increases the buffer should the winter weather prove colder than normal. The economic cost of such support via energy purchases, fiscal shields, energy company bailouts and consumption reduction has been high and will increasingly be seen in hard data (forward-looking surveys already reflect this).

Likewise, the impact on eurozone inflation has been marked. The key driver has been energy on a headline level, but the percolation of higher energy prices up into both food and core goods is a secondary factor along with a tendency for the exchange rate of the euro to weaken when energy prices surge. The European Central Bank (ECB), along with other central banks, has become more fearful that the current level of elevated inflation could lead to much higher consumer/business inflation expectations and greater future wage demands. Hence, they have pushed policy rates sharply higher and the market currently expects terminal rates of around 2.75% in 2Q23. Conversations around asset purchase policies will start in earnest in October and could add to uncertainty around both outright yields and periphery spread levels. On balance, we feel that the market is too aggressive in its near-term pricing for policy rates as the reality of the energy price impact on growth becomes more apparent, and as the policy argument could morph from pre-emptive ECB action to recession itself lowering inflation, and curtailing both inflation expectations and wage demands.

The ECB, along with other central banks, has become more fearful that the current level of elevated inflation could lead to much higher consumer/ business inflation expectations and greater future wage demands.

In the UK, September saw unprecedented volatility in domestic financial markets, particularly a sharp rise in gilt yields that required intervention by the Bank of England (BoE) on financial stability grounds and a delay to plans to begin selling its own stock as part of its quantitative tightening program. The trigger was the new government’s fiscal package, which included energy price support for households and businesses, and tax cuts. The government’s aim is to boost medium-term potential growth, but markets balked at the additional borrowing required and that it could add to near-term inflation pressures. Although markets were calmed by the BoE’s intervention, all eyes remained on both the government’s commitment to provide a more detailed plan (including how it will be funded) alongside independent forecasts, as well as on the reversal of any plans such as the one to lower the tax rate for the highest earners.* We expect the BoE to follow up on its pledge to deliver a significant increase rate hike at its November meeting . However, real disposable incomes will remain under increasingly acute pressure due to high food and energy prices as well as materially higher interest rates. We expect this to weigh heavily on economic activity, dampen inflationary pressures, and result in a looser labor market as hiring intentions continue to fall, easing concern over possible second-round effects. We therefore think that the terminal policy rate is likely to be below what the market is pricing.

* Through October, developments have continued thick and fast. Jeremy Hunt has been appointed as Chancellor, replacing Kwasi Kwarteng and rapidly reversing much of the fiscal plans that triggered such turmoil when announced on 23 September. The markets have been reassured by a commitment to ensure that debt will fall as a share of GDP in the medium term. While Prime Minister Liz Truss’ resignation added fresh uncertainty, markets were comforted by Hunt’s confirmation to remain in position. Then on 24 October it was announced that MPs selected Rishi Sunak as the new leader via an accelerated process.

China: Challenges Persist

Property market sentiment in China is critical to consumption confidence as households’ net worth are shrinking due to falling home values.

China continues to be weighed down by multiple headwinds, from the destabilizing effects of its zero-Covid policy, a continuing slowdown in the property sector and slowing export demand. Domestic confidence weakness persists, both from property markets’ uncertainty as well as weak labor market conditions. Year-to-date (YTD), new household loans have halved to RMB 2.76 trillion compared to 2021, long-term loans plunged 54% year-over-year (YoY) to RMB 1,974 billion while short-term lending dropped 40% YoY to RMB 786 billion. The construction and real estate sector’s contribution to GDP ranges from 14% directly to as high as 30%. Property market sentiment is critical to consumption confidence as households’ net worth are shrinking due to falling home values, which are expected to crimp spending as 40% of household wealth is tied to real estate. The key hindrance to reopening remains the risk of a large number of senior deaths; the question is whether the deleterious economic and social effects will become too difficult to bear.

The Big Picture

Global Market Rates: Relative Value by Region

CANADA: Policy rates may undershoot forwards but market yields are likely to remain range-bound given the yield curve is already so inverted.

US: Stickiness of lagging inflation measures has postponed the Fed’s pause and elevated the peak rate. We now expect the Fed to pause in 1Q23. Longer-dated US Treasury (UST) bonds are likely to be supported by slowing growth, both domestically and globally, and an expectation that restrictive Fed policy will successfully bring down inflation.

UK: We feel that the market is expecting too much in terms of rate hikes, and therefore gilts should outperform.

EUROPE: We expect a moderate decline in yields but would be wary around Italian spreads as the market is beginning to question fiscal trajectories.

CHINA: We expect rates to remain low with long-term rates well anchored by targeted tightening and a universal easing approach toward all macroeconomic levers.

JAPAN: We expect stable JGB yields with a slight steeper curve under the YCC program.

AUSTRALIA: We remain focused on the 10- and 20-year bonds as the curve still remains relatively steep versus other DM yield curves, and still remains priced for further RBA action.

See Relative Value by Sector section for the Emerging Markets outlook.

Ongoing Fed hikes increase the chances for recession both in the US and globally. As of yet, however, the only real sign of weakness in the US economy is the emerging sharp declines in residential construction spending. On the price front, there are a number of encouraging signs that inflation will slow markedly, but these indications have yet to bear tangible fruit.

Canada

The Bank of Canada has matched, even led, Fed tightening to date, but the Canadian economy is more sensitive to both higher rates and slower global growth. We anticipate policy rate hikes may end as soon as October if there is any downshift in the labor market from here.

Europe

With the ECB part way through front-loading policy tightening, inflation likely having peaked and the growth outlook deteriorating, we feel that the ECB will not be able to deliver the tightening markets are currently pricing. The risk of energy rationing still remains a key risk.

While we expect the BoE to deliver a significant rate hike at its November meeting, we believe that the BoE’s hiking cycle is likely to end earlier and lower than the market expects as fiscal pressures weaken household demand and the job market loosens.

China

We expect 2022 growth to come in between 4% and 5%; 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 1.5%-2.0% in 2022 and 2023. Inflation rates are expected to increase in 2022 and moderate early in 2023. The Bank of Japan (BoJ) will likely maintain its current monetary accommodation—unlike other developed market (DM) central banks—to support its economy under the relatively low inflation. However, we think that the BoJ is open to make minor adjustments necessary to maintain the yield-curve control (YCC) framework because of the pressure from increasing amounts of Japanese government bonds (JGBs) to purchase.

Australia

The Reserve Bank of Australia (RBA) has moved the cash rate quickly from 0.10% to 2.60% and we now expect it to have a more moderate approach to monetary policy tightening and achieve a 3.10% cash rate by the end of 2022. Living costs have risen and that, combined with the rate rises, will bring growth down in 2023. We believe the RBA is attempting to walk the tightrope and hoping to achieve its goal of returning inflation to its target band over time, without forcing a recession.

Relative Value by Sector

Corporate fundamentals may have peaked, but they are coming off a strong starting point. Concerns abound that earnings will decelerate given tighter financial conditions, rising input costs and the FX impact of a surging US dollar. Margins, however, are only coming off of near decade highs while corporate management continues to behave relatively conservatively given uncertainty with the macro backdrop.

+ Spreads may widen if monetary policy overtightens to trigger a severe recession (not our base case) but recent re-pricing has made valuations more appealing. We maintain overweights to banking (where further ratings upgrades are expected), energy, select reopening industries and rising-star candidates, where allowed.

Europe

European IG earnings are likely to reflect an increasingly challenged operating environment. However, most IG companies enter this period with strong balance sheets and benefit from scale and diversification. European utilities face higher funding needs but with government support we see some opportunities in this space.

+ Yields at multi-year highs look attractive. In particular. We like the 3-5 year part of the market. We find most value in financials and REITs and are cautious on more cyclical consumer-facing sectors.

Australia

Credit fundamentals remain sound despite the prospect of the economy slowing. We are focused on issuers that can manage the pressure of inflation, which, fortunately, due to the monopolistic or duopolistic nature of many issuers in Australia, they do have some pricing power, and many of the regulated assets are protected by resets.

+ We remain overweight credit, particularly in short-dated holdings with a preference for select REITs and infrastructure assets that have regulated resets. We also favor senior unsecured bank paper.

HY credit spreads are relatively attractive. Default rates are likely to rise from very low levels in the coming quarters, but yields are providing ample cushion for higher defaults—which are likely to be below historical averages given the higher credit quality of the market on average. Technicals have been negative YTD given outflows from mutual funds, but higher yields are beginning to attract new institutional buyers.

+ We continue to see opportunity in service-related sectors that are still recovering from the Covid-led recession (i.e., reopening trades including airlines, cruise lines and lodging) and potential rising stars. We are more cautious on companies with closer ties to housing-related activity and therefore lack pricing power.

Europe

Credit fundamentals face challenges including slowing regional growth, elevated energy prices and tightening financial conditions. Refinancing needs for existing issuers are modest in the near term.

+/- Valuations have repriced with yields back to multiyear highs and spreads pricing in higher default rates. We see value in BB and B rated issues—focusing on more defensive industries, including telecom/ cable and health care.

Bank loan spreads are relatively attractive. While fundamentals are expected to decline from robust levels as growth slows, yields are providing ample cushion for gradually higher defaults. Valuations have improved meaningfully, and technicals may soon improve as demand for discounted floating-rate loans from CLOs and institutions exceeds the limited new-issue supply.

+ We believe outperformance will come from credit selection and avoiding problem credits. We are focused on select names where fundamentals remain intact and prices are at discounts to their call price.

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 rated 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.

Agency MBS

Diminishing Fed and bank demand for agency mortgage-backed securities (MBS) coupled with increased volatility remain headwinds, but the fundamental picture has greatly improved as spreads widened significantly and look attractive historically, while prepayment risk subsided.

+ We are constructive on 30- and 20-year subsectors relative to 15-year MBS and focus on specified pools’ security selection to enhance carry and convexity.

Non-Agency Residential MBS (NARMBS)

After booming during the pandemic, home prices have begun to stall and roll over under the pressure of higher mortgage rates and lack of affordability. Supply-chain issues have still delayed the construction of many homes but as the supply comes online over the next six to 12 months in the face of waning demand, we see downward pressure on home prices.

+ Due to the increase in new-issue supply, we are opportunistic on credit risk transfer (CRT) securities as well as non-QM deals.

Non-Agency Commercial MBS (CMBS)

Fundamentals vary by sector with continued strength in multi-family, industrial and lodging but challenges in retail and office. Rapidly rising coupons are stunting transaction activity and leading to cap-rate widening, pressuring valuations and creating refinancing risk.

+/– Macro and rates pressures are depressing prices across the market; however, if volatility declines attractive yields are available across the capital stack for high-quality 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. We’re neutral at the top of the capital stack and selective in IG-rated tranches.

US TIPS real yields are attractive at levels above prior cycle highs, but 10-year breakeven inflation (BEI) levels are only fair at 2.3%. Retail fund outflows are likely to hurt performance as monthly inflation rates are set to fall.

+ Real yields above 1.5% are at peak levels seen since the GFC, and with CPI still positive, TIPS have a good shot at outperforming cash. With BEI only fair, liquidity and outflow risks argue for caution versus nominal USTs.

Europe

Inflation should peak in 4Q22 as energy prices are lower and government policies have capped/lowered domestic energy prices. The decline will be slowed by continued energy price pass-through into core goods and currency weakness.

+/– With German real yields above zero, the market pricing ECB terminal rates near 3%, inflation beginning to turn lower and growth prospects darkening we have closed our nominal short and moved to a very small long position.

Japan

Inflation-linked JGBs look attractive. Inflation rates are expected to increase at least in the short run while the current 10-year BEI is still well below 2% of the BoJ’s inflation target. The balance between issuances and buybacks continues to be supportive.

+ We maintain an overweight to Japanese real yields against nominal yields.

Despite the negative impact of elevated rate volatility on municipal bond prices, tax-exempt relative value has become increasingly attractive at higher nominal rates. We anticipate that any alleviation of inflation uncertainty could quickly improve market sentiment and soon reverse the record negative demand cycle.

+ We continue to favor municipal revenue sectors that would benefit from an ongoing economic recovery, and are focused on higher grade securities given valuations and recession risk.

EM Sovereigns (USD)

Varied 2022 macro shocks have led to divergent performance and outlooks across EM regions and countries. We continue to watch global central bank policy, commodity prices, Chinese regulatory developments and geopolitics as key macro drivers of EM returns.

+/– IG-rated EM sovereigns have widened meaningfully YTD but still appear uncompelling versus US IG credit spreads. Vigilance is warranted on lower-rated countries given tightening financial conditions.

EM Local Currency

EM local currency returns face headwinds from dollar strength and US growth exceptionalism, offset by EM central banks’ proactive tightening measures over the past 18 months. Inflation trends may diverge across EM as Europe continues to face an ongoing energy shock, allowing countries to customize their terminal-rate behavior.

+/– While FX will remain highly macro-driven, signs of the peaking of EM policy rates could provide opportunities to add exposure to EM local rates. We continue to avoid currencies of countries running unorthodox monetary policy.

EM Corporates

EM corporates continue to maintain discipline with lower leverage and conservative financial policies despite loosening DM credit standards. Amid volatile markets, near-term risks to EM corporates will likely emanate from technicals and sovereign dynamics rather than traditional balance sheet considerations.

+/– We are waiting for EM primary issuance to resume, which will likely need to be priced at a concession to secondary and DM levels. In the meantime, we continue to watch for more dislocated pockets of value in HY-rated corporate issuers.

Investment-Grade (IG) Corporate Credit

Spreads may widen if monetary policy overtightens to trigger a severe recession (not our base case) but recent re-pricing has made valuations more appealing. We maintain overweights to banking (where further ratings upgrades are expected), energy, select reopening industries and rising-star candidates, where allowed.

Europe

Yields at multi-year highs look attractive. In particular. We like the 3-5 year part of the market. We find most value in financials and REITs and are cautious on more cyclical consumer-facing sectors.

Australia

We remain overweight credit, particularly in short-dated holdings with a preference for select REITs and infrastructure assets that have regulated resets. We also favor senior unsecured bank paper.

High-Yield (HY) Corporate Credit

We continue to see opportunity in service-related sectors that are still recovering from the Covid-led recession (i.e., reopening trades including airlines, cruise lines and lodging) and potential rising stars. We are more cautious on companies with closer ties to housing-related activity and therefore lack pricing power.

Europe

Credit fundamentals face challenges including slowing regional growth, elevated energy prices and tightening financial conditions. Refinancing needs for existing issuers are modest in the near term.

+/-

Valuations have repriced with yields back to multiyear highs and spreads pricing in higher default rates. We see value in BB and B rated issues—focusing on more defensive industries, including telecom/ cable and health care.

Bank Loans

We believe outperformance will come from credit selection 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)

We view AAA rated 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.

Mortgage and Consumer Credit

Agency MBS

We are constructive on 30- and 20-year subsectors relative to 15-year MBS and focus on specified pools’ security selection to enhance carry and convexity.

Non-Agency Residential MBS (NARMBS)

Due to the increase in new-issue supply, we are opportunistic on credit risk transfer (CRT) securities as well as non-QM deals.

Non-Agency Commercial MBS (CMBS)

+/–

Macro and rates pressures are depressing prices across the market; however, if volatility declines attractive yields are available across the capital stack for high-quality credits.

Asset-Backed Securities (ABS)

+/–

We favor well-protected ABS classes from higher quality sectors. We’re neutral at the top of the capital stack and selective in IG-rated tranches.

Inflation-Linked

Real yields above 1.5% are at peak levels seen since the GFC, and with CPI still positive, TIPS have a good shot at outperforming cash. With BEI only fair, liquidity and outflow risks argue for caution versus nominal USTs.

Europe

+/–

With German real yields above zero, the market pricing ECB terminal rates near 3%, inflation beginning to turn lower and growth prospects darkening we have closed our nominal short and moved to a very small long position.

Japan

We maintain an overweight to Japanese real yields against nominal yields.

Municipals

We continue to favor municipal revenue sectors that would benefit from an ongoing economic recovery, and are focused on higher grade securities given valuations and recession risk.

Emerging Market (EM) Debt

EM Sovereigns (USD)

+/–

IG-rated EM sovereigns have widened meaningfully YTD but still appear uncompelling versus US IG credit spreads. Vigilance is warranted on lower-rated countries given tightening financial conditions.

EM Local Currency

+/–

While FX will remain highly macro-driven, signs of the peaking of EM policy rates could provide opportunities to add exposure to EM local rates. We continue to avoid currencies of countries running unorthodox monetary policy.

EM Corporates

+/–

We are waiting for EM primary issuance to resume, which will likely need to be priced at a concession to secondary and DM levels. In the meantime, we continue to watch for more dislocated pockets of value in HY-rated corporate issuers.