Western Asset: 4Q23 Global Outlook

Executive Summary

In the US, we are sticking with a view that moderating growth and acceptable inflation will stay the Fed’s hand and reverse the recent jumps in bond yields.
In Europe, the full impact of the significant policy tightening to date has yet to be felt, which affirms our belief that further rate hikes are unlikely.
In the UK, forward-looking indicators suggest growth will remain lackluster, with risks also skewed to the downside, which could see the focus shift to when future rate cuts may come.
In China, moderating growth and inflation should keep Chinese interest rates at current low levels for longer.

As we anticipated, global growth has downshifted and inflation rates worldwide are generally receding. Tightening financial conditions in the US and Europe, weaker demand for manufacturing and services across a number of countries and deflationary pressures in China are easing price pressures globally. These trends, coupled with the major central banks advocating for a prolonged period of restrictive monetary policy, are expected to further dampen economic growth and inflation which, in turn, should lead to lower developed market (DM) government bond yields and a modestly weaker US dollar. That stated, concerns over a “higher-for-longer” rate environment driven by factors such as stronger-than-expected growth in the US, increased US Treasury (UST) supply to cover a growing fiscal deficit and inflation remaining above respective central bank targets may lead to periods of heightened market volatility. Spread sectors such as emerging markets (EM), high-yield, bank loans and select areas of the mortgage-backed securities (MBS) space offer attractive yield but we acknowledge their vulnerability to unanticipated shifts in macro-related sentiment, geopolitical developments and the ongoing risk of central bank overtightening.

KEY DRIVERS

The US economy has meandered through different macro environments this year. Early in the year, economic growth data was softish, but inflation ticked up. In recent months, some economic indicators have improved, but inflation has come back down to acceptable levels for the last three months. The economic strength revolves around a modest pick-up in consumer spending, a bounce in housing activity, government-induced jumps in nonresidential construction in response to the infrastructure bill and other legislation. We think the decline in inflation is sustainable. It looks like something much more than random fluctuation in the data. Meanwhile, we would expect housing activity to turn down again in response to the recent further jump in mortgage rates, and much the same can be expected with respect to consumer spending. In sum, we are sticking with a view that moderating growth and acceptable inflation will stay the Fed’s hand and reverse the recent jumps in bond yields, even with the challenges this view has faced in recent months.

China’s growth is on track for a 5% target this year, with more volatile monthly data due to the lack of persistent and strong growth drivers. Moderating growth and inflation should keep Chinese interest rates at current low levels for longer. In a recent Politburo meeting, China’s leaders acknowledged challenges in economic growth and pledged more countercyclical efforts to enhance domestic demand, improve expectations and prevent risks. A number of new supportive measures were rolled out after the meeting, including relaxation of mortgage restrictions in all Tier-1 and some Tier-2 cities and lowering the down-payment ratio and mortgage rates to boost housing demand. On the fiscal front, the government announced further reductions in personal income taxes. Officials also announced an additional local government bond issuance quota for refinancing purposes to alleviate local government debt risks. On the monetary side, the People’s Bank of China (PBoC) lowered the 7-day reverse repo rate and 1-year loan prime rate by 10 basis points (bps) in August and cut the bank reserve requirement ratio (RRR) by 25 bps in September. These policy efforts should help to buoy China’s economic recovery, but it is too early to tell for how long. The Central Economic Work Conference in December will provide more colour around the Chinese government’s future policy roadmap.

Overall, we see the risks to European growth being tilted to the downside as we move through the remainder of this year and into 2024, shifting from the current stagnation in activity to a mild contraction. Germany is still experiencing a mild technical recession and the impact of tightening credit conditions is increasingly being felt across the region. Most forward-looking survey indicators are consistent with ongoing weakness in both manufacturing and service sectors and residential construction is seeing sharp falls in demand. However, the labor market remains firm, which for now is supporting consumption, particularly in the services sector.

In September, the European Central Bank (ECB) raised rates again by 25 bps, to 4.00%, a level that markets and most Governing Council members see as the high point of this monetary tightening cycle. The ECB noted: “Key interest rates have reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to the target,” as reflected in its three-year inflation forecast which is now at 2.1%. The path for core inflation and inflation expectations will be the key determinant of ECB policy going forward and the latest flash print for September saw core inflation fall from 5.3% to 4.5% (30 bps lower than expected). Given that the full impact of the significant policy tightening to date has yet to be felt, along with our view that inflation will fall sharply in the coming months, we believe the market’s assessment that further rate hikes are unlikely is correct. The combination of weaker growth and falling inflation should provide support for European bond markets.

In the UK, inflation has been slower to fall than in the US and Europe, which led the market to discount a significant amount of additional monetary policy tightening. We felt that this was excessive given a slower passthrough of lower energy prices due to the way that household energy prices are set by the regulator, signs that economic activity was likely to remain subdued and a loosening labor market. We have been pleased to see inflation undershoot market forecasts and the timing of base effects have become more broadly understood, with inflation expected to slow further during the fourth quarter. As a result, the market has meaningfully lowered the anticipated rate path for the Bank of England (BoE), which left rates unchanged at 5.25% at its last meeting, and gilts have outperformed. While the BoE has continued to signal that further tightening could follow if there are signs of more inflationary pressures, we do not expect any further rate hikes. Forward-looking indicators suggest growth in the UK will remain lacklustre, with risks also skewed to the downside, which could see focus shift instead to when future rate cuts may come.

US: Staying the Course

We think the decline in inflation is sustainable.

China: Targeted Support and Early Signs of Stabilization

Moderating growth and inflation should keep Chinese interest rates at current low levels for longer.

Euro Area: Growth Slowing and Inflation Falling

We have been pleased to see inflation undershoot market forecasts.

UK: Less of an Outlier

The Big Picture

Global Market Rates: Relative Value by Region

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

US: US bond markets overreacted to both the higher expected UST supply and the shift in Fed rhetoric regarding 2024 policy rates. We expect bond yields to reflect lower longer-term growth and inflation. While the timing of the shift in Fed policy direction is still uncertain and months away, both medium- and long-dated bond yields should be moving lower in 2024.

Canada: While the front end of the Canadian government bond yield curve likely is in line with Bank of Canada (BoC) stability and comparable to US rates, longer-dated bond yields look low in comparison to both policy rates and US bond yields. Bonds are again fairly valued versus their US counterparts. The Canadian dollar is unlikely to benefit from portfolio inflows.

Europe: We believe that the ECB runs the risk of keeping policy too tight for too long. Weaker growth and falling inflation will support euro area bond yields. Debt metrics at the eurozone level are less onerous than elsewhere.

UK: We feel that focus will shift toward future BoE rate cuts, and gilts should provide positive returns.

China: We expect the PBoC to maintain low rates in Q4 and thereafter shift to a more normalized monetary policy stance.

Japan: We expect higher Japanese government bond (JGB) yields. If the Bank of Japan (BoJ) adjusts its policy further, the nominal 10-year yield would lead the move higher.

Australia: We remain tactical in the 10- and 20-year parts of the curve as volatility remains the norm. With the 10-year bond 40 bps above the cash rate, it is very different than other markets where an inverse relationship exists.

US growth is decelerating sharply into 2024, though uncertainty remains over the pace of the downtrend in inflation. Both the labor market rebalancing and decline in inflation will continue whether the Fed hikes again in Q4 or not. Risks to our benign base case remain to the downside.

Canada

The BoC has likely completed its rate-hiking cycle following the pause, but it will still be some time before rate cuts are warranted. Demand pressures remain resilient relative to supply in both housing and service sectors, and wages have surprised on the high side. The downtrend in core inflation has flattened out recently.

Europe

ECB policy has reached a level that ECB officials believe will bring inflation to target over their forecast horizon. Economic activity should remain weak as previous tightening gains traction and this will likely see inflation decline closer to target earlier than ECB forecasts.

The BoE recently left rates unchanged at 5.25%. We do not expect additional monetary policy tightening as inflation should slow further during Q4. Forward-looking indicators suggest that economic activity should remain lackluster at best as previous tightening gains traction and the labor market loosens further.

China

We expect 2023 growth to come in between 4.5% and 5.5%, with policymakers focused on economic recovery. We do not expect broad-based growth stimulus; rather, we expect continued, targeted measures.

Japan

Given stronger-than-expected growth and inflation, the BoJ remains open to make further adjustments in terms of a set of policy tools such as the size of its balance sheet.

Australia

Consumer resilience is expected to fade as the full effects of policy tightening takes hold. Although the heavy lifting by the Reserve Bank of Australia (RBA) is done, borrowing rate conversion, cost of living increases, contracting real incomes and declining savings should all work to curtail discretionary spending into 2024. That said, with unemployment expected to remain relatively low, it’s likely to create a scenario of only a mild recession or one averted.

Relative Value by Sector

Corporate fundamentals have peaked but remain resilient. Margins are pressured but top-line revenue growth continues in the low single-digit range. Corporate managements also continue to behave conservatively given uncertainty with the macro backdrop.

+/- Spread levels remain fair and do not offer much cushion against tail risks and macro uncertainty. We continue to maintain our overweights to banking, energy, select reopening industries and rising-star candidates, where allowed.

Europe

Corporate fundamentals are deteriorating in some sectors, albeit from a strong level. Higher government yields, thus far a tailwind, may ultimately become problematic for credit. Non-financials are largely not compelled to issue although the end of corporate sector purchase program (CSPP) reinvestments has weakened the technical.

+/- Strong YTD performance demands more caution as macro uncertainty remains elevated. Opportunities remain within banking and select real estate.

Australia

The recent reporting season showed that the fundamentals still remain sound despite the prospect of the economy slowing. We remain focused on issuers that can manage sticky inflation pressures and are defensive in nature. Fortunately, due to the monopolistic or duopolistic nature of many issuers in Australia, they naturally have these characteristics and many of the regulated assets are also protected by price resets.

+ We remain overweight credit, particularly short-dated holdings, with a preference for select REITs and utility/infrastructure assets that have regulated resets. We also favor senior unsecured major bank and foreign national champion bank issuance.

HY credit spreads are relatively attractive and likely imply a more meaningful deterioration in corporate balance sheets than expected over the next year. Yields are providing significant cushion to offset modestly higher defaults as peak fundamentals adjust to higher rates and slower growth. Technicals have been marginally negative over the last year given fund outflows, 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

Corporate fundamentals are decent based on recent earnings. Some weakness appearing in certain cyclical sectors such as the building industry and chemicals. The default rate is still fairly benign at around 2%, but is expected to increase gradually. Issuance is picking up, but generally for BB/B rated credits. The use of proceeds is focused on refinancing, so net supply remains muted.

+/- Valuations are fair with yields around 8%. Spreads of about 500 bps are around average levels for the year and vulnerable to more volatility. We remain focused on BB/B rated select new issues and short-dated yield to call opportunities.

Bank loan spreads are relatively attractive and likely imply a more meaningful deterioration in corporate balance sheets than expected over the next year. Yields are providing ample cushion for above-average defaults. Valuations have improved meaningfully over the last few quarters, and technicals may soon improve as demand from CLOs increases.

+ We believe outperformance will come from credit selection. We are focused on consumer services-oriented companies that typically have less cyclical cash flows, improving fundamentals, supportive asset coverage and with prices that 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 CLO issuance, keeping spreads relatively rangebound in the near term. Hedging costs for overseas investors have risen over the last year, but the higher spread for high quality CLO debt relative to other floating-rate investment-grade securities may result in more demand than supply in the near term.

+ 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

Agency MBS presently offer solid fundamentals with current spreads at attractive levels and prepayment risk is structurally low. Diminishing Fed and bank demand coupled with increased volatility remain headwinds but present investment opportunities.

+ We favor 30- and 20-year versus 15-year MBS, focusing on security selection to enhance yield and convexity profiles.

Non-Agency Residential MBS (NARMBS)

Persistently high mortgage rates in conjunction with limited new and existing housing supply continue to put downward pressure on housing affordability in the US. While real estate is presented with various challenges due to broad economic uncertainty, we do not see a significant risk of defaults in the broad residential market.

+ We are opportunistic on credit risk transfer (CRT) securities as well as non-QM deals that present attractive borrower profiles and higher credit qualities.

Non-Agency Commercial MBS (CMBS)

Spreads remain wide across the capital structure; however, senior exposures no longer skew as cheap following positive performance in Q3. Mezzanine and subordinate bonds remain wide to a variety of historical look-back scenarios as well as relative to traditional credit spread product comparisons but spreads for higher quality subordinate risk have found a floor and rebounded modestly. Higher new origination coupons are impacting refinancing success rates leading to increased extension assumptions while office sentiment has not improved.

+/- Low leverage exposures on high quality real estate with meaningful borrower equity present compelling opportunities to lend in both the conduit and single-asset single-borrower (SASB) market. New origination screens particularly attractive on a yield versus credit risk basis; however, some high-quality seasoned credits offer eye-popping total return opportunities.

Asset-Backed Securities (ABS)

Consumer fundamentals remain strong, but stress is emerging for lower-income consumers as they continue to lever up. We are cautious on consumer fundamentals and watchful of credit deterioration for lower-credit consumers. Prefer higher quality consumer sectors, established sponsors and sectors with positive tailwinds.

+ The credit curve has flattened. We are focused on senior AAA bonds across higher credit quality consumer sectors and on-the-run commercial ABS sectors.

US TIPS real yields are attractive at levels above prior cycle highs, and breakeven inflation (BEI) levels are close to Fed targets throughout the curve. Although we expect disinflation trends to continue, TIPS now represent good value outright and, in most risk scenarios, relative to USTs.

+ Longer-dated BEI are a good value versus nominal USTs in our base case, but could be attractive as a diversifier within US bond portfolios.

Europe

ECB tightening is beginning to gain traction via lending channels and lower headline and core inflation. Goods demand prospects look soft going forward and production tailwinds have lessened as backlogs have been filled. Services, a strong point, have begun to slow. Core inflation will fall sharply in 4Q23.

- 30-year breakevens are pricing 2.75% versus a 30-year average of around 1.75% and an ECB target of 2%. We remain underweight inflation at this tenor both versus the US and in outright terms.

Japan

Inflation-linked JGBs remain undervalued as the current 10-year BEI is well below 2%. Inflation is expected to remain high, but then moderate toward the end of this year. However, underlying inflationary pressures are proving stronger than initially expected, as suggested by a more sustained rise in core inflation than expected.

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

Third-quarter municipal underperformance has significantly improved the relative value of the asset class for investors subject to tax rates, as the after tax yield pick-up between tax-exempt municipals and comparably rated taxable fixed-income increased above five-year averages. From a fundamental perspective, muni credit conditions have likely peaked, as slower economic growth, lower tax collections and tighter credit conditions have factored into projected budget deficits for many municipalities.

+ Considering a backdrop of slowing growth and inflation, we are adding duration relative to the benchmark. The inverted yield curve is providing value in short and long maturities, and as such we are bar-belling curve exposure. While credit conditions have likely peaked, we expect overall credit conditions to remain strong, and that lower-rated IG securities will continue to offer value.

EM Sovereigns (USD)

Despite headwinds from continued pressure on DM bond yields, positive developments in global inflation and resilient US growth continue to support the outlook for EM assets. We view global central bank policy, commodity prices and geopolitics as key inputs for EM returns.

+ We believe HY frontier market sovereigns represent the best 2023 total return opportunity in EM given wide valuations and idiosyncratic credit stories.

EM Local Currency

EM central banks’ proactive tightening measures over the past two years have set up a more positive outlook for both rates and foreign exchange (FX) in 2023. Latin American central banks have begun to start cutting rates, although continued easing will be dependent on Fed policy.

+ While FX will remain highly macro-driven, elevated EM local bond yields, particularly in Latin America, can benefit from continued disinflation and a US soft landing. Conversely, Asian local currency yields remain historically low relative to USTs.

EM Corporates

EM corporates continue to maintain strong balance sheets, but we are watching the liquidity of domestic-focused issuers given higher local rates and tightened global financial conditions, while cyclical industries have headwinds from slower growth in Europe and China.

+/- Given comparatively tight valuations relative to DM corporates, we are focused on EM primary issuance at a concession to secondary. EM corporates’ lower duration and volatility may be ideal for clients looking for a more conservative allocation to EM.

Investment-Grade (IG) Corporate Credit

+/-

Spread levels remain fair and do not offer much cushion against tail risks and macro uncertainty. We continue to maintain our overweights to banking, energy, select reopening industries and rising-star candidates, where allowed.

Europe

+/-

Strong YTD performance demands more caution as macro uncertainty remains elevated. Opportunities remain within banking and select real estate.

Australia

We remain overweight credit, particularly short-dated holdings, with a preference for select REITs and utility/infrastructure assets that have regulated resets. We also favor senior unsecured major bank and foreign national champion bank issuance.

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

+/-

Valuations are fair with yields around 8%. Spreads of about 500 bps are around average levels for the year and vulnerable to more volatility. We remain focused on BB/B rated select new issues and short-dated yield to call opportunities.

Bank Loans

We believe outperformance will come from credit selection. We are focused on consumer services-oriented companies that typically have less cyclical cash flows, improving fundamentals, supportive asset coverage and with prices that 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 favor 30- and 20-year versus 15-year MBS, focusing on security selection to enhance yield and convexity profiles.

Non-Agency Residential MBS (NARMBS)

We are opportunistic on credit risk transfer (CRT) securities as well as non-QM deals that present attractive borrower profiles and higher credit qualities.

Non-Agency Commercial MBS (CMBS)

+/-

Low leverage exposures on high quality real estate with meaningful borrower equity present compelling opportunities to lend in both the conduit and single-asset single-borrower (SASB) market. New origination screens particularly attractive on a yield versus credit risk basis; however, some high-quality seasoned credits offer eye-popping total return opportunities.

Asset-Backed Securities (ABS)

The credit curve has flattened. We are focused on senior AAA bonds across higher credit quality consumer sectors and on-the-run commercial ABS sectors.

Inflation-Linked

Longer-dated BEI are a good value versus nominal USTs in our base case, but could be attractive as a diversifier within US bond portfolios.

Europe

30-year breakevens are pricing 2.75% versus a 30-year average of around 1.75% and an ECB target of 2%. We remain underweight inflation at this tenor both versus the US and in outright terms.

Japan

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

Municipals

Considering a backdrop of slowing growth and inflation, we are adding duration relative to the benchmark. The inverted yield curve is providing value in short and long maturities, and as such we are bar-belling curve exposure. While credit conditions have likely peaked, we expect overall credit conditions to remain strong, and that lower-rated IG securities will continue to offer value.

Emerging Market (EM) Debt

EM Sovereigns (USD)

We believe HY frontier market sovereigns represent the best 2023 total return opportunity in EM given wide valuations and idiosyncratic credit stories.

EM Local Currency

While FX will remain highly macro-driven, elevated EM local bond yields, particularly in Latin America, can benefit from continued disinflation and a US soft landing. Conversely, Asian local currency yields remain historically low relative to USTs.

EM Corporates

+/-

Given comparatively tight valuations relative to DM corporates, we are focused on EM primary issuance at a concession to secondary. EM corporates’ lower duration and volatility may be ideal for clients looking for a more conservative allocation to EM.