Executive Summary
- In the US, a more aggressive-than-expected Fed hiking regimen, along with the financial markets’ response to those pronouncements, increase the probability of a recession more than was the case a few months ago.
- In Europe, we see significant downside risks to eurozone growth if imports of natural gas from Russia were to decrease markedly.
- In the UK, 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.
- In China, we see the government’s zero-Covid policy and omicron variant’s virulent nature as ongoing headwinds to sustaining growth momentum in 2022.
The key to an improved tone and more stability in fixed-income markets is a moderation in inflation. Our base case is that supply chains will slowly begin to normalize. This trend, combined with the Federal Reserve (Fed) and other major central banks around the world tightening monetary policy along with negative real incomes slowing consumption, should see inflation moderate. We anticipate inflationary pressures will peak in 3Q22 and decline into 2023. 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. Not only may the rise in government yields abate, but lower volatility could also lead investors to reengage in fixed-income spread sectors, especially given current valuations. 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 Becoming Cloudier |
|---|
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. |
| Europe: Running Out of Gas |
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: Covid Continues to Muddy the Growth Outlook |
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: Growth Outlook Becoming Cloudier
 |
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.
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.
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. |
|---|---|
|
Europe: Running Out of Gas
 |
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.
An embargo escalation or decision by Russia to halt gas supplies could push headline inflation in the eurozone into double digits.
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: Covid Continues to Muddy the Growth Outlook
 |
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.
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. |
Global Market Rates: Relative Value by Region
| US | The economic outlook has deteriorated 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. Growth of 1% or less in coming quarters seems likely. |
|---|---|
| Canada | Expectations for Bank of Canada (BoC) tightening have risen to well above 3% by year-end. However, the evident turn in the rate-sensitive sectors of housing and durables indicate rates may peak at a lower rate. A sustained bond rally may wait for Q4 declines in employment or actual prices. In the meantime, fixed-income yields are attractive on long-term measures. |
| Europe | At this point, the degree of rate hikes on the continent is far from certain. 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. The risk of energy rationing in key eurozone economies is a prominent risk. |
| 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 1.5%-2.5% in 2022 and 2023. The Bank of Japan (BoJ) will likely maintain the current monetary accommodation unlike other developed market (DM) central banks. The BoJ will continue to place more focus on growth as long as inflation pressure remains relatively lower. |
| Australia | The Reserve Bank of Australia (RBA) joined the central bank attack on inflation in May and has since moved the cash rate up swiftly from 0.10% to 1.35%. The market is pricing a cash rate at 3.2% by year-end but we believe that around 2.25% is more likely. The direct impact of rate rises in Australia, due to most borrowers being on variable-rate mortgages, demands an assessment period. With living costs rising so abruptly as well, the economy could stagnate if the consumer recesses quickly. |
Relative Value by Sector
| Investment-Grade (IG) Corporate Credit |
|---|
| US |
| Outlook Corporate fundamentals may be peaking, but they are coming off a strong starting point. Concerns abound that profit margins may contract given rising input costs but margins are still near decade highs, while cash balances are also still elevated on a historical basis. The banking sector is also in robust shape given the high level of cautious oversight from regulators. |
| Relative Value + 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 |
| Outlook Fundamentals in European IG credit are strong but may deteriorate from here as a growth slowdown becomes more likely. Exposure to Russian gas is a current concern with particular focus on German industrial and utility credits. 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 credit, and IG spreads look attractive on both a historical and also a cross-currency-adjusted basis. With the ECB no longer buying in size and uncertainty around growth and inflation, we do not expect a reversion to the 2021 tights. We find most value in subordinated financials and REITs. |
| Australia |
| Outlook We are focused on issuers that can manage the pressure of inflation. 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. |
| Relative Value + We remain overweight with a preference for select REITs and infrastructure assets that have regulated resets. We also favor bank paper and covered bonds. |
| High-Yield (HY) Corporate Credit |
| US |
| Outlook HY credit spreads are relatively attractive. A moderating nominal growth environment will likely align with a rising, but below average default rate. Technicals have been negative year to date (YTD) given outflows from mutual funds, but higher yields are beginning to attract new institutional buyers. |
| Relative Value + We continue to position for a reopening trade and potential rising stars should volatility decline and growth slow only moderately. 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 The ECB tightening monetary policy, energy supply concerns and inflation pressures are impacting both growth sentiment and potentially corporate profitability. Refinancing needs for existing issuers are modest, given the prior year’s supply. This should help keep default rates from spiking. |
| Relative Value + Excluding the 2020 Covid shock, yields are back to levels not seen since 2012. We are focused on more defensive, less cyclical sectors such as telecom/cable and pharma. We are cautious on chemicals and consumer cyclical borrowers. |
| Bank Loans |
| US |
| Outlook Bank loan spreads are relatively attractive. While fundamentals are expected to decline from robust levels as growth slows, defaults are expected to remain below average. 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. |
| Relative Value + 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) |
| 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 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 YTD and prepayment risk subsided. |
| Relative Value +/– We favor conventional MBS relative to Ginnie Mae as the current administration has made a noticeable shift to expand affordable housing. We are constructive on 30-year and 20-year subsectors relative to 15-year MBS. |
| Non-Agency Residential MBS (NARMBS) |
| Outlook Housing has performed strongly over the past year with national home prices increasing 20.4% year-over-year (YoY). While real estate prices are expected to cool from the record increases, market spreads are elevated with increased risk premiums. |
| Relative Value + Due to the increase in new-issue supply, we are opportunistic on credit risk transfer (CRT) as well as non-QM deals. |
| Non-Agency Commercial MBS (CMBS) |
| Outlook Fundamentals vary by sector with continued strength in multi-family, industrial and lodging, but challenges remain in retail and office sectors. Higher coupons have stunted new transaction activity but the slowing pipeline is putting upward pressure on discounted bonds. |
| Relative Value +/– As macro and supply pressures ease, we are constructive across the capital stack for high-quality 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. We’re neutral at the top of the capital stack and selective in IG-rated tranches. |
| Inflation-Linked |
| US |
| Outlook The glacial drop in core inflation until now has been offset by renewed energy price gains. We look to better supply-side factors to push inflation lower. However, our forecasted decline in 2023 is at risk of delay given the recent strength in house prices and rents despite the clear downturn in housing activity and sentiment. |
| Relative Value +/– Real yields out the curve are now positive and at levels that are comparable to pre-Covid history. Shorter-dated TIPS are at risk of underperforming comparable nominal US Treasuries as commodity prices are buffeted by geopolitics and recession fears. |
| Europe |
| Outlook Inflation continues to rise via higher gas and electricity prices on the back of Russian gas supply curtailment. This is expected to continue into Q4. |
| Relative Value – We are underweight in eurozone index-linked bonds, while remaining short in nominal German bunds as the ECB responds to higher inflation via scaling back asset purchases and raising rates. |
| Japan |
| Outlook We keep a constructive view on inflation-linked JGBs. 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. |
| Relative Value + We maintain an overweight to Japanese real yields against nominal yields. |
| Municipals |
| US |
| Outlook The sector continues to benefit from record revenue collections associated with a tight labor market and national reopening trends. While we expect state and local revenue growth to slow, we do believe municipalities are in a strong position to manage through economic volatility. |
| Relative Value +/– We maintain an overweight to higher-beta revenue sectors that would continue to benefit from an ongoing economic recovery, while also finding value in large high-grade issuers with favorable liquidity characteristics. |
| Emerging Market (EM) Debt |
| EM Sovereigns (USD) |
| Outlook The unevenness of the 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 the synchronized economic contraction and rebound of 2020-2021. |
| Relative Value +/– 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 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. We continue to avoid currencies of countries running unorthodox monetary policy, while watching for signs of the Fed’s hiking cycle slowing. |
| 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 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. |
| Outlook | Relative Value | ||
|---|---|---|---|
| Investment-Grade (IG) Corporate Credit | |||
| US | Corporate fundamentals may be peaking, but they are coming off a strong starting point. Concerns abound that profit margins may contract given rising input costs but margins are still near decade highs, while cash balances are also still elevated on a historical basis. The banking sector is also in robust shape given the high level of cautious oversight from regulators. | + | 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 | Fundamentals in European IG credit are strong but may deteriorate from here as a growth slowdown becomes more likely. Exposure to Russian gas is a current concern with particular focus on German industrial and utility credits. Bank balance sheets remain in strong shape with higher rates supportive of profitability. | +/– | Yields have reached multi-year highs in euro-denominated IG credit, and IG spreads look attractive on both a historical and also a cross-currency-adjusted basis. With the ECB no longer buying in size and uncertainty around growth and inflation, we do not expect a reversion to the 2021 tights. We find most value in subordinated financials and REITs. |
| Australia | We are focused on issuers that can manage the pressure of inflation. 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 with a preference for select REITs and infrastructure assets that have regulated resets. We also favor bank paper and covered bonds. |
| High-Yield (HY) Corporate Credit | |||
| US | HY credit spreads are relatively attractive. A moderating nominal growth environment will likely align with a rising, but below average default rate. Technicals have been negative year to date (YTD) given outflows from mutual funds, but higher yields are beginning to attract new institutional buyers. | + | We continue to position for a reopening trade and potential rising stars should volatility decline and growth slow only moderately. 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 | The ECB tightening monetary policy, energy supply concerns and inflation pressures are impacting both growth sentiment and potentially corporate profitability. Refinancing needs for existing issuers are modest, given the prior year’s supply. This should help keep default rates from spiking. | + | Excluding the 2020 Covid shock, yields are back to levels not seen since 2012. We are focused on more defensive, less cyclical sectors such as telecom/cable and pharma. We are cautious on chemicals and consumer cyclical borrowers. |
| Bank Loans | |||
| US | Bank loan spreads are relatively attractive. While fundamentals are expected to decline from robust levels as growth slows, defaults are expected to remain below average. 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. |
| 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 | 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 YTD and prepayment risk subsided. | +/– | We favor conventional MBS relative to Ginnie Mae as the current administration has made a noticeable shift to expand affordable housing. We are constructive on 30-year and 20-year subsectors relative to 15-year MBS. |
| Non-Agency Residential MBS (NARMBS) | Housing has performed strongly over the past year with national home prices increasing 20.4% year-over-year (YoY). While real estate prices are expected to cool from the record increases, market spreads are elevated with increased risk premiums. | + | Due to the increase in new-issue supply, we are opportunistic on credit risk transfer (CRT) 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 remain in retail and office sectors. Higher coupons have stunted new transaction activity but the slowing pipeline is putting upward pressure on discounted bonds. | +/– | As macro and supply pressures ease, we are constructive 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. |
| Inflation-Linked | |||
| US | The glacial drop in core inflation until now has been offset by renewed energy price gains. We look to better supply-side factors to push inflation lower. However, our forecasted decline in 2023 is at risk of delay given the recent strength in house prices and rents despite the clear downturn in housing activity and sentiment. | +/– | Real yields out the curve are now positive and at levels that are comparable to pre-Covid history. Shorter-dated TIPS are at risk of underperforming comparable nominal US Treasuries as commodity prices are buffeted by geopolitics and recession fears. |
| Europe | Inflation continues to rise via higher gas and electricity prices on the back of Russian gas supply curtailment. This is expected to continue into Q4. | – | We are underweight in eurozone index-linked bonds, while remaining short in nominal German bunds as the ECB responds to higher inflation via scaling back asset purchases and raising rates. |
| Japan | We keep a constructive view on inflation-linked JGBs. 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. |
| Municipals | |||
| US | The sector continues to benefit from record revenue collections associated with a tight labor market and national reopening trends. While we expect state and local revenue growth to slow, we do believe municipalities are in a strong position to manage through economic volatility. | +/– | We maintain an overweight to higher-beta revenue sectors that would continue to benefit from an ongoing economic recovery, while also finding value in large high-grade issuers with favorable liquidity characteristics. |
| Emerging Market (EM) Debt | |||
| EM Sovereigns (USD) | The unevenness of the 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 the synchronized economic contraction and rebound of 2020-2021. | +/– | 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 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. We continue to avoid currencies of countries running unorthodox monetary policy, while watching for signs of the Fed’s hiking cycle slowing. |
| 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 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. |