Western Asset: 3Q19 Global Outlook

Executive Summary

We expect global growth, which has moderated since last quarter, to remain resilient on the back of steady US growth, improving domestic conditions in Europe and signs that sustained monetary and fiscal stimuli across Asia are gaining traction.
We’ve downgraded our US growth estimate to between 1.75% and 2.00% for 2019 due to slower manufacturing and home construction activity.
The overall level of global developed market bond yields reflects too much pessimism in our opinion, and within this universe, German bunds are the most overvalued.
We expect eurozone growth to be around 1% this year—only slightly below estimates of the region’s potential annual growth rate after five consecutive years of above-potential growth.
In our view, the Fed’s recent dovish pivot and signs of slowing US growth outperformance are constructive for EM financial conditions and flows.

Global growth concerns have intensified since last quarter as an initial trade spat between the US and China has morphed into a broader conflict with the risk of expanding on new fronts. Markets have also been rattled by the prospect of a US recession, a sustained slowdown in eurozone growth and higher oil price volatility on escalating tensions in the Middle East. Despite these concerns, we expect global growth to remain resilient on the back of steady US growth, improving domestic conditions in Europe and signs that sustained monetary and fiscal stimuli across Asia are gaining traction. We acknowledge that trade friction will be an ongoing drag on investor and business confidence, but central banks globally have become much more explicit in their commitment to unleash additional policy accommodation to truncate downside risks. Here we provide a summary of the key drivers behind our global outlook, how we’re positioned in broad market portfolios and a more detailed description of where we see value in today’s markets.

KEY DRIVERS

At present, we are estimating US growth between 1.75% and 2.00% in 2019. This is a slight downgrade from the 2.00%-2.25% range projected in April. We were expecting slower growth this year in manufacturing activity and in home construction, and this has occurred. In addition, retail sales growth has slowed a bit, sharpening the slowing in manufacturing activity relative to what we projected earlier this year. Even though equipment investment, exports and inventories have slowed, none of them are showing outright weakness—certainly not enough to threaten recession. Even for homebuilding, the roughly 10% drop seen in 2018 pales against the 30% or so declines seen over the 2006-2008 period. So, at this time, again, we project slower growth in 2019 than what was experienced over 2017-2018, but we do not see recession risk as being more than slight.

With this in mind, we see no compelling reason to share the Fed’s optimism that inflation will soon be 2% or higher. As discussed in our recent paper Falling Inflation Could Move the Fed, faster nominal spending growth that would make either sustained higher inflation or sustained higher economic growth has failed to occur despite all of the Fed’s efforts. While it is not a sure thing that core Personal Consumption Expenditures (PCE) inflation will remain at the 1.4% annualized pace of the last few months, recent rates look a lot less transitory than Fed comments had tried to make them. We believe it is most likely that inflation will remain below the 2% rate the Fed has targeted. The longer observed rates stay at or below that range, the more pressure there will be on the Fed to reflect that reality in its policy deliberations later this year. This is especially so given the Fed’s recent musing about price level (average inflation) targeting.

After a very weak 2H18, growth in both Germany and in the broader eurozone has improved and come in above market expectations as the negative impact of industry-specific factors, in particular those affecting the auto sector, have started to fade. Forward-looking survey data have improved and rebounded from the low point in January. The domestic drivers of growth in the majority of eurozone countries, including Germany, remain robust and thus far have proven to be resilient to protracted weakness in the manufacturing sector.

While weakening on the margin in some economies (including Germany), the European labor market overall remains solid with good income growth supporting private consumption. Incorporating both hard data and forward-looking indicators, we expect eurozone growth to be around 1% this year—not spectacular but only slightly below estimates of the region’s potential annual growth rate after five consecutive years of above-potential growth. Based on this, we feel recession fears are significantly overdone. In addition, we perceive that the European Central Bank (ECB) has materially strengthened its commitment to providing renewed policy accommodation, based on comments made at its recent annual Forum in Sintra, Portugal.

While we remain attentive to external headwinds, in particular to the potential escalation of global trade tensions, we believe investors are too pessimistic about the outlook for both eurozone and global growth. Absent a significant worsening of trade tensions and/or a sharp deceleration in US and Chinese activity in 2H19, we believe the overall level of global developed market bond yields reflects too much pessimism, and within this universe, German bunds are the most overvalued.

Our baseline outlook for Asian economies in 3Q19 is a continuation of trade-tension-inflicted drags on regional economic activity. The most visible manifestation will be contractions in Asian exports and a gradual but discernible decline in economic growth. Risks to this mildly bearish central scenario are tilted to steeper declines if we transition to a full-blown tariff war coupled with information and technology supply chain disruptions and a loss of business confidence from a technology war. However, weak inflation data in Asia provides Asian central banks with headroom to ease interest rates further to buffer the slowdown. Central banks that have significant headroom will be in economies that have high real interest rates (e.g., Indonesia and the Philippines) and strong external positions (e.g., South Korea).

The full Chinese policy response to a scaled up trade and technology war with the US is unknown at this stage. Our base case is that Chinese authorities will use fiscal levers such as relaxing restrictions on the usage of proceeds from local government special bond issuance. We attach a lower probability to significant monetary easing and FX-weakness given sensitivity of US-China trade negotiations and the risk to financial stability. Additional policy easing is expected to be targeted at privately owned businesses and infrastructure instead of old-style easing (e.g., total social financial and fixed asset investment measures) that will result in future imbalances. Given the decline in China’s current account surplus, foreign capital flows due to the inclusion of China bonds and equities in mainstream indices will help strengthen the capital account.

Oil prices have held up due to resilient oil demand growth, US production growth, OPEC and Russia’s compliance with target quotas, supply disruptions and geopolitical risk. Consequently, fundamentals continue to point to a better balance over time. However, recent events including increased concern over macro demand amid the trade standoff between the US and China, the current stage of the business cycle, Venezuela sanctions, and escalating tensions in the Middle East have introduced increased volatility. The lattermost has served to push price support to higher levels. Consequently, focus on the supply side has returned to a major choke point, the Strait of Hormuz, where approximately one-third of global daily seaborne oil volumes traverse. Short-term price spikes may result, but we believe fundamentals will ultimately prevail.

Looking at the demand side of the equation, annual oil demand continues to grow and is currently led by EM countries (primarily China and India). Developed market demand growth is primarily led by the US and Europe, and remains flat on improved energy efficiency. The growth rate of oil demand may be slower than in prior years, but remains positive at healthy levels despite the slowdown we are observing in global economic growth. That stated, the supply side of the equation continues to dominate the oil price discussion as US production has achieved record levels, surpassing Saudi production. This has altered the market dynamic where the Saudis historically could exert more control over supply and thus prices. But, we have observed activity in the US begin to slow as producers responded proactively to lower prices by further capital discipline and is accentuated by natural production declines in the reservoirs. Furthermore, OPEC’s and Russia’s commitment to production cuts appear to be extended for an additional nine months in order to balance the market and provide a basis for price stability within a range.

US: No Threat of Imminent Recession	At present, we are estimating US growth between 1.75% and 2.00% in 2019. This is a slight downgrade from the 2.00%-2.25% range projected in April. We were expecting slower growth this year in manufacturing activity and in home construction, and this has occurred. In addition, retail sales growth has slowed a bit, sharpening the slowing in manufacturing activity relative to what we projected earlier this year. Even though equipment investment, exports and inventories have slowed, none of them are showing outright weakness—certainly not enough to threaten recession. Even for homebuilding, the roughly 10% drop seen in 2018 pales against the 30% or so declines seen over the 2006-2008 period. So, at this time, again, we project slower growth in 2019 than what was experienced over 2017-2018, but we do not see recession risk as being more than slight. With this in mind, we see no compelling reason to share the Fed’s optimism that inflation will soon be 2% or higher. As discussed in our recent paper Falling Inflation Could Move the Fed, faster nominal spending growth that would make either sustained higher inflation or sustained higher economic growth has failed to occur despite all of the Fed’s efforts. While it is not a sure thing that core Personal Consumption Expenditures (PCE) inflation will remain at the 1.4% annualized pace of the last few months, recent rates look a lot less transitory than Fed comments had tried to make them. We believe it is most likely that inflation will remain below the 2% rate the Fed has targeted. The longer observed rates stay at or below that range, the more pressure there will be on the Fed to reflect that reality in its policy deliberations later this year. This is especially so given the Fed’s recent musing about price level (average inflation) targeting.
Europe: Excessive Pessimism Is Unwarranted	After a very weak 2H18, growth in both Germany and in the broader eurozone has improved and come in above market expectations as the negative impact of industry-specific factors, in particular those affecting the auto sector, have started to fade. Forward-looking survey data have improved and rebounded from the low point in January. The domestic drivers of growth in the majority of eurozone countries, including Germany, remain robust and thus far have proven to be resilient to protracted weakness in the manufacturing sector. The domestic drivers of growth in most eurozone countries, including Germany, remain robust. While weakening on the margin in some economies (including Germany), the European labor market overall remains solid with good income growth supporting private consumption. Incorporating both hard data and forward-looking indicators, we expect eurozone growth to be around 1% this year—not spectacular but only slightly below estimates of the region’s potential annual growth rate after five consecutive years of above-potential growth. Based on this, we feel recession fears are significantly overdone. In addition, we perceive that the European Central Bank (ECB) has materially strengthened its commitment to providing renewed policy accommodation, based on comments made at its recent annual Forum in Sintra, Portugal. While we remain attentive to external headwinds, in particular to the potential escalation of global trade tensions, we believe investors are too pessimistic about the outlook for both eurozone and global growth. Absent a significant worsening of trade tensions and/or a sharp deceleration in US and Chinese activity in 2H19, we believe the overall level of global developed market bond yields reflects too much pessimism, and within this universe, German bunds are the most overvalued.
Asia: Central Banks Stand Ready to Act	Our baseline outlook for Asian economies in 3Q19 is a continuation of trade-tension-inflicted drags on regional economic activity. The most visible manifestation will be contractions in Asian exports and a gradual but discernible decline in economic growth. Risks to this mildly bearish central scenario are tilted to steeper declines if we transition to a full-blown tariff war coupled with information and technology supply chain disruptions and a loss of business confidence from a technology war. However, weak inflation data in Asia provides Asian central banks with headroom to ease interest rates further to buffer the slowdown. Central banks that have significant headroom will be in economies that have high real interest rates (e.g., Indonesia and the Philippines) and strong external positions (e.g., South Korea). The full Chinese policy response to a scaled up trade and technology war with the US is unknown at this stage. Our base case is that Chinese authorities will use fiscal levers such as relaxing restrictions on the usage of proceeds from local government special bond issuance. We attach a lower probability to significant monetary easing and FX-weakness given sensitivity of US-China trade negotiations and the risk to financial stability. Additional policy easing is expected to be targeted at privately owned businesses and infrastructure instead of old-style easing (e.g., total social financial and fixed asset investment measures) that will result in future imbalances. Given the decline in China’s current account surplus, foreign capital flows due to the inclusion of China bonds and equities in mainstream indices will help strengthen the capital account.
Estimated Global Growth Rates
Commodities: Geopolitical Tensions Add to Oil Price Volatility	Oil prices have held up due to resilient oil demand growth, US production growth, OPEC and Russia’s compliance with target quotas, supply disruptions and geopolitical risk. Consequently, fundamentals continue to point to a better balance over time. However, recent events including increased concern over macro demand amid the trade standoff between the US and China, the current stage of the business cycle, Venezuela sanctions, and escalating tensions in the Middle East have introduced increased volatility. The lattermost has served to push price support to higher levels. Consequently, focus on the supply side has returned to a major choke point, the Strait of Hormuz, where approximately one-third of global daily seaborne oil volumes traverse. Short-term price spikes may result, but we believe fundamentals will ultimately prevail. Recent events have introduced increased volatility to oil prices, especially the escalating tensions in the Middle East. Looking at the demand side of the equation, annual oil demand continues to grow and is currently led by EM countries (primarily China and India). Developed market demand growth is primarily led by the US and Europe, and remains flat on improved energy efficiency. The growth rate of oil demand may be slower than in prior years, but remains positive at healthy levels despite the slowdown we are observing in global economic growth. That stated, the supply side of the equation continues to dominate the oil price discussion as US production has achieved record levels, surpassing Saudi production. This has altered the market dynamic where the Saudis historically could exert more control over supply and thus prices. But, we have observed activity in the US begin to slow as producers responded proactively to lower prices by further capital discipline and is accentuated by natural production declines in the reservoirs. Furthermore, OPEC’s and Russia’s commitment to production cuts appear to be extended for an additional nine months in order to balance the market and provide a basis for price stability within a range.

The Big Picture

Developed Market Rates: Relative Value by Region

US	We’re currently looking for US growth between 1.75% and 2.00% in 2019. Equipment investment, exports and inventories have slowed; however, none of them are outright weak, certainly not enough to threaten recession. Even for homebuilding, the roughly 10% drop seen there in 2018 pales against the 30% or so declines seen over 2006-2008. So, at this time, again, we project slower growth in 2019 than what was experienced over 2017-2018, but we do not see recession risks as being more than slight.
Canada	Canadian policy rates look to be on hold as an expected trend growth rate for 2019 is still offset by real estate and global trade risks. The recent uptick in inflation will perhaps delay the policy response relative to other trading partners, but it is notable that interest rate sensitive sectors of the economy have already slowed.
Europe	We expect eurozone growth to be around 1% this year—not spectacular but only slightly below estimates of the region’s potential annual growth rate after five consecutive years of above-potential growth. Based on this, we feel recession fears are significantly overdone. In addition, we perceive that the ECB has materially strengthened its commitment to providing renewed policy accommodation per its recent statement at the annual Forum in Sintra, Portugal.
UK	The Bank of England has signaled toward tighter monetary policy as inflation has held close to its 2% target, and the economy has been underpinned by high employment and strong wage growth. However, this has become more conditional as central bank easing expectations have shifted significantly lower globally, and an extension to the Brexit negotiation period has prolonged uncertainty which could weigh on activity. Fears over a “no-deal” Brexit have also increased as Boris Johnson—the front-runner to succeed Theresa May as the Conservative party leader and therefore Prime Minister—has threatened to have the UK leave the EU at the end of October even if an agreement is not reached. We believe, though, that the balance of probabilities favor a softer Brexit outcome that avoids such an event.
Japan	We expect the Bank of Japan (BoJ) to maintain its accommodative monetary policy for some time to meet its 2% inflation goal, which is in line with recent forward guidance. No further easing is expected at this moment. The BoJ, however, may make some adjustments in the framework to enhance the policy sustainability.
Australia	Growth in Australia has slowed down in line with other developed markets and we now expect growth of 2.5% in 2019. Although a reluctant cutter, the Reserve Bank of Australia (RBA) did cut by 25 basis points (bps) in June and again in July—the first consecutive rate cut since 2012—due to a recalibration lower of its NAIRU estimate and has given indications that another rate cut is certainly a live option in its July meeting. The bank is closely monitoring data, particularly employment, and seeking a broader policy response from the government due to the limited impact of monetary policy to deliver the desired outcomes of sustained lower unemployment, higher wage inflation and strong sustainable economic growth. With the Government back in surplus, the RBA may get some of that assistance from fiscal policy.

Relative Value by Sector

US investment-grade (IG) credit index spreads have drifted wider; dovish central bank policies globally support holding risk near term. We remain cautious on the food & beverage, healthcare/pharmaceuticals and automotive sectors.

+/– We remain focused on banking, energy and metals & mining as they exhibit the least sensitivity to tariff- related risk and are poised for further uplift from the ratings agencies.

Europe

European IG credit fundamentals remain solid but are susceptible to growth and tariff pressures. We are watching for near term regional growth risks and on an industry basis the autos / retails sectors. The euro market feels fairly well supported in terms of overseas and local demand but valuations are less attractive than at the start of the year.

+ Bias to financials over non-financials given strong balance sheets and spread pick-up available.

Australia

Fundamentals remain strong as management retains a conservative attitude to balance sheets alongside solid profitability. Limited issuance and maturities in 2019 should also assist on the technical front.

+ Overweight to sector but holding a short duration focus to manage spread risk. Sector biases remain in financials, REITS and regulated utilities.

Further spread tightening on stable corporate fundamentals and positive technicals has driven current valuations closer to fair value. Looming risks warrant caution. Opportunities remain in higher quality issuers that continue to delever and have access to capital.

+ We remain underweight CCCs given valuations and the late stage credit cycle; we are overweight metals & mining (e.g., copper), consumer cyclical services, financials and rising star candidates.

Europe

Market volatility has increased as sentiment fluctuates, impacting liquidity. This has caused more issuer specific dispersion. Technicals are fairly supportive, new issues generally in the BB and high B ratings bracket, but there is a lack of new issue premium.

+/– The weak regional growth backdrop, trade and Brexit-related uncertainties give us cause to take a more opportunistic/cautious approach to new issues and secondary market opportunities.

Borrowers continue to show moderate growth and ample cash flow coverage; lower short-term rates could further improve cash flow. We expect CLO formation to drive demand; however, a lower rate backdrop will likely cause moderate outflows from retail accounts. Loans remain attractive as a carry trade.

+ With CLO demand driving the secondary bid, we expect demand to be strongest in B1 and higher rated names irrespective of underlying fundamentals. We have been able to extract significant value and drive tighter structures in recent new-issue deals, a positive trend demonstrating attractive opportunities in new issuance.

CLO supply remains robust. While fundamentals and relative value are strong, we expect that supply technicals may keep CLO spreads range-bound over the next quarter. In the BBB and BB CLO space we expect there to be modest widening should supply turn out to be overwhelming; we would look to exploit this.

+ Front end AAAs and 1- to 2-year seasoned AAAs are most attractive. Within lower mezzanine tranches (BBB/BB) there are pockets of opportunity from structurally/fundamentally sound deals.

Agency MBS

We are constructive on mortgages due to locally wide spread levels, attractive hedge adjusted carry and the expectation that central banks will remain accommodative. Concerns regarding GSE reform and refinance risk warrant some caution.

+/– We are positive on MBS vs. USTs and favor lower coupons and agency commercial MBS.

Non-Agency Residential MBS (RMBS)

We are constructive on housing fundamentals and expect modest home price growth over the coming years, with limited downside risks as housing appears reasonably valued and supported. Credit underwriting standards are historically high, making the quality of new loan production strong.

+ We are positive on the credit risk of government- sponsored enterprises (Fannie Mae and Freddie Mac) and recently issued non-agency loans as well as re-performing loans and securities.

Non-agency Commercial MBS (CMBS)

We remain constructive on the CMBS market, due to broadly positive commercial real estate fundamentals and a favorable economic outlook; we expect the fundamental outlook to be uneven across property types and markets.

+ We are positive on short-duration, well-structured single-borrower securitizations and loans; in conduit deals we see better value in AAA rated bonds.

Asset-Backed Securities (ABS)

We remain constructive on consumer fundamentals and the current state of leverage; we expect opportunities exist in well-protected, off-the-run sectors, which offer attractive risk/return profiles.

+/– We are constructive on off-the-run senior high-quality ABS sectors, such as FFELP student loans, auto floor-plan and rental car.

The level of breakeven inflation spreads are below Fed targets and are good long-term value in our base case scenario. However, poor carry over the nearterm and risks pointing to lower inflation are unlikely to attract substantial inflows nor push longer-term inflation expectations higher.

+/– In the near term, we prefer to maintain an overweight in US real yields combined with tactical positioning in nominal bonds to manage overall duration exposure.

Europe

European breakeven spreads have recently fallen sharply discounting the rebound in oil prices which has benefitted other index-linked markets. We expect headline inflation to average 1.20% in 2019, which is higher than the level priced in the swap and cash markets. Thus we expect some gradual catch up to oil prices and fundamentals going forward.

+/– In index-linked accounts we remain short both nominal and real yields.

We continue to see good fundamentals in the overall municipal market due to a number of factors, including strong market technicals, low unemployment, improving tax revenues and modest budgetary spending proposals; adjusted for ratings, municipal bonds are attractive versus their taxable counterparts for maturities of five years and greater.

+ We remain focused on idiosyncratic risks over “market beta”; we favor revenue bonds over general obligation debt with an emphasis on industrial development revenue bonds and the transportation sectors.

EM Sovereigns (USD)

Despite uncertainty about global growth conditions, the Fed’s recent dovish pivot and signs of slowing US growth outperformance are constructive for EM financial conditions and flows. From a technical standpoint, EM remains underrepresented in global bond indices. In this regard, the progressive inclusion of sizable markets, notably China and Gulf Cooperation Council (GCC) countries, will increase the sector`s visibility and investor appetite.

+ Select IG and HY-rated EM USD-denominated sovereigns remain attractive from both carry and total return standpoints. We are currently looking to add exposure to lower-risk GCC countries and attractively priced Frontier sovereigns, while BBB rated sovereigns appear more fully valued.

EM Local Currency

A dovish Fed and stable to strengthening EM currencies have taken pressure off EM central banks to tighten policy. EM real yields and differentials versus DM are supportive of the asset class and have scope to compress. Diminishing impact of US fiscal stimulus, and the re-introduction of stimulus in China augur well for the end of US growth exceptionalism. In our view, these factors should be positive for EM local currency debt.

+ We currently find local rates to be the most attractive part of the EM local currency universe given high real yields and a more dovish outlook for EM central banks. We favor the local bonds of stable countries with moderate inflation, including Indonesia, India, Brazil and Russia.

EM Corporates

EM corporates continue to benefit from a combination of resilient fundamentals and conservative balance sheet management. Unlike US corporates, EM companies have less of a focus on share buybacks/M&A and have continued to reduce debt after 2014-2016 commodity price and political crises. While the overall market shows robust bond issuance, EM corporate net issuance ex-China remains very low, creating positive technicals for the asset class.

+ We view crossover-rated bonds as being the best way to allocate to the EM corporate sector given both fundamentals and valuation. In terms of issuer selection, we prefer companies aligned with their sovereigns and those generating revenues in hard currency. For higher quality mandates, EM IG corporates are an attractive complement to US investment-grade allocations given higher spreads, shorter duration and more favorable issuance/BBB technicals.

	Outlook	Relative Value
IG Corporate Credit
US	US investment-grade (IG) credit index spreads have drifted wider; dovish central bank policies globally support holding risk near term. We remain cautious on the food & beverage, healthcare/pharmaceuticals and automotive sectors.	+/–	We remain focused on banking, energy and metals & mining as they exhibit the least sensitivity to tariff- related risk and are poised for further uplift from the ratings agencies.
Europe	European IG credit fundamentals remain solid but are susceptible to growth and tariff pressures. We are watching for near term regional growth risks and on an industry basis the autos / retails sectors. The euro market feels fairly well supported in terms of overseas and local demand but valuations are less attractive than at the start of the year.	+	Bias to financials over non-financials given strong balance sheets and spread pick-up available.
Australia	Fundamentals remain strong as management retains a conservative attitude to balance sheets alongside solid profitability. Limited issuance and maturities in 2019 should also assist on the technical front.	+	Overweight to sector but holding a short duration focus to manage spread risk. Sector biases remain in financials, REITS and regulated utilities.
High-Yield (HY) Corporate Credit
US	Further spread tightening on stable corporate fundamentals and positive technicals has driven current valuations closer to fair value. Looming risks warrant caution. Opportunities remain in higher quality issuers that continue to delever and have access to capital.	+	We remain underweight CCCs given valuations and the late stage credit cycle; we are overweight metals & mining (e.g., copper), consumer cyclical services, financials and rising star candidates.
Europe	Market volatility has increased as sentiment fluctuates, impacting liquidity. This has caused more issuer specific dispersion. Technicals are fairly supportive, new issues generally in the BB and high B ratings bracket, but there is a lack of new issue premium.	+/–	The weak regional growth backdrop, trade and Brexit-related uncertainties give us cause to take a more opportunistic/cautious approach to new issues and secondary market opportunities.
Bank Loans
US	Borrowers continue to show moderate growth and ample cash flow coverage; lower short-term rates could further improve cash flow. We expect CLO formation to drive demand; however, a lower rate backdrop will likely cause moderate outflows from retail accounts. Loans remain attractive as a carry trade.	+	With CLO demand driving the secondary bid, we expect demand to be strongest in B1 and higher rated names irrespective of underlying fundamentals. We have been able to extract significant value and drive tighter structures in recent new-issue deals, a positive trend demonstrating attractive opportunities in new issuance.
Collateralized Loan Obligations (CLOs)
US	CLO supply remains robust. While fundamentals and relative value are strong, we expect that supply technicals may keep CLO spreads range-bound over the next quarter. In the BBB and BB CLO space we expect there to be modest widening should supply turn out to be overwhelming; we would look to exploit this.	+	Front end AAAs and 1- to 2-year seasoned AAAs are most attractive. Within lower mezzanine tranches (BBB/BB) there are pockets of opportunity from structurally/fundamentally sound deals.
Structured Credit
Agency MBS	We are constructive on mortgages due to locally wide spread levels, attractive hedge adjusted carry and the expectation that central banks will remain accommodative. Concerns regarding GSE reform and refinance risk warrant some caution.	+/–	We are positive on MBS vs. USTs and favor lower coupons and agency commercial MBS.
Non-Agency Residential MBS (RMBS)	We are constructive on housing fundamentals and expect modest home price growth over the coming years, with limited downside risks as housing appears reasonably valued and supported. Credit underwriting standards are historically high, making the quality of new loan production strong.	+	We are positive on the credit risk of government- sponsored enterprises (Fannie Mae and Freddie Mac) and recently issued non-agency loans as well as re-performing loans and securities.
Non-agency Commercial MBS (CMBS)	We remain constructive on the CMBS market, due to broadly positive commercial real estate fundamentals and a favorable economic outlook; we expect the fundamental outlook to be uneven across property types and markets.	+	We are positive on short-duration, well-structured single-borrower securitizations and loans; in conduit deals we see better value in AAA rated bonds.
Asset-Backed Securities (ABS)	We remain constructive on consumer fundamentals and the current state of leverage; we expect opportunities exist in well-protected, off-the-run sectors, which offer attractive risk/return profiles.	+/–	We are constructive on off-the-run senior high-quality ABS sectors, such as FFELP student loans, auto floor-plan and rental car.
Inflation-Linked
US	The level of breakeven inflation spreads are below Fed targets and are good long-term value in our base case scenario. However, poor carry over the nearterm and risks pointing to lower inflation are unlikely to attract substantial inflows nor push longer-term inflation expectations higher.	+/–	In the near term, we prefer to maintain an overweight in US real yields combined with tactical positioning in nominal bonds to manage overall duration exposure.
Europe	European breakeven spreads have recently fallen sharply discounting the rebound in oil prices which has benefitted other index-linked markets. We expect headline inflation to average 1.20% in 2019, which is higher than the level priced in the swap and cash markets. Thus we expect some gradual catch up to oil prices and fundamentals going forward.	+/–	In index-linked accounts we remain short both nominal and real yields.
Municipals
US	We continue to see good fundamentals in the overall municipal market due to a number of factors, including strong market technicals, low unemployment, improving tax revenues and modest budgetary spending proposals; adjusted for ratings, municipal bonds are attractive versus their taxable counterparts for maturities of five years and greater.	+	We remain focused on idiosyncratic risks over “market beta”; we favor revenue bonds over general obligation debt with an emphasis on industrial development revenue bonds and the transportation sectors.
EM Debt
EM Sovereigns (USD)	Despite uncertainty about global growth conditions, the Fed’s recent dovish pivot and signs of slowing US growth outperformance are constructive for EM financial conditions and flows. From a technical standpoint, EM remains underrepresented in global bond indices. In this regard, the progressive inclusion of sizable markets, notably China and Gulf Cooperation Council (GCC) countries, will increase the sector`s visibility and investor appetite.	+	Select IG and HY-rated EM USD-denominated sovereigns remain attractive from both carry and total return standpoints. We are currently looking to add exposure to lower-risk GCC countries and attractively priced Frontier sovereigns, while BBB rated sovereigns appear more fully valued.
EM Local Currency	A dovish Fed and stable to strengthening EM currencies have taken pressure off EM central banks to tighten policy. EM real yields and differentials versus DM are supportive of the asset class and have scope to compress. Diminishing impact of US fiscal stimulus, and the re-introduction of stimulus in China augur well for the end of US growth exceptionalism. In our view, these factors should be positive for EM local currency debt.	+	We currently find local rates to be the most attractive part of the EM local currency universe given high real yields and a more dovish outlook for EM central banks. We favor the local bonds of stable countries with moderate inflation, including Indonesia, India, Brazil and Russia.
EM Corporates	EM corporates continue to benefit from a combination of resilient fundamentals and conservative balance sheet management. Unlike US corporates, EM companies have less of a focus on share buybacks/M&A and have continued to reduce debt after 2014-2016 commodity price and political crises. While the overall market shows robust bond issuance, EM corporate net issuance ex-China remains very low, creating positive technicals for the asset class.	+	We view crossover-rated bonds as being the best way to allocate to the EM corporate sector given both fundamentals and valuation. In terms of issuer selection, we prefer companies aligned with their sovereigns and those generating revenues in hard currency. For higher quality mandates, EM IG corporates are an attractive complement to US investment-grade allocations given higher spreads, shorter duration and more favorable issuance/BBB technicals.