Western Asset expects that the second half of the year should see very strong growth in global GDP as the world economy reopens. That stated, we are cautious about extrapolating short-term cyclical boosts into a presumption of a higher secular trend rate of growth or inflation. The secular challenges that have kept US and global growth to a moderate pace at best over the last several decades persist. These include the stagnation of Western societies’ middle-class wages, aging demographics and rising global debt burdens. Moreover, the small and medium-sized business destruction in many countries not seen since the Great Depression may take years to replace. Given this backdrop, Western Asset expects central banks to remain extraordinarily accommodative for the foreseeable future. Our portfolios are positioned to withstand further market volatility, yet remain flexible enough to capture value opportunities as they appear. Here, we provide a summary of the key drivers behind our global outlook and describe where we see value across global fixed-income markets.

KEY DRIVERS
US: Recovery Has Matured Further; Services Still Awaiting a More Complete Reopening

The US economy behaved much as we expected in 1Q21, and the contrasts we see in the status from one industry to the next have sharpened. That is, output levels in manufacturing and construction have largely caught up with aggregate demand in those sectors, and so we think it is likely that growth in these sectors will actually slow in the months ahead. There have been some signs of such slowing recently, as factory orders slipped a bit in February, and, more importantly, new-home sales and housing starts appear to have gone flat in recent months. Consensus opinion has blamed these slowdowns on a winter blizzard that shut down Texas power supplies for a few days in February. Those power shutdowns could indeed have suppressed homebuilding and manufacturing activity, but we think there is more to the recent slowdowns there than merely weather, especially as new-home sales have been flat to down for the last six months. Then again, March payroll data showed strong job growth in both these sectors. Prior to March, while output had recovered nicely, staffing levels were still markedly depressed from pre-Covid levels. So, it will be interesting to see whether the March job gains signal further output growth in manufacturing and homebuilding or merely a catching up of staffing levels with output levels already attained.

Meanwhile, for the service sectors, where essentially all the remaining "slack" in the US economy resides, any reopening has so far been only halting, and growth there has been accordingly sluggish. Restaurants had reopened to something like 25% indoor capacity in California, and entertainment venues are only now reaching these levels. The new White House administration has not yet announced any timetables for a more complete reopening of these sectors.

Absent a complete full-capacity reopening of restaurants, hotels, airports, theaters, etc. and with manufacturing and homebuilding already having fully recovered, we are inclined to think that realized US growth will fall short of the expectations that seem to be built into market pricing, given how sharply term yields have risen in recent months. Finally, as might be inferred from the previous remarks, we are skeptical that there is any substantial economic stimulus in the bills that have been passed by Washington recently.

Europe: Recovery Delayed, But Not Canceled

Rebound expectations for continental Europe have been hampered by the slow vaccine rollout and by renewed lockdowns in Q1 and early Q2. We view this as a delay in the economic rebound rather than a fundamentally altered trajectory, especially as vaccine supply is picking up markedly in Q2. On the fiscal side, we expect to see more countries echoing Germany’s important recent signal and provide additional fiscal support throughout H1 to deal with this recovery delay. Fiscal rules and debt breaks remain suspended for now—at the European level until GDP has reached its high-water mark, which we expect to happen in mid-2022 for the EU as a whole. First disbursements from the Next Generation EU (NGEU) recovery fund are likely to flow in Q3, and will play a much larger role in 2022 outcomes. The case against German participation in the NGEU, currently before the German Constitutional Court, has created some legal uncertainty that could prove long-lived even if the current injunction is rejected and the project goes ahead. The already legislated US stimulus will also add to European growth on the margin.

Looking beyond significant volatility in 2021 due to base effects, inflation in the eurozone is likely to remain muted over the medium term. Wage agreements in key sectors have been geared at protecting employment, but have been lackluster in terms of wage growth. This will allow the European Central Bank (ECB) to focus its interventions on ensuring favorable financing conditions in light of higher and more volatile global interest rates. Purchases under the Pandemic Emergency Purchase Program (PEPP) facility have been rising already in anticipation of the significantly higher pace promised by ECB President Christine Lagarde for Q2. Ultimately, the speed at which these purchases occur together with a potential extension into Q3 (which we expect in the June ECB decision) will determine whether there is a need to enhance the PEPP envelope. The higher purchase pace is partly met by higher issuance plans in eurozone economies and the EU level, but should still lead to a net absorption of government bonds.

The UK has made substantial progress in its vaccination campaign and is already in the process of reducing pandemic restrictions for good with imminent upside potential for the service sector—a very different picture from the developments on the continent. That said, substantial parts of the UK economy (e.g., tourism) rely on economies on the continent and globally to reopen at roughly the same pace and we see risks to the economic take-off on both sides. The new trading arrangements post Brexit have had a significant impact on the flow of goods and services between the UK and the continent, with exports down substantially at the beginning of the year. We expect this pattern to normalize somewhat as teething problems are overcome, but trade will no longer be free of frictions, and the pending decisions on EU market access for certain UK service sectors will also be significant. The recent UK budget was relatively expansionary in the near term by extending key support programs over the summer but will lead to a higher tax burden over the medium term. The Bank of England (BoE) so far has looked through inflation (and output) volatility, but given the progress on reopening the economy, we expect the BoE to be one of the earlier developed market central banks to turn the corner toward a less accommodative stance.

China: Sustaining Growth While Watchful of Risks

The National People’s Congress (NPC) was held from March 5 to 11 and reiterated its focus of balancing a sustained growth recovery with managing financial risk. Beijing reintroduced the annual GDP growth target for this year (above 6%) and stated that it will continue to set an annual GDP growth target in the coming years. A larger than expected annual quota for special local government bonds (SLGB) at RMB3.65 trillion (RMB3.0 trillion expected) and an official fiscal deficit of 3.2% of GDP (3.0% expected) means the broad-based fiscal deficit is expected to reach 6.5% of GDP this year (8.4% last year and 5.0% in 2019).

In contrast to the 13th Five-Year Plan (2016-2020) that emphasized growing the service sector, the new guidance for the 14th Five-Year Plan (2021-2025) has set a goal of keeping the manufacturing sector’s share of the economy stable. More specifically, Beijing has increased its focus on more self-sufficient supply chains and technology upgrading against the backdrop of US-China trade tensions as well as potential supply chain disruptions, as highlighted by the COVID-19 situation. The government may set a target of 3% of GDP for R&D spending in the 14th Five-Year Plan (from 2.5% of GDP in the 13th Five-Year Plan). There is no change to our view for range-bound yields in China given that we expect slower credit growth, slower sequential economic growth momentum and no sharp U-turn in the monetary policy stance. We continue to expect China to be an anchor of stability for growth, though such growth will increasingly be domestically driven with less spillover demand from the rest of the world.

US: Recovery Has Matured Further; Services Still Awaiting a More Complete Reopening
US Recovery

The US economy behaved much as we expected in 1Q21, and the contrasts we see in the status from one industry to the next have sharpened. That is, output levels in manufacturing and construction have largely caught up with aggregate demand in those sectors, and so we think it is likely that growth in these sectors will actually slow in the months ahead. There have been some signs of such slowing recently, as factory orders slipped a bit in February, and, more importantly, new-home sales and housing starts appear to have gone flat in recent months. Consensus opinion has blamed these slowdowns on a winter blizzard that shut down Texas power supplies for a few days in February. Those power shutdowns could indeed have suppressed homebuilding and manufacturing activity, but we think there is more to the recent slowdowns there than merely weather, especially as new-home sales have been flat to down for the last six months. Then again, March payroll data showed strong job growth in both these sectors. Prior to March, while output had recovered nicely, staffing levels were still markedly depressed from pre-Covid levels. So, it will be interesting to see whether the March job gains signal further output growth in manufacturing and homebuilding or merely a catching up of staffing levels with output levels already attained.

Meanwhile, for the service sectors, where essentially all the remaining “slack” in the US economy resides, any reopening has so far been only halting, and growth there has been accordingly sluggish. Restaurants had reopened to something like 25% indoor capacity in California, and entertainment venues are only now reaching these levels. The new White House administration has not yet announced any timetables for a more complete reopening of these sectors.

We think that realized US growth will fall short of the expectations that seem to be built into market pricing. Double O Small Icon

Absent a complete full-capacity reopening of restaurants, hotels, airports, theaters, etc. and with manufacturing and homebuilding already having fully recovered, we are inclined to think that realized US growth will fall short of the expectations that seem to be built into market pricing, given how sharply term yields have risen in recent months. Finally, as might be inferred from the previous remarks, we are skeptical that there is any substantial economic stimulus in the bills that have been passed by Washington recently.

Europe: Recovery Delayed, But Not Canceled
Europe Recovery

Rebound expectations for continental Europe have been hampered by the slow vaccine rollout and by renewed lockdowns in Q1 and early Q2. We view this as a delay in the economic rebound rather than a fundamentally altered trajectory, especially as vaccine supply is picking up markedly in Q2. On the fiscal side, we expect to see more countries echoing Germany’s important recent signal and provide additional fiscal support throughout H1 to deal with this recovery delay. Fiscal rules and debt breaks remain suspended for now—at the European level until GDP has reached its high-water mark, which we expect to happen in mid-2022 for the EU as a whole. First disbursements from the Next Generation EU (NGEU) recovery fund are likely to flow in Q3, and will play a much larger role in 2022 outcomes. The case against German participation in the NGEU, currently before the German Constitutional Court, has created some legal uncertainty that could prove long-lived even if the current injunction is rejected and the project goes ahead. The already legislated US stimulus will also add to European growth on the margin.

Looking beyond significant volatility in 2021 due to base effects, inflation in the eurozone is likely to remain muted over the medium term. Wage agreements in key sectors have been geared at protecting employment, but have been lackluster in terms of wage growth. This will allow the European Central Bank (ECB) to focus its interventions on ensuring favorable financing conditions in light of higher and more volatile global interest rates. Purchases under the Pandemic Emergency Purchase Program (PEPP) facility have been rising already in anticipation of the significantly higher pace promised by ECB President Christine Lagarde for Q2. Ultimately, the speed at which these purchases occur together with a potential extension into Q3 (which we expect in the June ECB decision) will determine whether there is a need to enhance the PEPP envelope. The higher purchase pace is partly met by higher issuance plans in eurozone economies and the EU level, but should still lead to a net absorption of government bonds.

The new trading arrangements post Brexit have had a significant impact on the flow of goods and services between the UK and the continent. Double O Small Icon

The UK has made substantial progress in its vaccination campaign and is already in the process of reducing pandemic restrictions for good with imminent upside potential for the service sector—a very different picture from the developments on the continent. That said, substantial parts of the UK economy (e.g., tourism) rely on economies on the continent and globally to reopen at roughly the same pace and we see risks to the economic take-off on both sides. The new trading arrangements post Brexit have had a significant impact on the flow of goods and services between the UK and the continent, with exports down substantially at the beginning of the year. We expect this pattern to normalize somewhat as teething problems are overcome, but trade will no longer be free of frictions, and the pending decisions on EU market access for certain UK service sectors will also be significant. The recent UK budget was relatively expansionary in the near term by extending key support programs over the summer but will lead to a higher tax burden over the medium term. The Bank of England (BoE) so far has looked through inflation (and output) volatility, but given the progress on reopening the economy, we expect the BoE to be one of the earlier developed market central banks to turn the corner toward a less accommodative stance.

China: Sustaining Growth While Watchful of Risks
China Growth

The National People’s Congress (NPC) was held from March 5 to 11 and reiterated its focus of balancing a sustained growth recovery with managing financial risk. Beijing reintroduced the annual GDP growth target for this year (above 6%) and stated that it will continue to set an annual GDP growth target in the coming years. A larger than expected annual quota for special local government bonds (SLGB) at RMB3.65 trillion (RMB3.0 trillion expected) and an official fiscal deficit of 3.2% of GDP (3.0% expected) means the broad-based fiscal deficit is expected to reach 6.5% of GDP this year (8.4% last year and 5.0% in 2019).

Beijing reintroduced the annual GDP growth target of over 6% for this year. Double O Small Icon

In contrast to the 13th Five-Year Plan (2016-2020) that emphasized growing the service sector, the new guidance for the 14th Five-Year Plan (2021-2025) has set a goal of keeping the manufacturing sector’s share of the economy stable. More specifically, Beijing has increased its focus on more self-sufficient supply chains and technology upgrading against the backdrop of US-China trade tensions as well as potential supply chain disruptions, as highlighted by the COVID-19 situation. The government may set a target of 3% of GDP for R&D spending in the 14th Five-Year Plan (from 2.5% of GDP in the 13th Five-Year Plan). There is no change to our view for range-bound yields in China given that we expect slower credit growth, slower sequential economic growth momentum and no sharp U-turn in the monetary policy stance. We continue to expect China to be an anchor of stability for growth, though such growth will increasingly be domestically driven with less spillover demand from the rest of the world.

The Big Picture

Developed Market Rates: Relative Value by Region

CANADA: Provincial and corporate spreads are expected to remain near current narrow levels as the Canadian economy continues to reopen. While longer-term bond yields may still move higher, we don’t expect the two rate hikes by the Bank of Canada that are already priced into the 2022 curve.
US: We expect rates to remain range-bound with duration (at the back end of the curve) serving as a valuable risk-off hedge.
UK: The BoE is concerned about rising gilt yields like many other central banks, but the threshold to increase bond purchase programs is high. We feel that the market is pricing too fast a degree of monetary policy normalization, however. We are currently agnostic on the currency but could see downside risks emerge from a trade and capital flow perspective.
EUROPE: With the recent rise in global core rates and stepped-up ECB purchases, we see very moderate room for spread compression in higher-risk sovereigns as valuations should remain supported by ECB purchases.
JAPAN: We expect a steeper yield curve, especially in the super-long end as the front end and intermediate part of the curve are likely to stay low under the yield curve control framework by the BoJ.
AUSTRALIA: We are overweight the high-grade supranational debt sector with a focus on the mid-curve 7- to 10-year bonds. We are mildly underweight semi-government bonds that now look expensive thanks to QE buying. Current swap curve volatility will also drive value here on the curve.
See Relative Value by Sector section for the Emerging Markets outlook.
US Absent a complete full-capacity reopening of restaurants, hotels, airports, theaters, etc. and with manufacturing and homebuilding already having fully recovered, we are inclined to think that realized US growth will fall short of the expectations that seem to be built into current market pricing.
Canada The Canadian economy is recovering even faster than expected despite a slower Covid vaccination rate. While the industrial and energy sectors are doing better, the housing market is doing a bit too well. House prices are up more than in the US and fears are that the Bank of Canada will have to address them. The Canadian dollar has remained strong versus the US dollar and should keep the Bank of Canada on hold alongside the US.
Europe Suspension of EU-wide fiscal rules and flows from the recovery fund will support economies starting in H2. Assuming legal challenges will falter, EU-level borrowing will expand markedly right away, increasing the pool of supranational safe-haven assets. The ECB is increasing its purchases under the PEPP to underline its commitment to favorable financing conditions.
UK The UK is far ahead in the process of unwinding pandemic restrictions for good as the vaccination drive is quite advanced. The economic recovery is likely to be forceful, but might be hampered by more structural changes in the UK’s relationship with continental Europe.
Japan We expect that the Japanese economy will continue to recover as the Tankan business survey has improved. A slow vaccine rollout is a risk, but the Japanese government is likely to keep the current flexible fiscal stance to support the recovery. Also, the BoJ is likely to keep interest rates very low for a long period of time.
Australia The reopening of the economy ahead of the schedule laid out by both the government and the Reserve Bank of Australia (RBA) in late 4Q20 hasn’t changed their conviction with regard to holding monetary policy in a super easy stance. They still forecast no change in the cash rate for at least three years despite the progress made to date, which has the market questioning the soundness of this as property prices increase sharply.

Relative Value by Sector

Investment-Grade (IG) Corporate Credit
US
Outlook We are optimistic on credit fundamentals and reassured that companies will maintain conservative balance sheet management. While favorable technicals endure, valuations have already returned to pre-Covid levels for many sectors.
Relative Value +/– We are maintaining overweights to banking, select reopening industries and rising-star candidates where allowed.
Europe
Outlook Growth in Europe is picking up though Covid lockdowns continue to impact certain sectors. Liquidity profiles generally look very solid and we have seen a number of rating upgrades in 1Q21. Bank balance sheets remain strong.
Relative Value Valuations are no longer compelling with spreads back at pre-Covid levels. We find opportunities in subordinated financials and REITs.
Australia
Outlook Limited primary issuance and a healthy maturity profile should hold investment-grade credit in good stead. The stable policy setting being laid down by the Reserve Bank of Australia (RBA) over the next three years should also help, as should growth well ahead of schedule and lower than expected unemployment which should continue to drive profitability as the economy opens up.
Relative Value + We remain overweight the REIT sectors which, compared to financials, remain relatively attractive. The infrastructure sector remains on the wider side but should continue to contract as activity levels return to normal.
High-Yield (HY) Corporate Credit
US
Outlook US HY spreads were 50 bps tighter in 1Q21 despite the rise in US Treasury (UST) rates. We saw record new issuance, heavily focused on refinancings with a slight pickup in M&A; we expect this trend to continue.
Relative Value + Issue selection and asset class allocation remain the key drivers for portfolios. We will look to add selectively (away from LBO issuance) for total return/spread compression given valuations.
Europe
Outlook Companies continue to focus on balance sheet management. Issuance has increased and with it an increased portion of lower-rated, B/CCC issuance. M&A-related issuance has also increased, but we expect refinancing to remain a significant use of proceeds.
Relative Value + We continue to focus on B rated issues from a valuation perspective and believe that BB securities will benefit from broader investor demand. We like defensive sectors such as pharma and also selective cyclical industrials and consumer-related sectors.
Bank Loans
US
Outlook In the loan market, we see $25 billion of visible repayments for quarter-end which should help with a fairly heavy forward calendar. We expect net CLO issuance to rise once the wave of refinancings clear which, when coupled with continued retail flows into loans, should keep loan demand steady and hopefully put a floor on any softness in the secondary markets.
Relative Value + We believe outperformance will come primarily from significant interest carry, avoiding problem credits, and owning select names with more meaningful impact from Covid where fundamentals and liquidity remain intact and there is still real price convexity in the credit.
Collateralized Loan Obligations (CLOs)
US
Outlook We expect the CLO primary issuance to remain heavy but also to be met with renewed demand post quarter end. The broader loan market default rate is trending at 2% while the universe of loans held in CLOs is running a default rate of less than 50 bps. Any additional widening in the CLO market should be viewed as an opportunity to add attractive yield.
Relative Value + We retain our view that AAAs will continue to perform well in either a bearish or bullish scenario. We expect supply to remain heavy, which will lead to opportunities to add lower-rated CLOs at attractive levels in the coming months.
Mortgage and Consumer Credit
Agency MBS
Outlook We are neutral at current valuations and expectations of continued support from Federal Reserve (Fed) purchases over the near term.
Relative Value +/– We favor TBA in production coupons and specified pools in higher coupons. Agency CMBS offer portfolio diversification.
Non-Agency Residential MBS (NARMBS)
Outlook Home prices have been supported by historically low mortgage rates, a dismal lack of supply on the market, tight lending conditions and a rebirth of household formations, which continue to support further home price appreciation and fundamentals for credit investors.
Relative Value + We are positive on GSE credit risk transfers as well as legacy NARMBS/new-issue re-performing loan deals.
Non-Agency Commercial MBS (CMBS)
Outlook While the commercial sector remains further behind in terms of recovery, momentum is also building in this sector. In the near term, we remain cautious as it is uncertain how long it will take for commercial real estate markets to fully recover from the negative impacts of the pandemic. We expect the fundamental outlook to be uneven across property types and markets as the impact of COVID-19 varies on each property type and geography.
Relative Value +/– We are positive on short-duration, well-structured single-borrower securitizations and loans. We remain selective and prefer bonds that can better withstand a period of reduced operating income and forbearance and provide good risk/reward.
Asset-Backed Securities (ABS)
Outlook We are cautious on consumer fundamentals and watchful of credit performance on consumer ABS sectors due to the impact of the pandemic on the economy and uncertain pace of recovery.
Relative Value +/– We favor well-protected senior ABS classes from high-quality sectors with low Covid disruption impact.
Inflation-Linked
US
Outlook TIPS have outperformed nominals since last spring, lifting expected inflation rates above Fed targets for the next several years. While reopening will surely lift service prices that have been depressed, both the Fed and the market will likely look through these modest price spikes. Instead, we still expect the world to remain disinflationary beyond the reopening. Energy prices are not expected to have any strong trend now that production is equilibrating to slowly recovering global demand.
Relative Value Strong inflows into TIPS amid the economic reopening may lift inflation expectations, but we expect this to be only temporary. While TIPS still have a role in portfolio construction, our expectation is that TIPS will underperform comparable maturity nominal USTs over the remainder of the year.
Europe
Outlook In 2021, European inflation will be very lumpy with many base effects dominating the near-term picture. Despite our low expectations for inflation, breakeven inflation spreads have rallied sharply pushing medium-term forwards closer to the ECB target of just below 2%. We continue to monitor the supply-side-led rise in survey input and output prices and how these pass through into actual inflation.
Relative Value +/– Given valuations, we are currently taking a neutral stance in eurozone inflation-linked paper.
Japan
Outlook We believe that Japanese inflation-linked bonds remain undervalued, assuming the expected recovery of the Japanese economy. Also, the total amount of the buybacks by the Ministry of Finance and the BoJ keeps exceeding that of the issuances.
Relative Value + We maintain an overweight in Japanese real yields against nominal yields.
Municipals
US
Outlook Within the most recent $1.9 trillion American Rescue Plan Act relief package, state and local municipalities received $350 billion of direct aid to address revenue shortfalls associated with the pandemic. Western Asset believes that while some entities will receive more federal aid than needed, the stimulus package will be particularly supportive of lower-grade municipalities, providing liquidity that will lengthen the runway for these entities to address longer-term structural challenges. As the policy focus shifts to infrastructure, supply technicals will be in focus amid possibilities for a return of a taxable municipal infrastructure program.
Relative Value + We continue to favor lower investment-grade revenue sectors that should continue to benefit from an economic recovery. However, we are cognizant of relative rich valuations, thus we are maintaining an above average liquidity position to maintain flexibility to navigate near-term market fluctuations associated with an extended tax season or near-term interest rate volatility.
Emerging Market (EM) Debt
EM Sovereigns (USD)
Outlook Our central thesis is that the post-Covid recovery in EM as an asset class is not yet completed. We anticipate continued robust USD-denominated sovereign issuance by EM countries to fund fiscal programs and mitigate ongoing economic damage induced by the pandemic.
Relative Value +/– We continue to favor select IG-rated EM USD-denominated sovereigns from both a carry and total return standpoint, and exercise caution toward debt issued by lower-rated frontier sovereign countries that face a challenging uphill road ahead.
EM Local Currency
Outlook Despite a spike in US rates, the Fed’s inflation policy continues to suggest a policy rate that will be low-for-long, with ample liquidity acting as a tailwind to the global recovery. EM local rates and flows should continue to benefit from the attractive real rate differential between the US and EM countries, a dynamic we believe will exist for the foreseeable future.
Relative Value +/– We are mindful that certain EM central banks’ easing cycles are coming to a close. Hence, we remain biased toward but highly selective on local rates for their relatively attractive real yield and more favorable risk/reward characteristics.
EM Corporates
Outlook We view EM corporates’ shorter-duration, income-oriented posture as being favorable within the EM opportunity set amid pressure on global rates. Technicals remain strong given a lack of net supply and increased investor interest in the asset class.
Relative Value + We continue to take advantage of primary issuance from short- and intermediate-dated IG and HY EM corporates.
Outlook Relative Value
Investment-Grade (IG) Corporate Credit
US We are optimistic on credit fundamentals and reassured that companies will maintain conservative balance sheet management. While favorable technicals endure, valuations have already returned to pre-Covid levels for many sectors. +/– We are maintaining overweights to banking, select reopening industries and rising-star candidates where allowed.
Europe Growth in Europe is picking up though Covid lockdowns continue to impact certain sectors. Liquidity profiles generally look very solid and we have seen a number of rating upgrades in 1Q21. Bank balance sheets remain strong. Valuations are no longer compelling with spreads back at pre-Covid levels. We find opportunities in subordinated financials and REITs.
Australia Limited primary issuance and a healthy maturity profile should hold investment-grade credit in good stead. The stable policy setting being laid down by the Reserve Bank of Australia (RBA) over the next three years should also help, as should growth well ahead of schedule and lower than expected unemployment which should continue to drive profitability as the economy opens up. + We remain overweight the REIT sectors which, compared to financials, remain relatively attractive. The infrastructure sector remains on the wider side but should continue to contract as activity levels return to normal.
High-Yield (HY) Corporate Credit
US US HY spreads were 50 bps tighter in 1Q21 despite the rise in US Treasury (UST) rates. We saw record new issuance, heavily focused on refinancings with a slight pickup in M&A; we expect this trend to continue. + Issue selection and asset class allocation remain the key drivers for portfolios. We will look to add selectively (away from LBO issuance) for total return/spread compression given valuations.
Europe Companies continue to focus on balance sheet management. Issuance has increased and with it an increased portion of lower-rated, B/CCC issuance. M&A-related issuance has also increased, but we expect refinancing to remain a significant use of proceeds. + We continue to focus on B rated issues from a valuation perspective and believe that BB securities will benefit from broader investor demand. We like defensive sectors such as pharma and also selective cyclical industrials and consumer-related sectors.
Bank Loans
US In the loan market, we see $25 billion of visible repayments for quarter-end which should help with a fairly heavy forward calendar. We expect net CLO issuance to rise once the wave of refinancings clear which, when coupled with continued retail flows into loans, should keep loan demand steady and hopefully put a floor on any softness in the secondary markets. + We believe outperformance will come primarily from significant interest carry, avoiding problem credits, and owning select names with more meaningful impact from Covid where fundamentals and liquidity remain intact and there is still real price convexity in the credit.
Collateralized Loan Obligations (CLOs)
US We expect the CLO primary issuance to remain heavy but also to be met with renewed demand post quarter end. The broader loan market default rate is trending at 2% while the universe of loans held in CLOs is running a default rate of less than 50 bps. Any additional widening in the CLO market should be viewed as an opportunity to add attractive yield. + We retain our view that AAAs will continue to perform well in either a bearish or bullish scenario. We expect supply to remain heavy, which will lead to opportunities to add lower-rated CLOs at attractive levels in the coming months.
Mortgage and Consumer Credit
Agency MBS We are neutral at current valuations and expectations of continued support from Federal Reserve (Fed) purchases over the near term. +/– We favor TBA in production coupons and specified pools in higher coupons. Agency CMBS offer portfolio diversification.
Non-Agency Residential MBS (NARMBS) Home prices have been supported by historically low mortgage rates, a dismal lack of supply on the market, tight lending conditions and a rebirth of household formations, which continue to support further home price appreciation and fundamentals for credit investors. + We are positive on GSE credit risk transfers as well as legacy NARMBS/new-issue re-performing loan deals.
Non-Agency Commercial MBS (CMBS) While the commercial sector remains further behind in terms of recovery, momentum is also building in this sector. In the near term, we remain cautious as it is uncertain how long it will take for commercial real estate markets to fully recover from the negative impacts of the pandemic. We expect the fundamental outlook to be uneven across property types and markets as the impact of COVID-19 varies on each property type and geography. +/– We are positive on short-duration, well-structured single-borrower securitizations and loans. We remain selective and prefer bonds that can better withstand a period of reduced operating income and forbearance and provide good risk/reward.
Asset-Backed Securities (ABS) We are cautious on consumer fundamentals and watchful of credit performance on consumer ABS sectors due to the impact of the pandemic on the economy and uncertain pace of recovery. +/– We favor well-protected senior ABS classes from high-quality sectors with low Covid disruption impact.
Inflation-Linked
US TIPS have outperformed nominals since last spring, lifting expected inflation rates above Fed targets for the next several years. While reopening will surely lift service prices that have been depressed, both the Fed and the market will likely look through these modest price spikes. Instead, we still expect the world to remain disinflationary beyond the reopening. Energy prices are not expected to have any strong trend now that production is equilibrating to slowly recovering global demand. Strong inflows into TIPS amid the economic reopening may lift inflation expectations, but we expect this to be only temporary. While TIPS still have a role in portfolio construction, our expectation is that TIPS will underperform comparable maturity nominal USTs over the remainder of the year.
Europe In 2021, European inflation will be very lumpy with many base effects dominating the near-term picture. Despite our low expectations for inflation, breakeven inflation spreads have rallied sharply pushing medium-term forwards closer to the ECB target of just below 2%. We continue to monitor the supply-side-led rise in survey input and output prices and how these pass through into actual inflation. +/– Given valuations, we are currently taking a neutral stance in eurozone inflation-linked paper.
Japan We believe that Japanese inflation-linked bonds remain undervalued, assuming the expected recovery of the Japanese economy. Also, the total amount of the buybacks by the Ministry of Finance and the BoJ keeps exceeding that of the issuances. + We maintain an overweight in Japanese real yields against nominal yields.
Municipals
US Within the most recent $1.9 trillion American Rescue Plan Act relief package, state and local municipalities received $350 billion of direct aid to address revenue shortfalls associated with the pandemic. Western Asset believes that while some entities will receive more federal aid than needed, the stimulus package will be particularly supportive of lower-grade municipalities, providing liquidity that will lengthen the runway for these entities to address longer-term structural challenges. As the policy focus shifts to infrastructure, supply technicals will be in focus amid possibilities for a return of a taxable municipal infrastructure program. + We continue to favor lower investment-grade revenue sectors that should continue to benefit from an economic recovery. However, we are cognizant of relative rich valuations, thus we are maintaining an above average liquidity position to maintain flexibility to navigate near-term market fluctuations associated with an extended tax season or near-term interest rate volatility.
Emerging Market (EM) Debt
EM Sovereigns (USD) Our central thesis is that the post-Covid recovery in EM as an asset class is not yet completed. We anticipate continued robust USD-denominated sovereign issuance by EM countries to fund fiscal programs and mitigate ongoing economic damage induced by the pandemic. +/– We continue to favor select IG-rated EM USD-denominated sovereigns from both a carry and total return standpoint, and exercise caution toward debt issued by lower-rated frontier sovereign countries that face a challenging uphill road ahead.
EM Local Currency Despite a spike in US rates, the Fed’s inflation policy continues to suggest a policy rate that will be low-for-long, with ample liquidity acting as a tailwind to the global recovery. EM local rates and flows should continue to benefit from the attractive real rate differential between the US and EM countries, a dynamic we believe will exist for the foreseeable future. +/– We are mindful that certain EM central banks’ easing cycles are coming to a close. Hence, we remain biased toward but highly selective on local rates for their relatively attractive real yield and more favorable risk/reward characteristics.
EM Corporates We view EM corporates’ shorter-duration, income-oriented posture as being favorable within the EM opportunity set amid pressure on global rates. Technicals remain strong given a lack of net supply and increased investor interest in the asset class. + We continue to take advantage of primary issuance from short- and intermediate-dated IG and HY EM corporates.