Executive Summary
- In the US, the effects of rate hiking are accumulating, inflation is moderating, and economic growth is slowing. Given these conditions, it makes little sense and would be counterproductive for the Fed to continue to tighten aggressively.
- In Europe, a hit on 4Q22 growth was avoided. Easing supply-chain issues and production have been a boon, but going forward growth should begin to weaken as production will likely reflect weak demand.
- In the UK, domestic markets recovered from unprecedented volatility and the BoE was able to proceed with active quantitative easing after a delay.
- In China, authorities are moving full speed ahead with their reopening plan. We believe the PBoC is likely to maintain its current accommodative stance in 1Q23, but posture for normalization if inflation risks rise after reopening.
Recent inflation prints across a number of key developed markets (DMs) offer optimism in the fight against inflation. While global central banks are expected to raise interest rates further in the short term, weaker economic data and lower inflation have seen markets pare back policy rate hike expectations. As inflation continues to moderate, we expect DM government bond yields to stabilize as we move through 1H23. Fundamental headwinds to global growth and inflation remain. These include the reduction of global fiscal stimulus, the withdrawal of monetary policy accommodation and the persistence of secular-related headwinds such as global debt burdens, aging demographics, and technology displacement. As growth and inflation moderate and the risks surrounding central bank policy become more balanced, so too should the market environment for fixed-income investors. Here, we provide a summary of the key drivers behind our global outlook and describe where we see value across global fixed-income markets.

US: On a Glidepath to Slower Growth |
We believe the effects of Federal Reserve (Fed) rate hikes to date are accumulating, albeit remarkably slowly and diffusely. Inflation is moderating across the economy, most clearly in goods prices, but also in services prices and in housing costs (home prices and rents); the latter effects, however, have yet to show up in the Consumer Price Index (CPI) for technical reasons. We expect this moderation to continue. We think month-to-month inflation will be within the Fed’s target ranges before the middle of 2023. While year-over-year (YoY) measures won’t show this improvement as quickly, the “perception lags” arising from looking at YoY measures are well understood by any trained economist, and we believe the Fed will be astute enough to make this deduction as well. The US construction industry has been in recession for some time, even while construction companies continue to replenish staffing. Lately, we are seeing similar developments in manufacturing, where both production and production hours worked have begun to decline, even as factory worker counts continue to recover. Understaffing is most acute in service industries, but even there job growth has slowed substantially except in those industries that were hardest hit by Covid restrictions (and where job counts are hundreds of thousands below pre-Covid levels). Even as service jobs continue to rebound, service-related workweeks are being cut enough that total production hours worked are decelerating or even declining. We take these trends as clear evidence that either Fed rate hikes are taking their toll or that economic growth is slowing on its own, even while residual understaffing in the wake of Covid restrictions has meant further job growth. With these conditions, and given the progress made on inflation, it makes little sense and is likely counterproductive for the Fed to continue to tighten aggressively, and we think a change in its policy slant will be coming soon. |
Europe: Worse Case Avoided, Lower Inflation and Softer Growth Coming |
The combination of clement winter weather and voluntary demand reduction from both households and firms has led to a sharp fall in natural gas prices in Europe. Thus, the fear that growth would take a marked hit in the last quarter of 2022 has been avoided. Growth has also been aided by easing supply-chain problems such that production has been running quite strong, particularly in the auto sector. But this is a production boost from past demand and from a survey perspective, backlogs have come down sharply and future order indications are low. Hence, going forward growth will begin to weaken as production will reflect current weak demand. The fall in energy prices is very important in terms of inflation. From a first-order standpoint this will lower energy prices; slowing the impact on actual inflation will be the energy price shields (government policies to offset the costs to both households and firms). Second-order impacts are likely just as important. Inflation expectations should begin to turn lower and the pass-through of energy price rises into both goods and service prices should recede. European Central Bank (ECB) Economist Phillip Lane suggests that half of eurozone inflation comes from energy cost pass-through. Last, lower energy prices will lower the cost of government support policies and likely result in less bond supply than previously expected over 2023. We anticipate that core goods prices will begin to turn lower this quarter; we can already see this in surveys, the Producer Price Index (PPI) and wholesale prices. Core services should begin to shift lower later in the first quarter as wage demands in new job postings are beginning to fall. Energy price declines will begin to recede gently at first, but later in the year the base effects will lead to sharper falls in headline inflation. The ECB has posited a series of 50-basis-point (bp) hikes over the next two meetings and most members see the peak rate being reached in the summer. The market is pricing in a peak rate of 3.50%, thus another 150 bps of hikes in 1H23. With inflation expectations and future wage demands no longer rising (and in some cases gently falling), the hawkish argument is weakening a little at the margin. Both measures remain elevated, so there is clearly more to do. We, however, remain in the camp that the peak rate will be lower than that which is currently priced by the market. Gilts significantly outperformed DM peers as UK domestic markets recovered from the unprecedented volatility that followed the ill-fated “Mini Budget” at the end of September. This was aided by the resignation of both the Chancellor and the Prime Minister, with their respective successors quickly reversing many of the fiscal plans and pledging to ensure that debt would fall as a share of GDP in the medium term. With market stability reinstated, the Bank of England (BoE) was able to proceed with its active quantitative easing program after an initial delay while the market was still stressed. A further test of market functioning and investor demand for gilts came as the BoE began to unwind its portfolio of long-dated securities via reverse enquiry operations. This was completed early in January. We believe that the BoE will raise the Bank Rate further during 1Q23, but quite possibly at a slower pace and to a lower peak than the market has currently priced. Data has shown further evidence of slowing economic activity, natural gas prices and inflation expectations have both fallen materially and hiring intentions have been declining for a number of months, loosening the job market and easing concerns over the risk of a wage-price spiral. |
China: Full Speed Ahead on Reopening |
China continues to grapple with its Covid exit, a reopening that poses risks to the health care system and that may see people staying at home for fear of infection. That stated, the authorities are moving full speed ahead with their reopening plans. At the Central Economic Work Conference, China’s senior leadership committed to regaining economic confidence by adopting a policy package to turn around the economy in 2023. Specifically, the meeting highlighted five key areas of focus for next year’s economic agenda: expanding domestic demand, building a modern industrial system, strengthening support for state-owned enterprises (SOEs) and for private companies, increasing efforts to attract foreign direct investment, and diffusing economic and financial risks. The People’s Bank of China (PBoC) at its 4Q22 Monetary Policy Committee (MPC) meeting remained cautious on the growth outlook by stating that “the foundation for achieving economic recovery needs to be further consolidated.” The PBoC also reiterated a pro-growth stance and called for greater support for the economy, and in particular for the property sector. We believe the PBoC is likely to maintain its current accommodative stance in 1Q23, but posture for normalization if inflation risks rise after reopening in 2Q23, specifically from service price pressures on the back of low base effects. Though reflation will be manageable, it will take time to close the negative output gap in China and absorb significant labor market slack. Unlike the reopening supply disruptions faced by other economies in 2021, China does not face similar supply constraints. However, any pickup in China’s growth is unlikely going to be of the magnitude or extent that it would meaningfully lift the global economy. China’s reopening will act as a demand-push shock to the economy, but this push will be mostly driven by pent-up services demand with more limited goods spillover demand. |
US: On a Glidepath to Slower Growth
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We believe the effects of Federal Reserve (Fed) rate hikes to date are accumulating, albeit remarkably slowly and diffusely. Inflation is moderating across the economy, most clearly in goods prices, but also in services prices and in housing costs (home prices and rents); the latter effects, however, have yet to show up in the Consumer Price Index (CPI) for technical reasons. We expect this moderation to continue. We think month-to-month inflation will be within the Fed’s target ranges before the middle of 2023. While year-over-year (YoY) measures won’t show this improvement as quickly, the “perception lags” arising from looking at YoY measures are well understood by any trained economist, and we believe the Fed will be astute enough to make this deduction as well.
It makes little sense and is likely counterproductive for the Fed to continue to tighten aggressively.
![]() The US construction industry has been in recession for some time, even while construction companies continue to replenish staffing. Lately, we are seeing similar developments in manufacturing, where both production and production hours worked have begun to decline, even as factory worker counts continue to recover. Understaffing is most acute in service industries, but even there job growth has slowed substantially except in those industries that were hardest hit by Covid restrictions (and where job counts are hundreds of thousands below pre-Covid levels). Even as service jobs continue to rebound, service-related workweeks are being cut enough that total production hours worked are decelerating or even declining. We take these trends as clear evidence that either Fed rate hikes are taking their toll or that economic growth is slowing on its own, even while residual understaffing in the wake of Covid restrictions has meant further job growth. With these conditions, and given the progress made on inflation, it makes little sense and is likely counterproductive for the Fed to continue to tighten aggressively, and we think a change in its policy slant will be coming soon. |
Europe: Worse Case Avoided, Lower Inflation and Softer Growth Coming
![]() |
The combination of clement winter weather and voluntary demand reduction from both households and firms has led to a sharp fall in natural gas prices in Europe. Thus, the fear that growth would take a marked hit in the last quarter of 2022 has been avoided. Growth has also been aided by easing supply-chain problems such that production has been running quite strong, particularly in the auto sector. But this is a production boost from past demand and from a survey perspective, backlogs have come down sharply and future order indications are low. Hence, going forward growth will begin to weaken as production will reflect current weak demand. The fall in energy prices is very important in terms of inflation. From a first-order standpoint this will lower energy prices; slowing the impact on actual inflation will be the energy price shields (government policies to offset the costs to both households and firms). Second-order impacts are likely just as important. Inflation expectations should begin to turn lower and the pass-through of energy price rises into both goods and service prices should recede. European Central Bank (ECB) Economist Phillip Lane suggests that half of eurozone inflation comes from energy cost pass-through. Last, lower energy prices will lower the cost of government support policies and likely result in less bond supply than previously expected over 2023. We anticipate that core goods prices will begin to turn lower this quarter; we can already see this in surveys, the Producer Price Index (PPI) and wholesale prices. Core services should begin to shift lower later in the first quarter as wage demands in new job postings are beginning to fall. Energy price declines will begin to recede gently at first, but later in the year the base effects will lead to sharper falls in headline inflation. The ECB has posited a series of 50-basis-point (bp) hikes over the next two meetings and most members see the peak rate being reached in the summer. The market is pricing in a peak rate of 3.50%, thus another 150 bps of hikes in 1H23. With inflation expectations and future wage demands no longer rising (and in some cases gently falling), the hawkish argument is weakening a little at the margin. Both measures remain elevated, so there is clearly more to do. We, however, remain in the camp that the peak rate will be lower than that which is currently priced by the market. Gilts significantly outperformed DM peers as UK domestic markets recovered from the unprecedented volatility that followed the ill-fated “Mini Budget” at the end of September. This was aided by the resignation of both the Chancellor and the Prime Minister, with their respective successors quickly reversing many of the fiscal plans and pledging to ensure that debt would fall as a share of GDP in the medium term. With market stability reinstated, the Bank of England (BoE) was able to proceed with its active quantitative easing program after an initial delay while the market was still stressed. A further test of market functioning and investor demand for gilts came as the BoE began to unwind its portfolio of long-dated securities via reverse enquiry operations. This was completed early in January. We believe that the BoE will raise the Bank Rate further during 1Q23, but quite possibly at a slower pace and to a lower peak than the market has currently priced. Data has shown further evidence of slowing economic activity, natural gas prices and inflation expectations have both fallen materially and hiring intentions have been declining for a number of months, loosening the job market and easing concerns over the risk of a wage-price spiral. |
China: Full Speed Ahead on Reopening
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Though reflation will be manageable, it will take time to close the negative output gap in China and absorb significant labor market slack.
![]() China continues to grapple with its Covid exit, a reopening that poses risks to the health care system and that may see people staying at home for fear of infection. That stated, the authorities are moving full speed ahead with their reopening plans. At the Central Economic Work Conference, China’s senior leadership committed to regaining economic confidence by adopting a policy package to turn around the economy in 2023. Specifically, the meeting highlighted five key areas of focus for next year’s economic agenda: expanding domestic demand, building a modern industrial system, strengthening support for state-owned enterprises (SOEs) and for private companies, increasing efforts to attract foreign direct investment, and diffusing economic and financial risks. The People’s Bank of China (PBoC) at its 4Q22 Monetary Policy Committee (MPC) meeting remained cautious on the growth outlook by stating that “the foundation for achieving economic recovery needs to be further consolidated.” The PBoC also reiterated a pro-growth stance and called for greater support for the economy, and in particular for the property sector. We believe the PBoC is likely to maintain its current accommodative stance in 1Q23, but posture for normalization if inflation risks rise after reopening in 2Q23, specifically from service price pressures on the back of low base effects. Though reflation will be manageable, it will take time to close the negative output gap in China and absorb significant labor market slack. Unlike the reopening supply disruptions faced by other economies in 2021, China does not face similar supply constraints. However, any pickup in China’s growth is unlikely going to be of the magnitude or extent that it would meaningfully lift the global economy. China’s reopening will act as a demand-push shock to the economy, but this push will be mostly driven by pent-up services demand with more limited goods spillover demand. |
Global Market Rates: Relative Value by Region
US | We believe the effects of Fed rate hikes to date are accumulating and that inflation is moderating across the economy. Given the slowdown in economic activity (specifically in construction and manufacturing) and the progress made on inflation, we think a change in the Fed’s policy slant will be coming soon. |
Canada | The Bank of Canada will likely end its rate hiking cycle ahead of the Fed, though recent employment and growth data mean that one last rate hike in 2023 is probable. The Canadian economy is more sensitive to both higher rates and slower global growth. |
Europe | A sharp deterioration in growth has been avoided and past demand is supporting current growth. Once this is filled, growth will begin to reflect future demand, which is weak. Inflation will gently begin to turn lower. |
UK | While we expect the BoE to deliver additional rate hikes during 1Q23, we believe that the BoE’s hiking cycle is likely to end earlier and lower than the market expects, as fiscal pressures weaken household demand and the job market loosens. |
China | We expect 2023 growth to come in between 4.5% and 5.5%; with policymakers focused on economic recovery. Reflation is likely to be more manageable given the negative output gap in China and significant labor market slack. |
Japan | The Bank of Japan (BoJ) will likely maintain its monetary accommodation despite market speculation of a policy change because it is still difficult to imagine that the inflation target will be met. Even after the December shock, the BoJ remains open to making further adjustments necessary to maintain the yield curve control (YCC) framework, allowing the nominal 10-year yield to rise. |
Australia | The Reserve Bank of Australia (RBA) moved the cash rate quickly from 0.10% to 3.10% over the eight months ending December 2022. Its effect on the economy remains to be seen, but should slow growth in 2023. We believe the RBA is attempting to walk a tightrope and hoping to achieve its goal of returning inflation to its target band over time, without forcing a recession and is therefore unlikely to reach the 4% cash rate priced by the market in 2023. |
Relative Value by Sector
Investment-Grade (IG) Corporate Credit |
US |
Outlook Corporate fundamentals may have peaked, but they are coming off a strong starting point. Concerns abound that earnings will decelerate given tighter financial conditions, rising input costs and a spent consumer. While corporate management continues to behave relatively conservatively given uncertainty with the macro backdrop, the key factor to watch is whether weakness from housing starts to spill over into the broader economy. |
Relative Value +/- Spreads have recovered from the recent wides and are currently just fair, being respectful of both potential forthcoming economic weakness and the strong financial condition investment-grade companies were in coming in to this turn. We maintain overweights to banking (where further ratings upgrades are expected), energy, select reopening industries and rising-star candidates, where allowed. |
Europe |
Outlook Investment-grade companies enter this period with strong balance sheets and benefit from scale and diversification. European utilities face higher funding needs but with government support we see some opportunities in this space. Bank balance sheets remain strong and we expect profitability to improve due to higher net interest income. |
Relative Value + Yields at multi-year highs look attractive. In particular we like the 3- to 5-year part of the market for total return potential. New-issue supply has been heavy but has provided some good entry points in attractively priced financials. |
Australia |
Outlook Credit fundamentals remain sound despite the prospect of the economy slowing. 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 credit, particularly in short-dated holdings with a preference for select REITs and infrastructure assets that have regulated resets. We also favor senior unsecured bank paper. |
High-Yield (HY) Corporate Credit |
US |
Outlook High-yield credit spreads are relatively attractive. Default rates are likely to rise from very low levels in the coming quarters, but yields are providing ample cushion for higher defaults—which are likely to be below historical averages given the higher credit quality of the market on average. Technicals have been negative over the last year given outflows from mutual funds, but higher yields are beginning to attract new institutional buyers. |
Relative Value + We continue to see opportunity in service-related sectors that are still recovering from the Covid-led recession (i.e., reopening trades including airlines, cruise lines and lodging) and potential rising stars. We are more cautious on companies with closer ties to housing-related activity and therefore lack pricing power. |
Europe |
Outlook Headwinds for credit fundamentals include slowing growth and higher borrowing costs. Refinancing needs for existing issuers are modest in the near term. We expect 1Q23 opportunities as we anticipate increasing issuance and market volatility. |
Relative Value +/- Valuations have repriced tighter—spreads are now back below 500 bps. We focus on BB and B rated issues—and defensive industries. |
Bank Loans |
US |
Outlook Bank loan spreads are relatively attractive. While fundamentals are expected to decline from robust levels as growth slows, yields are providing ample cushion for gradually higher defaults. Valuations have improved meaningfully, and technicals may soon improve as demand for discounted floating-rate loans from CLOs may exceed moderate 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 CLO issuance, keeping spreads relatively range-bound in the near term. Hedging costs for overseas investors have risen over the last few quarters, but high-quality CLOs still screen attractive for overseas investors, which should lead to demand. |
Relative Value + We view AAA rated CLO debt at current levels as very attractive and retain our view that it will continue to perform well in either bullish or bearish bank-loan-spread environments given strong structural protections. |
Mortgage and Consumer Credit |
Agency MBS |
Outlook Diminishing Fed and bank demand for agency MBS coupled with increased volatility remain headwinds, but the fundamental picture has greatly improved as spreads widened in 2022 and look attractive historically, while prepayment risk has subsided to low levels. |
Relative Value + We are constructive on 30- and 20-year subsectors relative to 15-year MBS, focusing on pre-Covid coupons and specified pools’ security selection to enhance carry and convexity. |
Non-Agency Residential MBS (NARMBS) |
Outlook Rising mortgage rates have put downward pressure on housing affordability, resulting in a reduction of housing demand. In conjunction, housing supply continues to normalize through an ease in supply-chain issues and new-home completions. While housing is expected to cool, we do not see a significant risk of defaults. |
Relative Value + Due to the increase in new-issue supply, we are opportunistic on credit risk transfer (CRT) securities as well as non-QM deals. |
Non-Agency Commercial MBS (CMBS) |
Outlook As volatility has declined, attractive yields are available across the capital stack for high-quality credits. Lodging growth continues its upwards trend, multi-family and industrial rent growth appears to have peaked, and office struggles to find a direction. |
Relative Value + We favor discounted price bonds backed by high-quality collateral in both short- and long-duration with high total return opportunity. Mezzanine credit and subordinate credit relative value screens particularly cheap but performance will be idiosyncratic. |
Asset-Backed Securities (ABS) |
Outlook Covid-era deleveraging has reversed and consumer debt is back to pre-pandemic levels. We are cautious on consumer fundamentals and watchful of credit deterioration on lower credit consumer ABS sectors. |
Relative Value + Senior AAA bonds across higher credit quality consumer sectors are attractive over corporates. Commercial ABS investment-grade sectors are historically wide to corporates and have positive technical tailwinds. |
Inflation-Linked |
US |
Outlook US TIPS real yields are attractive at levels above prior cycle highs, and breakeven inflation (BEI) levels are between 2.0% and 2.2% out to 10 years. Should inflation prove as tame as we expect, demand for even short-dated TIPS could go in reverse. Nonetheless, real yields are compelling. |
Relative Value + Longer-dated BEI are fairly valued versus nominal USTs, but could be attractive as a diversifier within US bond portfolios. |
Europe |
Outlook Energy prices fell sharply in 4Q22 as winter weather was warmer than usual. Signs from surveys, PPI and wholesale prices point to future declines in core goods pricing. Services price inflation remains elevated, but near-term wages seem to have peaked and inflation expectations have pulled back a little. Thus, headline inflation should decline modestly in 1H23. |
Relative Value +/– With German real yields above zero, the market pricing ECB terminal rates near 3.5%, inflation beginning to turn lower and growth prospects declining, we have closed our nominal short and moved to a very small long position. |
Japan |
Outlook Inflation-linked JGBs look attractive. Inflation rates are expected to continue to increase while the current 10-year BEI is still well below 2% of the BoJ’s inflation target. The balance between issuances and buybacks continues to be supportive. |
Relative Value + We maintain an overweight to Japanese real yields against nominal yields. |
Municipals |
US |
Outlook Tax-exempt relative value has become increasingly attractive at higher nominal rates. We believe that the risk has shifted from elevated inflation to declining growth in the wake of the Fed’s aggressive hiking policy, but that credit fundamentals remain favorable. |
Relative Value + We favor revenue sectors that would benefit from an ongoing economic recovery, as well as lengthening duration in the face of declining growth. |
Emerging Market (EM) Debt |
EM Sovereigns (USD) |
Outlook Positive developments in global inflation and China’s Covid policies have incrementally improved the outlook for EM assets. We continue to watch global central bank policy, commodity prices, Chinese regulatory developments and geopolitics as key macro drivers of EM returns. |
Relative Value +/– We believe high-yield frontier market sovereigns represent the best 2023 total return opportunity in EM. |
EM Local Currency |
Outlook EM central banks’ proactive tightening measures over the past two years have set up a more positive outlook for both rates and FX in 2023. We expect countries to customize their terminal-rate behavior given divergent growth trends by region. |
Relative Value + While FX will remain highly macro-driven, signs of EM policy rates peaking could provide opportunities to add exposure to EM local rates. Asian currencies should benefit from the end of China’s zero-Covid policies. |
EM Corporates |
Outlook EM corporates continue to maintain strong balance sheets with lower leverage than their DM peers. Risks to the sector primarily come from sovereign developments (e.g., China and Russia). |
Relative Value +/– We are focused on EM primary issuance at a concession to secondary and DM levels. EM corporates’ lower duration and volatility continue to represent an attractive risk/reward proposition. |
Sector | Outlook | Relative Value | |
Investment-Grade (IG) Corporate Credit | |||
US | Corporate fundamentals may have peaked, but they are coming off a strong starting point. Concerns abound that earnings will decelerate given tighter financial conditions, rising input costs and a spent consumer. While corporate management continues to behave relatively conservatively given uncertainty with the macro backdrop, the key factor to watch is whether weakness from housing starts to spill over into the broader economy. | +/- | Spreads have recovered from the recent wides and are currently just fair, being respectful of both potential forthcoming economic weakness and the strong financial condition investment-grade companies were in coming in to this turn. We maintain overweights to banking (where further ratings upgrades are expected), energy, select reopening industries and rising-star candidates, where allowed. |
Europe | Investment-grade companies enter this period with strong balance sheets and benefit from scale and diversification. European utilities face higher funding needs but with government support we see some opportunities in this space. Bank balance sheets remain strong and we expect profitability to improve due to higher net interest income. | + | Yields at multi-year highs look attractive. In particular we like the 3- to 5-year part of the market for total return potential. New-issue supply has been heavy but has provided some good entry points in attractively priced financials. |
Australia | Credit fundamentals remain sound despite the prospect of the economy slowing. 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 credit, particularly in short-dated holdings with a preference for select REITs and infrastructure assets that have regulated resets. We also favor senior unsecured bank paper. |
High-Yield (HY) Corporate Credit | |||
US | High-yield credit spreads are relatively attractive. Default rates are likely to rise from very low levels in the coming quarters, but yields are providing ample cushion for higher defaults—which are likely to be below historical averages given the higher credit quality of the market on average. Technicals have been negative over the last year given outflows from mutual funds, but higher yields are beginning to attract new institutional buyers. | + | We continue to see opportunity in service-related sectors that are still recovering from the Covid-led recession (i.e., reopening trades including airlines, cruise lines and lodging) and potential rising stars. We are more cautious on companies with closer ties to housing-related activity and therefore lack pricing power. |
Europe | Headwinds for credit fundamentals include slowing growth and higher borrowing costs. Refinancing needs for existing issuers are modest in the near term. We expect 1Q23 opportunities as we anticipate increasing issuance and market volatility. | +/- | Valuations have repriced tighter—spreads are now back below 500 bps. We focus on BB and B rated issues—and defensive industries. |
Bank Loans | |||
US | Bank loan spreads are relatively attractive. While fundamentals are expected to decline from robust levels as growth slows, yields are providing ample cushion for gradually higher defaults. Valuations have improved meaningfully, and technicals may soon improve as demand for discounted floating-rate loans from CLOs may exceed moderate 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 CLO issuance, keeping spreads relatively range-bound in the near term. Hedging costs for overseas investors have risen over the last few quarters, but high-quality CLOs still screen attractive for overseas investors, which should lead to demand. | + | We view AAA rated CLO debt at current levels as very attractive and retain our view that it will continue to perform well in either bullish or bearish bank-loan-spread environments given strong structural protections. |
Mortgage and Consumer Credit | |||
Agency MBS | Diminishing Fed and bank demand for agency MBS coupled with increased volatility remain headwinds, but the fundamental picture has greatly improved as spreads widened in 2022 and look attractive historically, while prepayment risk has subsided to low levels. | + | We are constructive on 30- and 20-year subsectors relative to 15-year MBS, focusing on pre-Covid coupons and specified pools’ security selection to enhance carry and convexity. |
Non-Agency Residential MBS (NARMBS) | Rising mortgage rates have put downward pressure on housing affordability, resulting in a reduction of housing demand. In conjunction, housing supply continues to normalize through an ease in supply-chain issues and new-home completions. While housing is expected to cool, we do not see a significant risk of defaults. | + | Due to the increase in new-issue supply, we are opportunistic on credit risk transfer (CRT) securities as well as non-QM deals. |
Non-Agency Commercial MBS (CMBS) | As volatility has declined, attractive yields are available across the capital stack for high-quality credits. Lodging growth continues its upwards trend, multi-family and industrial rent growth appears to have peaked, and office struggles to find a direction. | + | We favor discounted price bonds backed by high-quality collateral in both short- and long-duration with high total return opportunity. Mezzanine credit and subordinate credit relative value screens particularly cheap but performance will be idiosyncratic. |
Asset-Backed Securities (ABS) | Covid-era deleveraging has reversed and consumer debt is back to pre-pandemic levels. We are cautious on consumer fundamentals and watchful of credit deterioration on lower credit consumer ABS sectors. | + | Senior AAA bonds across higher credit quality consumer sectors are attractive over corporates. Commercial ABS investment-grade sectors are historically wide to corporates and have positive technical tailwinds. |
Inflation-Linked | |||
US | US TIPS real yields are attractive at levels above prior cycle highs, and breakeven inflation (BEI) levels are between 2.0% and 2.2% out to 10 years. Should inflation prove as tame as we expect, demand for even short-dated TIPS could go in reverse. Nonetheless, real yields are compelling. | + | Longer-dated BEI are fairly valued versus nominal USTs, but could be attractive as a diversifier within US bond portfolios. |
Europe | Energy prices fell sharply in 4Q22 as winter weather was warmer than usual. Signs from surveys, PPI and wholesale prices point to future declines in core goods pricing. Services price inflation remains elevated, but near-term wages seem to have peaked and inflation expectations have pulled back a little. Thus, headline inflation should decline modestly in 1H23. | +/– | With German real yields above zero, the market pricing ECB terminal rates near 3.5%, inflation beginning to turn lower and growth prospects declining, we have closed our nominal short and moved to a very small long position. |
Japan | Inflation-linked JGBs look attractive. Inflation rates are expected to continue to increase while the current 10-year BEI is still well below 2% of the BoJ’s inflation target. The balance between issuances and buybacks continues to be supportive. | + | We maintain an overweight to Japanese real yields against nominal yields. |
Municipals | |||
US | Tax-exempt relative value has become increasingly attractive at higher nominal rates. We believe that the risk has shifted from elevated inflation to declining growth in the wake of the Fed’s aggressive hiking policy, but that credit fundamentals remain favorable. | + | We favor revenue sectors that would benefit from an ongoing economic recovery, as well as lengthening duration in the face of declining growth. |
Emerging Market (EM) Debt | |||
EM Sovereigns (USD) | Positive developments in global inflation and China’s Covid policies have incrementally improved the outlook for EM assets. We continue to watch global central bank policy, commodity prices, Chinese regulatory developments and geopolitics as key macro drivers of EM returns. | +/– | We believe high-yield frontier market sovereigns represent the best 2023 total return opportunity in EM. |
EM Local Currency | EM central banks’ proactive tightening measures over the past two years have set up a more positive outlook for both rates and FX in 2023. We expect countries to customize their terminal-rate behavior given divergent growth trends by region. | + | While FX will remain highly macro-driven, signs of EM policy rates peaking could provide opportunities to add exposure to EM local rates. Asian currencies should benefit from the end of China’s zero-Covid policies. |
EM Corporates | EM corporates continue to maintain strong balance sheets with lower leverage than their DM peers. Risks to the sector primarily come from sovereign developments (e.g., China and Russia). | +/– | We are focused on EM primary issuance at a concession to secondary and DM levels. EM corporates’ lower duration and volatility continue to represent an attractive risk/reward proposition. |