
Geopolitics

Convictions
- The invasion of Ukraine by Russia introduced a high level of geopolitical uncertainty and elevated volatility
- Risks to both inflation and global growth will likely remain elevated due to the uncertainty; global growth forecasts are falling

Rationale

Monetary Policy
Convictions
- Over the past few months, the Fed has made a hawkish pivot; the number of Fed rate hikes expected by both the Fed and by the market has increased significantly, but we expect fewer hikes than the current consensus
- ECB out of crisis mode with PEPP set to end after 2Q22
Rationale

Inflation

Convictions
- Elevated inflation to recede in the second half of 2022
- We hold a contrarian view versus current market consensus
- Our view of moderating inflation underpins the prospects for central banks not having to tighten so aggressively

Rationale

COVID-19
Convictions
- Covid is transitioning from pandemic to endemic
- Vaccines are key to fighting the disease
Rationale

Fiscal Policy

Convictions
- Global fiscal stimulus will be sharply reduced
- In the US, spending is not expected to increase significantly given that the Build Back Better Act did not pass

Rationale

Growth
Convictions
- 2%-3% US growth in 2022
- Approximately 4%-5% growth for China in 2022, given new Covid lockdowns in 2Q
- Eurozone growth projections have decelerated to the 2%-3% range
Rationale
One of the areas that has really lagged recently, but may be the best reopening sector is emerging markets (EM). Because ongoing global growth is our base case, and if we also get the reduced inflation that we expect to see over the course of 2022, then this would be extremely supportive of the case for EM finally making its recovery. We’re also favoring high-yield credit, which is a sector we’ve moved into strongly following the Covid downturn. Even though spreads are tighter and valuations are more compressed, we think that when you look at the current situation—higher quality, defaults falling sharply and fallen angels on the verge of upgrades—the fundamentals are very strong for high-yield credit.
2Q22 Spotlight

Mortgage Credit
While real estate prices are expected to cool from the record increases of 2021, market spreads are elevated with increased risk premiums. Mortgage credit looks attractive outright and on a relative-value basis. Following the re-emergence from Covid lockdowns, lending stayed conservative and real estate markets remain well supported by long-term fundamentals. The mortgage team favors taking credit risk versus prepayment risk, favoring non-agency and select commercial MBS (CMBS) issues over agency residential MBS (RMBS).

Bank Loans and Collateralized Loan Obligations (CLOs)
Fundamentals remain healthy and minimal defaults are expected given the economic outlook. Demand for higher-yielding floating-rate securities from retail, institutional clients and CLOs is expected to be supportive for spreads. Bank loans are also an attractive diversifier in our portfolios if rates continue to go higher (which is not our base case).
Rising Stars

Identifying rising stars—high-yield issues that will be upgraded to investment-grade status—is a process that can be enhanced by integrating bottom-up independent company analysis with top-down, forward-looking growth estimates.
Typically, outperformance of rising stars occurs months before the actual upgrade by two of the major rating agencies.
For background, the passive investment-grade buyer base is at least five times larger than high-yield, which can provide technical buying support for securities when they are upgraded. As an active manager, we apply our own research capabilities to help identify companies’ debt that may be upgraded to investment-grade. For portfolios that have discretion, we purchase securities where valuations don’t reflect the improved credit risk and likely agency upgrades. Having a purchase strategy in place before the rating agencies finalize upgrades can add a lot of value to portfolios.
Western Asset’s Credit Team anticipates a substantial increase of rising stars across industries. Many of the names that were downgraded by the rating agencies in the early stages of the pandemic are likely to move back into investment-grade.

2Q22 Market & Strategy Update Webcast
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