The Big Picture | Western Asset

KEY DRIVERS & RELATIVE VALUE
SECTOR THEMES
INDUSTRY THEMES

"We anticipate a strong year for fixed-income markets, driven by attractive yields and opportunities in select spread sectors. We see value in certain DM government bonds, including those in Australia, the UK and broader Europe. We also see opportunities in certain credit investments, including structured credit, especially commercial real estate and CLO tranches, as well as higher-rated bank loans. Potential volatility, particularly with the new US administration, highlights the importance of active management."

Michael Buchanan, CFA
Chief Investment Officer

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We are optimistic about fixed-income returns in 2025 given the prevalence of higher available yields.
While global growth is downshifting, we expect it to remain positive. US growth should continue to outpace most other developed markets.
Inflation globally is now very close to central bank targets, although there are inter-country discrepancies, such as stubborn inflation in the US (an outlier among DM economies). The overall trend gives central banks room to cut policy rates.
Spread sector fundamentals should remain supportive, and current valuations reflect this.
We see opportunities to hold duration in select developed markets such as Australia, the UK and in core Europe, as well as in short-dated USTs.
Select parts of the securitized and corporate bond markets offer attractive return potential.

OVERVIEW

Global growth has slowed, and inflation rates have declined markedly across both developed market (DM) and emerging market (EM) economies. Our base case calls for these trends to persist. Goods price inflation is running modestly below pre-pandemic levels and, with ongoing deflationary pressures from Asia, it's hard to envision a meaningful persistent uptick. Services inflation should continue to slow as wage pressures abate with the softening jobs market and slower demand in the service sector. The inflation backdrop has generally allowed key DM central banks to begin reducing policy rates at a time when the growth backdrop is calling for less restrictive policy; however, the US remains an outlier among DM economies with its stubbornly higher inflation. The global growth trajectory, however, is highly dependent on US government policy outcomes. We remain overweight to interest-rate duration, particularly given the recent rise in yields. We see value in Australia, the UK and in core Europe, as well as in short-dated US Treasuries (USTs) that are less susceptible to the uncertain outlook for US fiscal policy. Spread sectors have performed well, and we expect this to continue. However, valuations are trading at or through historical averages. We see value in select sectors and names. EM debt appears to remain fundamentally attractive, but both internal and external political risks have hampered performance in some countries.

"Economic activity in the UK has been subdued, and the BoE is expected to continue gradually easing policy restrictions. Inflation is expected to fall back to target by 2Q25, driven by declining services inflation. The ECB is likely to reduce policy rates to 1.75% by year-end. We maintain a modestly overweight duration position in both the UK and core-European bonds and an underweight in the euro."

Richard A. Booth
Portfolio Manager

KEY DRIVERS AND RELATIVE VALUE BY REGION

US: Soft Landing on Track

The US economy should expand near trend well into 2025, buoyed by housing and consumer demand. Core inflation should continue to run near the Federal Reserve (Fed) target level of 2%. US bond yields remain high relative to pre-pandemic growth and inflation levels. Market uncertainty about Trump administration policy changes could lead to market volatility in early 2025.

EUROPE: Lacklustre Growth as Inflation Returns to Target in 1H25

Prospects for economic growth in the eurozone remain challenged. We expect inflation to fall back to target in Q2 led by falling services inflation. The European Central Bank (ECB) is expected to reduce policy rates to 1.75% by year-end. We remain modestly overweight duration via both nominal and real yields while maintaining a small underweight in the euro.

UK: Gradual Removal of Policy Restraint to Continue

Recent economic activity has missed expectations and is likely to remain subdued. While the Bank of England (BoE) will have to monitor the impact of October's budget, surveys suggest that the passthrough to prices is likely to be modest while the labour market should further weaken. This would allow the BoE to continue to gradually remove restrictive policy.

CANADA: Data Tug of War Continues

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With core inflation running at target and a near-neutral policy rate, the Bank of Canada is likely to pause further action. Slowly improving indicators should reduce slack in the economy, and a modest bottoming out in residential real estate is already apparent. However, domestic political uncertainty must now contend with US trade restrictions as major obstacles for the economy and Canadian dollar.

AUSTRALIA: Gradual Removal of Policy Restraint to Begin Soon

The Reserve Bank of Australia (RBA) rhetoric had been hawkish up until December 2024. Although core inflation continues to show progress toward the RBA's target, the RBA now appears to be showing some concern that the higher rates are taking a toll. Our portfolios are moderately long duration as we expect yields to move lower as the RBA cautiously eases; however, market volatility is likely to keep this position active.

JAPAN: Higher Rates Ahead

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We expect Japan's economy to grow 1.5% in the first half of 2025, led by the recovery in private consumption and strong business investments. Inflation is likely to remain above 2%. As such, we expect the Bank of Japan to raise policy rates at a cautious pace. This should result in higher Japanese government bond yields and yield-curve flattening.

CHINA: Structural Challenges Persist; Policymakers Responsive

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Recent measures by the Chinese government signal attempts to revive investor sentiment and consumer confidence. However, there is no shift from the structural goals of limiting leverage growth and de-risking the property sector. Although deflationary pressures persist and confidence is weak, policymakers appear ready to do more, albeit still in a moderate form.

MEXICO: Awaiting Trump 2.0

Market sentiment continues to be dominated by the country's fiscal challenges and the uncertainty surrounding US trade policy under Trump. We remain biased toward local rates over FX, as Banxico is expected to proceed with its easing cycle given the high real rate environment, ongoing disinflation trends and the potential for additional easing by the Fed.

INDIA: Fundamentals, Valuations and Technicals Favor Indian Bonds

While GDP growth forecasts were lowered to the mid-6% range for FY25, these levels are still trending higher than regional peers on average. With Consumer Price Index (CPI) inflation moderating, the bias is for looser monetary policy. Despite recent portfolio outflows, India is backed by substantial FX reserves. Bonds are expected to outperform given attractive carry and tailwinds from EM bond index inclusion.

BRAZIL: Facing More Fiscal Pressure

The Brazilian real has already factored in several pessimistic elements, which we anticipate will correct over time. However, the absence of sustainable fiscal policy measures will continue to weigh on the currency despite tighter monetary policy by the central bank over the coming months.

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"We believe companies that issue bank loans will benefit from a stable fundamental backdrop and lower interest costs. With this backdrop, we continue to favor BB rated bank loans for stable, carry-driven returns. We also will target single-B rated loans in select sectors for compelling interest carry and total return potential. For more total-return-focused mandates, we continue to favor BBB rated CLOs."

Ryan J. Kohan
Head of Bank Loans

SECTOR THEMES

Investment-Grade (IG) Corporate Credit

In the US, fundamentals remain strong for IG corporates as balance sheets are positioned to withstand economic uncertainty and management teams continue to exercise caution. Demand for IG corporates has kept pace with robust supply. We expect this trend to continue for the next quarter as the rates market has priced in more attractive yields for corporates. Given strong fundamentals and positive technicals, valuations appear fairly priced.

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In Europe, IG fundamentals are more challenged in some sectors, such as autos, but bank balance sheets remain strong. Spreads continue to look relatively tight, but we see value in European banks and utilities. We are more selective on real estate issuers given strong performance during 2024. Record levels of supply are being absorbed by ongoing inflows into the asset class.

In Australia, fundamentals remain sound despite the economy slowing due to defensive balance sheet positioning. We maintain an overweight in credit, particularly in short-dated holdings, with a preference for select REITs and utility/infrastructure assets that have regulated resets. We also favor senior unsecured major bank and foreign national champion bank issuance.

High-Yield (HY) Corporate Credit

In the US, HY credit spreads reflect balance sheet strength, the prudent behavior of management teams and supportive demand for higher yielding securities relative to supply. We continue to see some opportunity in service-related sectors that are still recovering from the pandemic-era recession, and in energy (E&P) and potential rising stars. We are more cautious on consumer products, retailers and home construction.

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In Europe, corporate fundamentals remain fairly sound. Primary issuance continues to be dominated by refinancing activity. We remain selective with a BB/B rating focus as spreads remain tight and rangebound.

Bank Loans

Bank loan yields remain particularly attractive relative to fixed coupon alternatives, and we anticipate further spread compression by year-end. We continue to expect a stable (i.e., 5%-6%) coupon-driven return from BB loans with strong underlying credit quality. We believe stable value will come from well-capitalized companies in industrials, while we are finding total return opportunities in select areas of health care, media and technology sectors.

Collateralized Loan Obligations (CLOs)

We see more opportunity in AAA, BBB and select BB rated debt tranches of CLOs that are invested in broadly syndicated bank loans. We believe that AAAs and BBBs should continue to perform well in either bullish or bearish bank-loan-spread environments, given strong structural protections. BB CLO spreads are close to their 5-year tights, but all-in yields on select BBs remain attractive at 10%-11% given a higher 3-month SOFR base rate.

Mortgage and Consumer Credit

Agency mortgage-backed securities (MBS) offer attractive spread valuations with low prepayment risk. We favor 30- and 20-year over 15-year MBS, higher coupons and non-benchmark sectors, focusing on security selection to enhance yield and convexity profiles.

Non-agency residential MBS (NARMBS) had strong performance in 2024 amid elevated new-issue volumes and credit spreads closing the year at the tight end of the range. Residential housing fundamentals remain supportive of securitization as existing and new home supply is expected to remain low for the coming year. We like new-issue deals at the top of the credit stack as well as seasoned credit bonds with ratings upgrade potential as deals continue to de-lever.

Commercial MBS (CMBS) rallied back strongly in 2024, outperforming most credit sectors; however, spreads down the capital structure remain wide relative to post-GFC averages. CRE prices have bottomed out, and capital is being deployed to take advantage of the reset valuations in both debt and equity markets. Seasoned bonds priced at a discount also offer intriguing total-return opportunities for short, event-driven trades.

We expect tighter lending standards to lead to stable consumer performance, and still favor higher-quality consumer credit amid tighter spreads. We are constructive on select esoteric sectors such as aircraft lease, digital infrastructure and whole-business ABS across A and BBB rated tranches. Senior spreads are in the mid- to high-100s and mezzanine spreads are in the mid-200s. Spreads, while at two-year tights, provide attractive carry relative to IG credit.

Inflation-Linked

US Treasury Inflation-Protected Securities (TIPS) real yields remain attractive at near-two-decade highs, though breakeven inflation (BEI) levels are near the highest levels seen over the past year. While there is substantial uncertainty over the impact of Trump administration policies on inflation, we doubt there will be a long-term impact. We see better opportunities to buy TIPS versus nominals, though portfolios remain long TIPS on a real-yield basis.

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European inflation expectations (via 5-year swaps) are around 2.0%. This rate is consistent with the ECB achieving its inflation mandate. Risks are currently balanced, with potential downsides from our expected near-term path for inflation (dipping below target in H2) and prospective US tariffs (should unsold export goods need domestic discounting), coupled with upsides from a weaker euro and energy, weather and geopolitical volatility.

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In Japan, the CPI remains above 2% and wage growth is gaining momentum due to a structural labor shortage. We maintain an overweight to Japanese real yields versus nominal yields as the current BEI rate is still below 2%.

Municipals

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Navigating the municipal market in early 2025 will require careful active management. New-issue supply is likely to exceed $450 billion, with retail demand being crucial as institutional demand remains subdued, potentially increasing rate volatility. We are closely monitoring how potential policy changes may affect sectors like energy, manufacturing, health care and transportation. Better opportunities reside in lower coupon bonds, shorter call structures, lower-end IG and specific below-IG issues.

Emerging Market (EM) Debt

We believe that frontier market sovereigns continue to represent a compelling carry and total return opportunity, given still-wide valuations and key idiosyncratic credit stories. IG-rated EM sovereigns remain tight and can be considered a source of cash for trades with better relative value across EM and other sectors.

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A stronger-than-expected US dollar has weighed on EM FX performance, while expectations of fewer rate cuts by the Fed could augur fewer rate cuts across EM. Given high real yields, we currently favor Latin American local rates, while Asian local currency bonds appear unattractive given historically low yields relative to USTs. We are monitoring US growth exceptionalism and the post-election trade friction as risks to EM FX going forward.

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EM corporates continue to maintain strong balance sheets, especially compared to their DM peers. With sector spreads at historically tight levels, we are seeking value in the primary market and in shorter-dated HY corporates.

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"Western Asset continues to favor the transportation sector, anticipating growth in global air travel demand in 2025. Despite rising labor and maintenance costs as well as increased airport fees, large legacy carriers benefit from increased demand for premium fares and have strengthened their balance sheets, maintaining substantial liquidity."

Suzanne M. Trepp, CFA
Research Analyst

INDUSTRY THEMES

Industry

Key Observations

Auto & Related

We favor a neutral sector positioning with a bias toward US auto manufacturers as they are stronger and pragmatic about EV market prospects and profitability. We are closely monitoring potential credit impacts due to higher tariffs and/or trade impacts from President Trump's proposed policies.

Banks

We are maintaining a large overweight for top-quality global banks due to their resilient performance, as banks have lower risk profiles due to stringent regulations, heightened oversight and improved risk management following the GFC.

Energy

Continued management conservatism and positive FCF generation provides stability; excess FCF returned to shareholders, M&A ongoing for scale. Cautious about increasing energy exposure given the aggressive move tighter in valuations last year.

Food & Beverage

Entering 2025, the food sector is carefully following the potential regulatory uncertainty created by the nomination of health-conscious Robert F. Kennedy, Jr. as the head of Health & Human Services. Most food companies have conservative balance sheets and maintain good liquidity that provides financial flexibility in an uncertain demand and regulatory environment.

Gaming

The US gaming sector's fundamentals remain intact, and we expect modest growth opportunities to take hold throughout FYE 2025. Outside the US, we continue to believe in the long-term growth story in Singapore and Macau with a preference for the latter.

Health Care

We are maintaining an underweight in IG health care due to the cyclical and secular decline in credit quality, rich valuations and negative event risks.

Metals & Mining

We remain overweight the sector with a bias toward copper producers. All eyes remain on Chinaâ€”its economic policy, reform agendas and subsequent execution, given its role as the largest consumer of commodities.

Pharmaceuticals

We are underweight IG pharmaceuticals on continued sector headwinds. Lower-rated specialty pharma is expected to pursue aggressive liability management this year.

Retailing

Discretionary consumer spending is expected to be mixed in 2025 as the low-income consumer is supported by jobs and real wage gains, while the high-income consumer is supported by rising wealth effects. Potential new tariffs represent a headwind for both retailers and consumers, who will absorb a portion of any additional tariffs that will have the greatest impact.

Telecommunications & Media

Our view remains fundamentally constructive, despite the maturing market and increased competitive intensity, as the leading operators continue to grow free cash flow and remain focused on their balance sheets. We remain selective within media given the secular shift from linear TV to streaming.

Transportation

Demand for global air travel should continue to grow in 2025 as consumers continue to prioritize experiences over things, and as corporate travel has almost fully recovered. The large legacy carriers are also benefiting from the structural rise in demand for premium fares. Most of the airlines have repaired their balance sheets over the past several years, and continue to maintain large liquidity cushions.

Utilities

We remain focused on first mortgage bonds and transmission & distribution assets. The industry continues to generate material negative free cash flow with large and growing capital budgets. The regulatory environment and ability to recover costs remains key to company assessments.

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Macro Market Trends:

Global Economic Perspectives from the Desk

Our new quarterly publication aggregates the expertise of our global investment leaders under CIO Michael Buchanan, synthesizing their insights into the Firm's comprehensive house view. The inaugural edition delves into the potential effects of Trump's proposed tariffs on global fixed-income markets.

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