These are the six major themes influencing positioning across our fixed income portfolios for the second half of 2022.
Global energy and food
Higher prices act as a tax on global consumer demand, feeding into core inflation and pressuring corporate profits. The impact will vary regionally; the United States is less vulnerable thanks to domestic production and pandemic-era savings. Europe will experience a sharper impact from higher reliance on foreign energy. Import-dependent emerging economies potentially face fiscal pressures and social unrest.
Inflation will decline but remain above the Federal Reserve’s comfort zone into 2023, buoyed significantly by housing costs. Lower demand and fewer supply chain constraints will cool goods prices. Hiring will slow, moderating wage growth and gradually reducing services inflation. Over time, repaired supply dynamics will allow growth and inflation to return to trend.
Central banks must act aggressively to tame inflation, slow growth and balance labor markets. The Fed will have to go beyond neutral to offset lingering effects of fiscal stimulus; the European Central Bank (ECB) will follow, but its policy will remain accommodative. A synchronous global hiking cycle and quantitative tightening will flatten rate curves as markets weigh the risks of policy errors.
Developed market growth
The path to avoiding recession is narrowing. U.S. growth will remain positive in 2022 as savings drawdowns support consumption. Inflation and slowing global growth will weigh on near-term activity in Europe, increasing the likelihood of recession. In the medium term, investments in productivity enhancement, supply chain resilience and renewable energy will support higher growth. Over time, increased government spending on energy and defense will benefit growth.
China / EM growth
China’s zero-Covid policy will keep near-term growth below target. China’s will be the only major central bank to actively ease policy, but monetary and fiscal support will target specific economic sectors. Other emerging economies will struggle in the face of higher developed market rates, a strong U.S. dollar, high food and energy prices, and local rate hikes.
Less accommodative monetary policy and uncertain growth will drive volatility; less liquid assets will require larger premiums. Volatility eventually will settle at a level higher than the norm since the Great Financial Crisis. Central banks will provide less support in an environment of structurally higher inflation. Recalibration of equity multiples and credit spreads will overshoot, providing opportunities for investors to profit from mispriced risks.
Bond Market Outlook
Global rates: The synchronous global hiking cycle should continue through 3Q22; the greatest risk is overtightening into a recession.
Investment-grade corporates: The macro environment remains a minefield for credit; with uncertainty high, we remain cautious despite solid fundamentals and more attractive valuations.
High-yield corporates: Fundamentals look fine; valuations look materially better and offer potential if we can avoid a harsh recession/default cycle.
Senior loans: The medium-term loan outlook continues to reflect primarily technical factors and secondarily fundamentals, given a somewhat supportive backdrop entering 2Q22 earnings reporting.
Securitized assets: We expect collateralized loan obligations (CLOs) to outperform thanks to improved relative value and attractive yields.
Emerging markets (EM): The global backdrop remains challenging for EM assets. Asia ex-China is likely to be the strongest region this year.
As of 06/30/22. Source: Bloomberg, JP Morgan and Voya Investment Management. Past performance is no guarantee of future results
Global rates and currencies
The synchronous global hiking cycle should continue through 3Q22. The most important question is: How rate sensitive is the post-pandemic economy? A much higher allocation to equity and higher leverage on cheap capital make the economy more sensitive to rates. On the other hand, correcting supply-side imbalances such as lower home inventories and lower energy capital investment may require higher terminal rates. To cool price pressures, the U.S. needs a negative output gap. To create this gap, the Fed needs to tighten financial conditions by about 300 basis points (bp). This tightening will work through the system for about a year, destroying wealth and demand.
The biggest risk is that the Fed overdelivers in trying to avoid a 1975-type error, when the Fed reversed course prematurely in response to recession and allowed inflation to become entrenched. The path from 8% inflation to 4% will be relatively easy, but getting from 4% to 2% likely will require layoffs. There are two possible paths: (1) bigger and earlier hikes to reduce the chance of entrenched inflation (and hence less need for a higher terminal rate) — bearish short term but bullish medium term; or (2) the market takes it for a policy error as the Fed gets tossed around by low-quality data. The tiebreaker of these paths resides with the inflation curve.
Investment grade corporates
After hanging near the +130 level, IG spreads sold off sharply following the June CPI release, ending the month 25 bp wider (the widest in two years). The macro environment remains a minefield for credit. Recession fears have become dominant in the markets, with higher-beta credits feeling the pain as the focus shifts to credit risk in a downturn. Second-quarter earnings will shed more light on corporate fundamentals, which we expect to be solid. Moving forward, the key will be guidance. Currently, option-adjusted spreads of +155 are at levels that usually lead to positive 12-month excess returns, but we don’t think the widest levels are in yet. Uncertainty is high, so we remain cautious.
June started OK but soon got ugly as HY spreads blew wider and the whole asset class repriced. BB rated bonds got hit a little less, gaining back some YTD underperformance. Single B rated bonds got hit a bit harder, and CCC rated bonds were again pressured after getting hammered in May. Fundamentals look fine, if not so relevant; technical factors may be a tailwind if we see a shift. Valuations are looking materially better and offer potential if we can avoid a harsh recession/default cycle. If we see inflation start to moderate and the Fed rhetoric chills, HY can bounce back. If we don’t, and a hard landing becomes the base case, HY will go lower. Place your bets: soft landing = buy, hard recession = sell.
Beyond the visible forward calendar, which is relatively concentrated, near-term new-issue activity is expected to remain sporadic until the backdrop improves. Assuming no meaningful improvement in macro conditions over the summer, spreads are expected to reflect higher risk premiums. Defaults, however, are not anticipated to increase significantly from current low levels over the next 12 months. Downgrade activity is likely to be a bigger concern for the loan market over the medium term. We continue to closely monitor credit selection and positioning, given the prospects of sector and rating dispersion as we head into typical pockets of summer illiquidity amid macro uncertainty; and likely, a weaker earnings environment.
Agency residential mortgage-backed securities (RMBS) were taken to the woodshed in early June, dropping 229 bp versus Treasuries. After the FOMC meeting, however, they reclaimed 66 bp of performance before month-end. Lower coupons suffered the most as fears of impending Fed sales weighed on prices. With the Fed’s tapering announcement behind us, the prospect for asset sales decreasing, and the Fed tightening cycle already underway, much of the uncertainty that has been clouding the MBS market has been removed. Going forward, RMBS performance will be affected mostly by swings in rate volatility as investors react to the Fed’s hiking schedule.
We have upgraded our assessment of collateralized loan obligations (CLOs) to positive. After underperforming dramatically in May and widening materially in June, we expect CLOs to outperform thanks to improved relative value, reduced issuance, attractive yields and the appeal of floating-rate/low-duration investments as market rates rise. There is clear risk to our outlook, however, as the drawdown in the loan market has been highly correlated with CLO spread moves. While the income-producing features of CLOs will increase in value as the Fed continues its hiking regime, the aging of the economic cycle brings credit risk associated with a potential recession.
We maintain a positive assessment of asset-backed securities (ABS), albeit with less conviction following two months of outperformance. Significantly improved yield/spread profiles are attracting more interest from income-focused buyers, and strong underlying collateral performance/transaction de-leveraging has supported risk-taking. We believe fundamentals will prove supportive as seasonality keeps most payment performance metrics at or inside pre-Covid levels. While the sector will lag in most risk-on markets, longer-term outperformance potential is high given the current outlook for lower growth and the rapidly evolving economic cycle.
We maintain a positive assessment of commercial mortgage-backed securities (CMBS). CMBS have enjoyed a reprieve from what had been historically high new issuance: June’s $10 billion plus represented a year-to-date low and a third month of decline. Within the CMBS ecosystem, credit appetite is deep and perceptions of risk have shifted lower. We see tightening potential down the stack as well, thanks to reduced supply pressures. This call is lower conviction, however, until income re-emerges as a priority versus the current focus on risk management.
June was a painful month for EM as hard currency spreads widened and the credit curve steepened. The global backdrop remains challenging for EM assets, which are confronted by continued inflation, declining growth expectations, a hawkish Fed and tightening financial conditions. Asia ex-China is likely to be the strongest engine of EM growth this year. Chinese growth is biased toward downside risk despite government pledges of more stimulus. The growth outlook in Eastern Europe is deteriorating, impacted by Russia’s war in Ukraine and EU recessionary fears. Despite the lower demand outlook, commodity prices are likely to remain elevated; this will boost exporting nations but will weigh on domestic consumption, particularly in Europe and Latin America.