The Market Shifts Focus from Inflation to Growth

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As inflation continues to head in the right direction, it’s time to focus on what’s next for growth—can the Fed pull off a soft landing?

Inflation was the dominant story of 2023. Market participants spent the year fixated on monthly CPI prints to gauge how far the Fed would have to go in its tightening cycle.

While inflation remains stubbornly high, the general trend is heading in the right direction, giving room for the Fed to start thinking about rate cuts. Against this backdrop, the market is starting to shift its focus to economic growth and the Fed’s ability to pull off the so-called “soft landing.” Here’s what our team is monitoring amid this changing market backdrop.

Insulation starts to wane

When interest rates started to rise, we noted that many areas of the economy had “insulation” from the potential damaging effects of higher rates. For example, as the lefthand charts shows, many borrowers locked in long-term financing at super-low rates during Covid. However, as I noted in my recent letter, insulation is not immunity. And over time, insulation wears thin. As the chart on the right shows, delinquency rates are trending upwards, a sign that consumers are starting to feel the pinch of higher rate.

Consumers locked in lower mortgage rates (billions)
Consumers locked in lower mortgage rates (billions)
But higher rates are now taking a bite
30+ day DQ rate by FICO: unsecured consumer loans
But higher rates are now taking a bite

Source: Fannie Mae, Freddie Mac, Intex and Voya Investment Management. UPB = unpaid balance and is in reference to outstanding mortgages.

Like consumers, many corporations have also locked in long-term financing at low rates. However, we’re keeping a close eye on new financing. The left chart below shows that $3 trillion of U.S. investment grade debt maturing in the next five years has a coupon under 5%. In 2023, newly issued bonds had a coupon 2.25% higher than that of the maturing bond. This means businesses will need to spend more to tap capital markets for debt financing. The good news for investors is that at current rate levels, we expect this pressure to stay contained to earnings. In other words, higher financing costs shouldn’t turn into a wave of corporate bankruptcies.

Corporations locked in lower rates (billlions)
U.S. inv. grade corp. debt by maturity and coupon
Corporations locked in lower rates (billlions)
But new issuance comes at a price (percent)
Avg. issued coupon - avg. maturity
But new issuance comes at a price (percent)

Source: ICE BofA, JP Morgan and Voya Investment Management

First chart Investment Grade corporate debt as represented by the ICE BofA Corporate Bond Index a of 06/30/23. Second chart as of 12/15/23.

Uncle Sam to the rescue (for now at least)

U.S. government spending is expected to remain the largest driver of economic growth in 2024, even as it declines in percentage terms. While this is welcome support in the near term, having an economy dependent on government spending is not ideal for establishing a long-term upward economic growth trend. The more that consumers and corporations can contribute their share to the economy’s growth, the better off we’ll be.

So yes, inflation is cooling and rates have found a plausible upper bound, but this does not mean we’re headed for a period of uninterrupted global expansion. The insulation that has protected many areas of the economy from higher rates is certainly starting to wear thin. As the market homes in on economic growth, we will continue to monitor these trends closely as 2024 unfolds.

Rates, spreads and yields
Fixed income sector total returns as of December 31
Rates, spreads and yields
1

As of 12/31/2023. Source: Bloomberg, J.P. Morgan, Voya IM. Past performance is no guarantee of future results.

Sector outlooks

Investment grade corporates 

  • Overall, investment grade issuers have shown better-than-expected earnings for 3Q23 and we believe earnings have troughed.
  • Investment grade (IG) fundamentals remain resilient although leverage and interest coverage ratios have weakened with the move higher in rates. 3Q23 revenues for IG issuers contracted 0.6% YoY, continuing the trend lower over the past six quarters.
  • New issuance in December was in line with expectations and ultimately did little to change the technical picture. However, expectations for January issuance are near $165 billion, which would be the second highest monthly issuance amount on record.
  • From a positioning perspective, we reduced our exposure to banking and utilities ahead of the expected January supply increase. In general, IG credit continues to offer attractive yield. However, we are neutral on spreads at these levels.

High yield corporates 

  • The market remains concerned about future corporate margins due to diminishing pricing power and rising labor costs.
  • From a fundamental perspective, we continue to have concerns about margins in coming quarters as companies’ pricing power slows and higher labor costs continue to flow through.
  • In our view, weaker earnings growth and higher interest costs will inevitably weigh on credit quality, extending the increase in defaults and credit stress.
  • From a positioning standpoint, we are overweight builders/building products, healthcare/pharma and energy. We are underweight technology and financials.

Senior loans 

  • We retain our cautious stance and are underweight cyclical sectors and those dependent on discretionary consumer spending.
  • Overall, senior loans experienced their strongest year since the 2008 financial crisis, finishing out the year with a robust return and outperforming other fixed income classes.
  • 3Q23 earnings for senior loan issuers were mixed, as key metrics showed further signs of deterioration, particularly among lower-rated borrowers. Negative earnings themes flagged by issuers pertain to some early weakening trends among lower income consumer cohorts (retail), continued pressure on linear advertising business models (broadcasting), destocking (packaging and chemicals), and capital needs (telecom and media).
  • From a positioning perspective, we are underweight auto, consumer discretionary, food & beverage, pharma, home health and power. We continue to avoid consumer reliant issuers with weaker credit profiles, particularly those with a discretionary offering and exposure to a low to mid-tier consumer, which should face the most downward earnings pressure in the near term.

Agency mortgages

  • December prepayment speeds are expected to decrease by 5% as weak seasonals and a holiday shortened month weighed on refinancing activity.
  • Bank demand has been erratic, influenced by new regulatory updates, slower deposit growth, and declining commercial and industrial loan demand. Money manager demand is expected to closely follow market volatility and fund flows.
  • Overall, net issuance in 2023 will be close to $450 billion (versus forecasts for $550 billion) and was consistently revised downward as lower refinancing and housing activity impeded origination.
  • Looking ahead to 2024, supply projections vary significantly based on rate expectations and housing. However, overall, fundamentals should remain a positive influence on mortgage returns for most of 2024.

Securitized credit

  • The near-term outlook across sub-sectors is positive, as improving financial conditions are providing a tailwind.
  • CLOs: In the near term, we expect CLOs to outperform. Improving financial conditions (albeit temporarily) alleviate our deeper, longer standing credit concerns, improving the outlook for CLOs to start 2024.
  • CMBS: The sector should continue to benefit from the rally lower in rates. Even after a nice December rally (which was expected), the slower nature with which credit spreads respond to rate movements leaves more premium to be squeezed in CMBS.
  • ABS: After lagging the broader market rally in November and December, the sector is poised to outperform due to the high-quality nature of ABS, attractive yields, and safe haven reputation (all of which make the sector attractive across a wide range of economic and market scenarios).
  • Non-agency RMBS: Like CMBS, this space benefits directly from improving financial conditions and is well positioned to start 2024. Unlike CMBS, the space should also benefit from strong underlying fundamental support.

Emerging market debt

  • Current spread levels continue to screen tight, but absolute yields remain attractive.
  • While China’s latest policy response appears to have stabilized the country’s economic activity, next year’s growth is likely to slow as housing and private sector confidence remain negative.
  • Overall, the emerging market growth outlook is low. While economic activity should pick up modestly in 2024 and compare favorably to developed markets, risks are skewed to the downside.
  • Despite tighter valuations, continued disinflation trends would support tightening in emerging market spreads. EM corporates look more attractive relative to EM sovereigns and US peers, particularly in high yield. Commodity prices have moderated but remain well supported and current levels are constructive for exporters.

A note to our readers

As I transition into my role as CEO of Voya Investment Management, this will be my last time authoring Fixed Income Perspectives. I am happy to be handing the pen to Eric Stein, Voya IM’s newly appointed Head of Investments and CIO of Fixed Income.

Like Voya’s broader fixed income platform, this monthly outlook is powered by the expertise of our 250+ fixed income investment professionals. As I have done these past 14 years, Eric will continue to draw on their insights and our culture of collaboration to bring you our best thinking about the factors driving fixed income markets and returns.

 

 

A note about risk

The principal risks are generally those attributable to bond investing. All investments in bonds are subject to market risks as well as issuer, credit, prepayment, extension, and other risks. The value of an investment is not guaranteed and will fluctuate. Market risk is the risk that securities may decline in value due to factors affecting the securities markets or particular industries. Bonds have fixed principal and return if held to maturity but may fluctuate in the interim. Generally, when interest rates rise, bond prices fall. Bonds with longer maturities tend to be more sensitive to changes in interest rates. Issuer risk is the risk that the value of a security may decline for reasons specific to the issuer, such as changes in its financial condition.

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Past performance does not guarantee future results. This commentary has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults, (5) changes in laws and regulations and (6) changes in the policies of governments and/or regulatory authorities. The opinions, views and information expressed in this commentary regarding holdings are subject to change without notice. The information provided regarding holdings is not a recommendation to buy or sell any security. Fund holdings are fluid and are subject to daily change based on market conditions and other factors.

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