Most credit markets generated negative total returns in November. At the forefront of investors’ minds were upcoming central bank tapering efforts and growing geopolitical headwinds, while mounting inflation pressures have increased uncertainty around future monetary policy and how aggressively central banks will respond. Evidence of a new Covid wave in Europe and the global spread of the Omicron Covid variant – which we do not expect will result in the same level of shutdowns as in the early days of the pandemic – led to new restrictions and spooked investors late in the month.
Despite growing risks, the fundamental backdrop remains relatively strong. Third-quarter earnings were mostly positive, albeit coming with increasing input costs and forecasts of less robust growth heading into 2022. The technical backdrop also has remained largely supportive, as demand continues to be robust with issuance expected to moderate next year. In addition, despite expected tightening by central banks, current levels of accommodation continue to support markets.
Against this backdrop, our fixed income allocations remain unchanged and we continue to buy selectively. While recent spread widening in certain asset classes has created some more attractive entry points, valuations remain near fair value and will likely continue to be largely range-bound.
US Macro View
Markus Schomer, CFA, Chief Economist
Raising the US Macro Bull Case
We raised our bull case US Macro scenario probability to 45% and lowered our central case to 40%. Our bear case is unchanged at 15% due to the risk of a new Covid flare-up and Fed policy errors.
The Fed. Now that chair Powell is renominated, we can stop speculating about strategy changes. But can the Fed stick to Powell’s slow taper and “rate-hikes-far-off- in-the-future” plan? Nobody thinks inflation is transitory anymore, and we’re running the risk of developing a wage-price spiral. Already, some FOMC members want faster tapering and earlier rate hikes.
Fourth-quarter trends. Purchasing managers’ index (PMI) surveys flagged the US growth reacceleration early. Retail sales and industrial production confirmed that economic activity picked up again in October. Only housing was disappointing, still beset by both surging input prices and serious labor shortages. We should remain on pace for our fourth-quarter US GDP growth forecast of 5%.
Peak inflation. Oil prices started to ease, but US inflation pressures are not likely to slow substantially until next March, when base effects from the current surge kick in. Between March and October of 2021, monthly headline inflation averaged 0.6%. Anything lower than that will allow the year-over-year rate to slow. But we don’t anticipate Consumer Price Index (CPI) inflation falling back below 4% until next August or back to 2% until the summer of 2023.
Target Portfolio Allocations (as of 23 November 2021)
John Yovanovic, CFA, Head of High Yield Portfolio Management
Fundamentals remain solid but face harder comparisons as we shift to a midcycle recovery. Third-quarter earnings produced a continuation of across-the-board upside surprises with some small misses in the consumer, telecom, and utilities sectors. Energy results remained solid and supply discipline is holding. Management teams continue to note rising labor and input costs, but companies generally are getting price increases to compensate, in some cases with incremental margin.
Spreads remain range-bound but resilient in the face of rising US Treasury yields. We remain in the 270-300 option-adjusted spread (OAS) target of our spread model. Spreads are fair near-term, but we continue to see merit for the asset class, which remains attractive relative to other options. At current spread levels, though, there is likely not enough cushion to fully absorb increases in interest rates. Our spread model continues to suggest 4% to 5% annual returns. Carry remains king. BB/B credit remains favored, and first-time issuers continue to provide value opportunities.
Primary issuance continues at a moderate pace, surpassing US$500 billion for 2021, a record. Despite rates pressure, inflows have returned and technicals remain solid. Year-to-date (YTD) outflows total US$10.6 billion, which have been more than offset by institutional inflows. These trends should continue into 2022. (Technicals based on JP Morgan Securities data as of 17 November.)
Leveraged Finance Allocation Decision
We maintain our allocation of 35%. Earnings improvement is expected to slow to more normal levels from the sharp recovery earlier this year. Valuations have improved, with spreads recently trading through the top of our OAS range, but remain around fair value. We continue to favor floating-rate loans and investment grade (IG) collateralized loan obligation (CLO) debt, as we expect rates to be a headwind in 2022. Overall we still favor credit, keeping portfolio risk around a beta greater than or equal to 1.0 and maintaining relatively higher current yield and portfolio option-adjusted duration at or below index levels.
Investment Grade Credit
US Dollar Investment Grade Credit
Dana Burns, Portfolio Manager, US Dollar Investment Grade Fixed Income
With net leverage now below pre-Covid levels and rising stars expected to well outpace fallen angels in 2022, fundamentals have improved. Nevertheless, we remain concerned about margin pressure in the industrial sector due to rising input costs. The reopening of economies continues to drive demand.
Credit spreads look more attractive given recent spread widening. We still find all-in yields and select credits and sectors attractive.
The technical backdrop for credit has improved recently with the return of foreign demand. Low broker-dealer inventories (negative in the five- to 10-year bucket) remain. Near-term concern surrounding Fed policy may slow demand.
Non-US-Dollar Investment Grade Credit
Roberto Coronado, Portfolio Manager, Non-US-Dollar Investment Grade Credit
Neutral. Companies in general continue to beat expectations, while net leverage is slightly below 2019 levels; balance sheets remain in good shape. We continue to monitor merger and acquisition (M&A) activity given the recent increase, but we are still comfortable with the credit metrics.
Neutral. Credit spreads have recently widened but they are still close to fair value at the index level. We expect volatility to increase somewhat in coming weeks, albeit from very low levels. We still believe that sector and security selection are central to outperformance.
Positive. The technical picture has remained supportive thanks to continuous buying from European Central Bank (ECB) programs and positive inflows into the asset class since the summer.
Investment Grade Credit Allocation Decision
We maintain our allocation of 20%. The fundamental backdrop is largely positive and demand for credit has remained strong, but we have seen increased uncertainty in the outlook for 2022. We expect issuance to slow next year and view this as a positive technical factor against the backdrop of steady demand from foreign investors.
Anders Faergemann, Portfolio Manager, Emerging Markets Fixed Income
While China’s slowdown has been well telegraphed and largely priced in by financial markets, less well-known is that ASEAN countries are likely to see stronger economic growth in 2022 than in 2021. Likewise, our forecasts are showing a pickup in activity in Central and Eastern Europe next year. Above all, China now has less influence on global investments than in previous business cycles.
Sovereign spreads have widened approximately 20 basis points (bps) in the recent wobble, yet maintain a positive tone within a narrow range of +340-360 bps over US Treasuries. The overall index is at +357 bps, IG is at +147 bps, and high yield (HY) at +611 bps. Sovereign HY spreads have widened slightly more yet continue to trade well within this year’s range of +555-628 bps over US Treasuries. (Valuations based on JP Morgan and Bloomberg data as of 19 November 2021.)
Emerging market outflows have been modest in the face of the recent spike in market volatility. JP Morgan has scaled back on its issuance expectations of US$60 billion before year-end, in line with our predictions. We believe gross issuance will decline significantly in 2022 from 2021. Net issuance will likely be modest and centered around IG.
Steven Cook, Co-Head of Emerging Markets Fixed Income
Our scores remain unchanged. With over half the companies in the MSCI Emerging Markets index having reported third-quarter earnings, 50% beat expectations. Top-line revenue and EBITDA were up 25% and 24% year-over-year, respectively (MSCI as of 11 November). Among our covered companies, 32% beat analyst expectations and only 5% of those that have reported have a negative six-month credit outlook.
Spread-to-worst on the CEMBI BD was virtually flat at 264 bps, with HY (up 11 bps) underperforming IG (down 5 bps) (JP Morgan as of 17 November). HY performance was driven by a 256-bp move wider on the month (which was retraced by 252 bps late in November) due to China’s property sector woes. We retain our bullish scores given that the market is currently mispricing the default risk on our coverage in Asia and because we believe there is limited contagion risk to the broader market, offering a spread pickup versus other asset classes.
With $19 billion of supply through mid-month, issuance declined overall but picked up slightly in Asia, accounting for 44% of the total. Net issuance of $294 billion YTD is in line with full-year expectations, so we expect limited issuance into year-end. On muted supply expectations and fund flows that haven’t changed significantly, we still see new allocations to the asset class. (Technicals based on JP Morgan data as of 15 November.)
Emerging Markets Allocation Decision
We maintain our allocation of 25%. EM investors are used to noisy headlines and market trepidation, yet risks related to China and the Fed are known, and emerging markets are in better shape than during previous periods of volatility. Spreads are attractive on a relative basis and fundamentals remain strong, yet the time of year may warrant some caution on technicals. As a result, we continue to buy selectively.
Andrew Budres, Portfolio Manager, Securitized Products
Fundamentals are still challenging. Mortgage rates are headed higher, but originators have no shortage of lower-quality borrowers brushed aside during high-production months or customers looking to refinance via cash-out products.
Spreads have already been taking into consideration an imminent taper. Higher rates or steeper curves should be good for mortgage-backed securities (MBS) spreads.
MBS supply will be much lower in 2022 than in the record year of 2021, but a hot housing market will keep the mortgage churn going as home sales spur refinancings and new loans.
Securitized Products Allocation Decision
We maintain our allocation of 20%. MBS performance since September has been correlated to rates movements, not Fed tapering. Any rumors about faster tapering most likely would impact MBS valuations negatively, as doing so probably could be accomplished more easily via MBS operations rather than Treasury operations. Against this backdrop, we are neutral to slightly cautious for the asset class.
Dmitri Savin, Portfolio Manager, Portfolio and Risk Strategist, Emerging Markets Fixed Income
Decoupling of policy expectations between the Fed and the ECB/ Bank of Japan have become more prominent in recent months, accentuating the current upward trend in the US dollar against the euro and the Japanese yen, which also have been beset by terms of trade factors.
We have moved our euro/US dollar forecast to 1.1250 within a range of 1.1000-1.1500 for the next 12 months. We are slightly long the US dollar and underweight the euro. We have changed our 12-month forecast range for US dollar/Japanese yen to 112.50-117.50. We are neutral the yen.
According to JP Morgan and International Monetary Market data through 15 November, net US dollar length is currently +$18.6 billion, equivalent to +0.8 standard deviations above five-year averages. However, it appears there is still room for the US dollar to gain in the context of a more open-minded Fed.
Non-US-Dollar Currency Allocation Decision
We maintain our 0% non-dollar allocation. While the technical break of 1.1500 in the euro/US dollar has opened the possibility of the pair moving lower faster than expected a month ago, we want to flag positioning and seasonal factors as potential triggers for a December reversal. Fundamentals and technicals justify an extension of the US dollar appreciation trend.
Our Scenario Probabilities Remain Unchanged Over the Month
Fixed Income Scenario Probabilities – Next 12 Months (as of 23 November 2021)
About This Report
Fixed Income Asset Allocation Insights is a monthly publication that brings together the cross-sector fixed income views of PineBridge Investments. Our global team of investment professionals convenes in a live forum to evaluate, debate, and establish top-down guidance for the fixed income universe. Using our independent analysis and research, organized by our fundamentals, valuations, and technicals framework, we take the pulse of each segment of the global fixed income market.