After generating positive excess returns in June, most fixed income asset classes gave back some of those gains in July. A tempered growth outlook due to an acceleration of Delta-variant Covid cases and continued high inflation drove the retreat. Nevertheless, the fixed income market remains skewed toward risk-taking, and investors continue to buy on weakness as they remain comfortable with current monetary and fiscal accommodative measures. In addition, while concerns grow about the Fed tapering sooner than anticipated, we do not expect any central bank action on that front until next year at the earliest.
Against this backdrop, our fixed income allocations remain unchanged, and we continue to be constructive on risk assets, buying on weakness. While a more severe and sustained Covid outbreak could change current market dynamics, governments now seem more prepared to handle an increase in cases, with steadily higher vaccination rates helping to keep hospitalizations and fatalities lower than in prior waves. We therefore expect to continue our current approach until the Fed gets more serious about tapering and scaling back current accommodative measures.
US Macro View
Markus Schomer, CFA, Chief Economist
Maintaining our bull case overweight
We left our scenario probabilities unchanged this month after a more substantial adjustment in June. We maintained the current bull case overweight (at 50% probability) for our US macro scenario given our forecasts for growth and inflation, both of which we expect to exceed 3%. Growth and inflation expectations remain above our central case definitions for much of the 12-month horizon. We continue to expect those two factors to remain in our central case in mid-2022, with GDP in a range around its 2% long-term potential rate and headline and core inflation trending around the Fed target of 2%.
Taper talk. Talking about tapering was again front-and-center at the Fed’s July press conference, where it acknowledged for the first time that some progress has been made. But on the Fed’s maximum employment target, Powell stressed the US is still far from the “substantial progress” threshold.
More fiscal stimulus? The pendulum seems to be swinging back to agreeing on a bipartisan infrastructure package. We wouldn’t bet on it, but at the same time we wouldn’t give up on it. An infrastructure package won’t provide significant near-term stimulus, but would lessen the fiscal cliff by providing some additional fiscal spending in the coming years.
Labor supply. Following the July Federal Open Market Committee (FOMC) meeting, which assessed taper timing, the focus is zooming in on a rebound in labor supply in the fall as catalyst for faster job growth. The Fed wants faster job growth before it starts tapering, so if that growth doesn’t spur hiring, tapering may be further delayed, as we expect.
Target Portfolio Allocations (as of 29 July 2021)
John Yovanovic, CFA, Head of High Yield Portfolio Management
Delta variant concerns started to weigh on investors’ minds, and we await comments during earnings reports. Covid flareups remain a risk, but one that still seems manageable due to vaccine efficacy in developed markets. Commodity prices have retraced a bit as supply and demand come into sync, but demand remains at healthy levels for producers.
Continued declines in Treasury yields have kept demand for credit relatively strong. The recent equity drawdown caused option-adjusted spreads (OAS) to move back to the 300 area (Bloomberg Barclays as of 22 July). Spreads are fair near term, though the view on 2021 is that total returns will be positive on an absolute basis and still attractive relative to the other options. Credit dispersion among issuers remains small relative to history, and valuations remain range-bound near all-time tights.
Primary issuance continues at a steady pace, with 2021 already at $333 billion, similar to annual levels from 2015 through 2019 (JP Morgan Securities as of 16 July). JPM sees 76 new issues in high yield (HY), which is tracking toward a record. Despite a steady stream of mutual fund outflows during 2021, pension funds and insurance companies remain steady buyers. To summarize, a persistent bid at wider levels leads to our neutral score.
Leveraged Finance Allocation Decision
We maintain our allocation of 40%. Amid fair valuations and improving fundamentals, our portfolio risk remains at 1.0. The improved backdrop justifies spread levels and the implied default rate but doesn’t leave much room for total return away from coupons. We see BB and single-B credit as equally attractive, while CCC is less favored.
Investment Grade Credit
US Dollar Investment Grade Credit
Dana Burns, Portfolio Manager, US Dollar Investment Grade Fixed Income
Fundamentals have improved as the economy gets back on track. However, shareholder-friendly activity and M&A are likely to increase.
Credit spreads continue to tighten and overall are now trading through long-term averages. Nevertheless, we continue to see attractive opportunities in select markets.
The technical backdrop for credit is positive due to strong foreign and domestic demand and low broker-dealer inventories. US investment grade (IG) supply in this year’s second half is forecasted to be 30% below first-half levels.
Non-US-Dollar Investment Grade Credit
Roberto Coronado, Portfolio Manager, Non-US-Dollar Investment Grade Credit
Neutral. Companies are reporting better numbers as economies start to reopen and leverage has remained under control, leaving balance sheets in European investment grade names in okay shape. So far, M&A activity in Europe has remained under control, and we do not expect activity to materially increase.
Neutral. Credit spreads are close to fair value at the index level, so we don’t expect a large move tighter. Similarly, we don’t see a reason for them to widen. Sector and security selection are the key to outperformance.
Positive. The technical picture has remained supportive thanks to continuous buying from European Central Bank (ECB) programs, lower supply expectations, and strong inflows into the asset class during July.
Investment Grade Credit Allocation Decision
We maintain our allocation of 15%. Fundamentals continue to improve and demand has remained strong, particularly from foreign buyers. We may see some weakness in the short term due to rising Covid rates and higher-than-normal issuance in August, but we would view this as a buying opportunity as we maintain our buy-on-weakness stance.
Anders Faergemann, Portfolio Manager, Emerging Markets Fixed Income
Growth forecasts for many emerging market (EM) countries are still being revised higher, especially for Latin America and Eastern Europe. Boosted by additional special drawing rights (SDR) allocations, the next cycle is likely to be marked by EM rating upgrades and lower debt ratios. EM’s external position is on a strong footing to withstand tighter US financial conditions, with surpluses in EM current accounts and foreign exchange (FX) reserve levels at record highs.
Sovereign spreads continue to trade in a narrow range, despite the recent blip wider. The overall index is at +356 basis points (bps), with IG +163 bps and HY +603 bps (JP Morgan and Bloomberg as of 23 July). Sovereign IG spreads are close to our estimated fundamental fair value, while sovereign HY spreads still have scope to tighten in tandem with improving fundamentals.
EM governments took advantage of lower US Treasury yields, causing higher-than-expected issuance in June and July. Near-term expectations for EM sovereign issuance are being adjusted lower, however. August is a light cash flow month, which will be outweighed by the extra SDR disbursements in the third quarter and ongoing inflows into the asset class, boosted by positive growth differentials.
Steven Cook, Co-Head of Emerging Markets Fixed Income
We maintain our positive outlook as corporates across EM continue to show conservative balance sheets and recovering profitability. HY net leverage should outperform IG given regional and sector components, declining by -0.9x to 1.9x (the lowest level since 2011), versus IG’s decline from -0.5x to 1.2x, bringing the overall level to 1.4x, all driven by increases in EBITDA across key sectors (JP Morgan as of 6 July).
We view IG short-term valuations as slightly more attractive on the back of EM corporate spreads holding up well despite the move lower in US Treasuries. EM corporates outperformed US credit on this basis and are showing lower sensitivity to rates. Strong liquidity continues to lift global credit, bringing our IG and HY scores in sync. We also retain our bullish long-term score given the spread pickup on offer versus other asset classes.
Net supply turned positive in June at $39 billion as the near-record gross supply was met by scheduled cash flows of $30 billion and elevated tenders/buybacks/calls of $8 billion, bringing total year-to-date net supply to $87 billion. Expected net issuance of $105 billion this year should be easily digested, given that it represents under 4% of the universe. (Technicals data from JP Morgan as of 6 July.)
Emerging Markets Allocation Decision
We maintain our allocation of 25%. During the year’s second half, we expect greater EM growth and narrower deficits to cause EM debt ratios to fall. Improving fundamentals and a strong technical picture, as well as a global backdrop of easy financial conditions, higher commodity prices, and gradual economic reopenings, bode well for EM.
Andrew Budres, Portfolio Manager, Securitized Products
The recent drop in the 10-year yield to below 1.4% has not pushed mortgage rates sharply lower, but could help mortgage originators target those who missed the refinance wave of 2020.
Spreads have widened out about three-quarters of the way to where they would be if the Fed was not buying.
Supply of mortgage-backed securities (MBS) in the first half came in at a torrid pace. It should moderate in the second half, but clearly more MBS will be originated in 2021 than the Fed will be buying.
Securitized Products Allocation Decision
We maintain our allocation of 20%. Even though an early taper focused solely on MBS seems unlikely, the sector’s lagging performance indicates investors are prepping early. As a result, spreads are widening to pre-intervention levels. Spreads may widen further, but we believe most of the impact from eventual Fed tapering is already priced in.
Dmitri Savin, Portfolio Manager, Portfolio and Risk Strategist, Emerging Markets Fixed Income
The market has recently been reacting to increased concerns of a softening global economy, admittedly from a high base, as well as global mobility shifting lower in response to the Delta Covid variant. The market may look to England’s reopening as the test case to determine how well consumer and business confidence hold up in an environment of rising cases amid high vaccination levels. The US dollar and Japanese yen have benefited from their safe-haven status, flattening yield curve, and overweight euro positioning.
We believe the US dollar can gain more against the euro and the Japanese yen once real yields start to rise and break-evens tighten, countering the dominant trend in 2020. Ultimately, the US dollar should end 2021 stronger than it started. We have a year-end forecast of 1.1750.
According to JPMorgan and International Monetary Market data through 25 July, reductions in euro net length have contributed to the dollar crossing over to marginally net long for the first time since March 2020. Euro positioning has been cut by speculative investors every week since the June FOMC meeting and has been the primary source driving US dollar positioning back to notionally neutral.
Non-US-Dollar Currency Allocation Decision
We maintain our 0% non-dollar allocation. We continue to believe the Fed will be in a stronger position than the dovish ECB, although strong July/August Consumer Price Index (CPI) results may test the Fed. As a result, we stick to our view of a mildly stronger US dollar over a 12-month horizon.
Our Central Case Scenario Probability Slightly Increased While Our High Growth Scenario Probability Decreased
Fixed Income Scenario Probabilities – Next 12 Months (as of 29 July 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.