Fixed Income Perspectives: The battle of the mandates

Lines are being drawn for a battle royale. In one corner, we have easing inflation and economic worries setting conditions for rate cuts. In the other corner, we have the labor market flexing its muscles. Oddsmakers (aka, fed funds futures) say the Fed has one more hike left before it reverses course and takes rates down by year end. Fed Chair Jerome Powell seems to have other ideas. 

Bull case: Rate cuts coming as inflation and the economy show signs of fatigue. The US Consumer Price Index fell by 0.1% in December, signaling that inflation may finally be transitioning lower. Many CPI components have returned to pre-2020 levels. Prices of core goods and energy are declining, and only shelter and food prices remain stubbornly high, although these could soften according to leading indicators such as home sales, new rents and agricultural commodities markets. The US economy, though still relatively buoyant, faces worries about potential earnings downgrades and economic damage from higher rates. Meanwhile, consumers are running up credit balances despite strong wages and a high cost of financing.

Base case: Rate cuts delayed by a tight labor market. US unemployment fell to a near-record low in December and initial jobless claims are hovering above a remarkably low 200,000 per week. There are still roughly two openings for every job seeker, and wage gains remain high (Exhibit 1). Though there are early signs of labor softening — including fewer quitters and fewer assignments for temporary workers — the employment picture is robust. The question is whether job market wobbling will become big enough to induce the Fed to cut rates. Anything short of 5% unemployment feels insufficient.

Don’t hold your breath waiting for lower rates. According to the average of the Fed’s “dot plots,” the central bank sees no need to steer the fed funds rate lower until 2024, contrasting with futures markets suggesting several cuts before year-end. The jobs market is generally key to Fed policy, and we think today is no exception. Inflation is receding but remains stubbornly high, and most people who want a job can probably find one. The Fed is likely to guide the fed funds rate to 5–5.25% as expected, but we see little chance of a cut later this year. As we head towards a rate pause, we favor sectors that benefit from a drop in bond volatility, such as mortgages and investment grade corporates.

Global rates: Global growth is strengthening, but most central banks ex-US are still in tightening mode.

Investment grade: Fundamentals remain relatively strong but valuations look expensive.

High yield: Spreads still are not pricing in enough risk for an outright buy as we expect downgrades to start picking up.

Senior loans: We’re skewed toward stronger names given a rise in downgrades amid deteriorating fundamentals.

Securitized credit: We’re increasingly positive on relative valuations, favoring higher quality CLOs and CMBS.

Agency RMBS: We think recent strength in agency mortgages is likely to continue into 2023.

Emerging markets: Though EMs are in good shape and inflation has peaked, valuations are a bit high for comfort.

Global rates and currencies

• Growth in the US remains strong, while Chinese and European economies are looking better.
• Whereas the Fed appears to be nearing its endgame, the ECB has a long way to go as it contends with spiraling wages. However, headline European inflation is set to decline given the base effect from energy.
• The key question regarding China’s recent economic boost is whether growth will be inflationary due to goods demand, or disinflationary due to goods supply.

Investment grade corporates

• IG corporate spreads started the new year at the tight end of their 9-month range.
• After a quiet December, IG supply has picked up in January as expected, led by financials.
• Earnings reflect a softening of fundamentals but overall remain reasonably healthy, indicating corporations are well prepared for an economic slowdown in 2023.
• Despite favorable fundamentals, valuations look full and warrant a defensive posture, waiting for better opportunities.

High yield corporates

• The fourth quarter rally finally ran out of steam, but fundamentals are still decent, if a bit muddy.
• We believe current valuations are reasonable but don’t adequately price in the risk of a potential economic slowdown.
• Weak equity markets are contributing to the stall in HY spreads, weighing on sentiment.
• Main risks to a blowout in spreads are an overly hawkish Fed, stubbornly high inflation, or a rollover in growth.
• We’re overweight building products and independent energy; underweight financials and consumer cyclicals.

Senior loans

• Medium-term challenge for loans is a degraded backdrop for technicals and fundamentals.
• Decelerating earnings are not helping loan markets. We continue to trade out of weakness (shaky single B) and into strength (stronger single B).
• There were no defaults in the sector last month, leaving the 12-month trailing default rate at 72 bp, well below its historical average.
• Downgrades are accelerating, led by Moody’s, triggered by earnings, margin pressure, excess leverage levels and increasing borrowing costs.
• Our portfolio is conservative now, overweight higher-quality names and maintaining a relatively high cash balance while awaiting buying opportunities.

Securitized credit

• We remain cautious on CLOs. The overhang from aging CLO warehouses improved in Q4 but remains an issue.
• We are positive on CMBS, seeing a tactical opportunity given the lack of coming supply.
• In the short term, we remain positive on RMBS. Issuance remains low, while potential demand from money managers and insurers could be substantial. Longer term, we find comfort in the fact that mortgage credit behavior is well underpinned by strong underwriting and regulatory oversight.
• For consumer ABS, we are downgrading our rating to neutral, citing full valuations following the strong rally in the fall. Nonetheless, fundamentals remain strong.
• We’re net positive on securitized credit overall, though diligent underwriting is particularly important.

Agency RMBS

• Net issuance for 2023 is looking to be similar to the 2022 level of about $550 billion, with the additional supply coming from Fed runoff offset by a slowdown in organic supply.
• Demand-wise, interest rate volatility has been keeping some buyers at bay, and that could easily change in 2023.
• We rate agency MBS as positive in the near term, primarily because we believe fixed income volatility will abate, leading to tighter spreads.

Emerging market debt

• EM credit spreads bucked the trend by rallying in December on the back of a better-than-expected US CPI, China’s reopening and supportive technicals.
• New issuance remained muted in December at about $3 billion across sovereigns and corporates. Relative to 2021, EM corporate issuance was down 60% and sovereign issuance was down 53% in 2022, respectively.
• EM inflation has begun to peak and central bank hiking cycles are nearing an end; inflation will remain above target in most countries and will preclude monetary easing.
• EM valuations are rich following the rally since late October. Like many markets, current levels do not price in a meaningful risk of recession.
• We remain cautious in the near term but China’s reopening would be supportive for EM growth prospects.