Fixed Income Perspectives 2H23 Outlook: Jobs Market Puts Fed in a “Hawkward” Situation

After skipping a rate hike in June, resilient labor markets are increasing investor uncertainty about the Fed’s future policy decisions. We expect intermittent volatility as investors digest the Fed’s attempts to thread a needle between economic growth and sticky inflation. Below are our key takeaways on the looming questions regarding the impact of Fed policy and the direction of the global economy and financial markets.

1. Sticky inflation will stay above the Fed’s target for longer

A downshift in consumer spending, higher borrowing costs and tighter credit standards will weigh on growth, the impact of which will be partially offset by healthy private sector balance sheets along with government and business investment in reorienting supply chains and labor-saving technology. The downward pressure from goods prices will pull overall inflation lower in the near term, but sticky wages resulting from a tight labor market will keep inflation above the Fed’s target.

2. Europe at risk of stagflation as inflation persists in the wake of a slowdown

Investment in defense and energy security will support growth in the near term but won’t boost potential growth in the long run. Despite monetary policy tightening, the structure of the European labor market will keep wage growth elevated and core inflation above the ECB’s target, fanning fears of stagflation.

3. China’s aspiration for a consumer-led economy remains out of reach

Despite high youth unemployment, policy stimulus will remain limited as the traditional policy of investment in housing and infrastructure has a diminishing impact on productivity and growth. The resulting slower growth and a lack of trust in domestic institutions will put at risk the transition to a consumer-led economy.

4. The desire for security will counterbalance the global trend of cost optimization

Heightened geopolitical tensions create a desire to increase self-sufficiency in essential commodities and technologies. The resulting inefficiency from noneconomic considerations will serve as an inflationary impulse for years to come. A desire to move away from the U.S. dollar (USD) will increase non-USD denominated trade, but efforts to replace the dollar as a reserve currency will fail due to a lack of confidence in alternatives.

5. DM central banks still tightening, while the window for EM central banks to cut is opening

Inflation remains the primary concern for central banks in advanced economies, keeping them resolute in maintaining a restrictive stance as long as inflation is above target. In the U.S. the Fed will only consider cuts in 2023 in the unlikely event that inflation falls below 3% and unemployment surpasses long-term average levels. With wage growth elevated, the ECB will continue to tighten until policy is clearly restrictive. In contrast, high real rates and weakening commodity prices will allow emerging market CBs to begin to cut rates.

6. Growth concerns favor up-in-quality investments, and higher rates restore fixed income as a portfolio anchor

A return to positive real rates will push investors to favor high-quality liquid fixed income as concerns about growth and credit losses mount. As market concerns focus primarily on growth, negative correlation between rates and risky assets will prove the norm, though fears of sticky inflation will cause correlations to periodically reverse alongside bouts of market instability. Corporate margins will come under pressure, but defaults will remain well below historical cycle peaks, limiting the depth of a market correction.

Investment grade: Valuations are less attractive after spreads retraced from mid-May levels, but all in yields continue to attract demand for the asset class.

High yield: We prefer high-single-B credits until there are more attractive opportunities to add risk.

Senior loans: We are avoiding consumer-reliant issuers with weaker credit profiles, particularly those with discretionary offerings and exposure to low-to mid-tier consumers.

Agency RMBS: A pause from the Fed, along with continued inflows to mortgage funds, is likely to strengthen mortgage performance over the next few months.

Securitized credit: Improving agency RMBS dynamics have helped lay a foundation for securitized credit sectors to rally.

Emerging markets: External factors such as a potential U.S. recession and the possibility of more aggressive Fed policy pose a risk to emerging markets.

Global rates and currencies

• Global markets show signs of diverging growth between the U.S. and the rest of the world. Primarily, this is due to the Fed’s aggressive and early stance in tightening, as well as an impending impact of stricter lending standards in the U.S.
• Inflation is predicted to drop globally, barring a significant commodity shock. However, European services inflation resilience has led to the market pricing in prolonged tightening in Europe compared to the U.S.
• While central banks will aim to hold rates steady for an extended period, we believe markets will likely price in rate cuts. This dynamic could lead to periods of intermittent volatility.

Investment grade corporates 

• Investment grade (IG) corporate spreads widened to +148 basis points in mid-May due to increasing rate volatility, rising concerns about the debt ceiling, and pressure on regional bank equities, but retraced late in the month to finish just 2 bps wider.
• 1Q 2023 corporate earnings exceeded expectations, with the S&P 500 reporting a 2.3% revenue surprise and a 6.6% earnings surprise. Notably, most regional banks outperformed expectations, with deposit outflows not as severe as feared.
• However, the lower EBITDA from reduced earnings is impacting leverage levels, leaving some IG companies less well positioned for a potential recession, and downward pressure is expected as growth slows.

High yield corporates 

• In May, high yield (HY) spreads widened slightly as equities struggled to find direction, and the increase in rates impacted total returns.
• The fundamental outlook remains unclear, and valuations are fair but not significantly cheap. As a result, we prefer high-single-B credits until there are more attractive opportunities to add risk.
• We are overweight builders/building products, retailers (specialty), energy (E&P) and chemicals (specific names rather than sector-wide).
• We are underweight cable/wirelines, financials and technology.

Senior loans 

• Senior loan performance was negative in May due to lower prices and weakening technicals amid continued retail outflows and decreased CLO issuance.
• 1Q earnings season themes include weakness in media & broadcasting issuers, decreasing margin pressure, rising borrowing costs, and decompression in lower-tiered single Bs/CCCs.
• The portfolio maintains a low single-B risk profile, with a neutral weight in BBs, underweight in CCCs.
• We are avoiding consumer-reliant issuers with weaker credit profiles, particularly those with discretionary offerings and exposure to low-to-midtier consumers, as these companies are expected to face the most significant downward earnings pressure in 1Q/2Q.

Securitized credit

• Looking forward, we remain positive overall on securitized market dynamics. Agency RMBS dynamics have improved, with FDIC lists continuing to be well received and lower rate volatility, providing tailwinds for performance in the near term.
• CMBS credit concerns will remain as the market searches for clearing levels for BBB and below level risk, but with near-term loss potential reduced, selling pressure should remain light. We believe technicals will drive CMBS price action in the near term and the balance is in favor of buyers, especially for ‘A’ and above rated risk not leveraged to office properties.
• Fundamentals still appear to be cracking in loan markets and with low-income consumers (relevant for certain ABS sub-sectors), but a more definitive turn in the economic cycle currently appears months away as tight labor markets and a more solid housing market provide support.
• In the meantime, sponsorship should remain steady across consumer ABS, CLO and RMBS sectors, with opportunistic support for CMBS as yield-hungry markets search for the cheapest cash flows.

Agency RMBS 

• Net issuance for 2023 is projected to be roughly $550 billion, similar to the supply number seen in 2022. Organic net supply projections have been reduced, but this should be offset by FDIC liquidations and additional support from Fed runoff.
• A pause from the Fed, along with continued inflows to mortgage funds, is likely to strengthen mortgage performance over the next few months.
• With supply remaining low, a revival in banks’ demand could significantly tighten spreads.

Emerging market debt

• External factors such as a potential US recession and the possibility of a more aggressive Fed policy pose a risk to the emerging market (EM) debt asset class. Meanwhile, disappointing data from China, a halt in reopening momentum, and declining commodity prices pose additional challenges to EM fundamentals.
• Inflation has peaked in most EM countries, pointing to future disinflation, but core CPI remains sticky. Central banks in LatAm and CEEMEA are nearing the end of their tightening cycles and could start cutting rates, aided by easing DM inflation, a likely Fed pause and a benign USD.
• Political risk remains high across LatAm, and a commodities price selloff is becoming a headwind for EM corporate credit metrics, with companies experiencing continued gross margin pressure and increasing defaults among B/CCC rated corporates in China and Brazil.