Fixed Income Asset Allocation Insights: Allocation Insights: Brightening Outlook Propels Credit Market Rally
Credit markets continued to rally into December, and valuations now fairly reflect optimism that we are firmly on the path toward economic and earnings recovery.
While these conditions would typically lead to more defensive positioning, we believe that the extremely strong credit market conditions that drove markets in November and December are likely to carry over and support credit risk into 2021. Most notably, we believe additional spread compression is likely amid continued support from central banks, increased investor optimism from progress on Covid vaccine distribution, and a strong technical backdrop resulting from robust demand as investors search for yield and issuance levels moderate.
We remain cognizant of the risks still present in the market, however, including high rates of Covid-19 infections and the emergence of virus mutations, along with political risks including insufficient fiscal stimulus in the US. However, we believe these issues will ultimately be outweighed by the various tailwinds supporting financial markets.
Against this backdrop, our fixed income allocations remain unchanged and we maintain a buy-on-dips approach within our individual asset class portfolios. We also continue to monitor a further shift toward lower-rated asset classes, as rates trading lower should have a smaller impact moving forward.
US Macro View
Markus Schomer, CFA, Chief Economist
Becoming less bearish in favor of the central case Scenarios: We continued to upgrade our scenario probabilities this month, moving another 5% from the bear case (now at 20%) to the central case (now at 75%), with the bullish case unchanged at 5%. The central case would indicate:
Moderate growth (1%-3%): GDP growth in a range around the 2% long-term potential rate
Moderate inflation (1%-3%): Headline and core inflation trending around the 2% Federal Reserve target
Main drivers: Gradual transition from policy-driven to private domestic demand-driven economic growth supported by low interest rates
Unemployment: Labor markets recovering from Covid recession, and wage growth in line with productivity growth
Fed: Policy rates at or below the r-star neutral rate, and an equilibrium real funds rate of 0%-0.25%
Once the Covid-related risks are behind us, we want to end up with a probability distribution tilted to the bullish side (for summer 2021). Until then, we maintain a bearish tilt on remaining concerns about the current Covid surge and insufficient fiscal support.
We are still in the mechanical part of the recovery, with growth determined by the reopening and reclosing of the economy
The economic news flow has become more mixed, with surveys still supporting a strong recovery but falling retail sales and deteriorating jobless claims sending warning signals that macro volatility could increase
Market movers The Fed. Many developed market central banks increased quantitative easing in light of the intensifying Covid crisis. The Fed was the outlier, leaving policy settings in place despite rising recovery risks. And the Fed’s Summary of Economic Projections (as of 16 December 2020) shows no sign of inflation exceeding the new >2% average inflation target in the next three years. So, the inconsistency persists between a more ambitious inflation target and the lack of policy support. Covid. The Covid crisis is dominated by two dramatically diverging story-lines. On the positive side, we now have four vaccines approved, and with EU decisions imminent, all major regions are now starting the vaccination process. On the other hand, rising hospitalizations are pushing health care resources closer to critical limits in the US and in Europe. Surveys versus the real economy. We have remained fairly bullish on the US growth trend in the fourth quarter. Business surveys and consumer confidence indices continue to show strong recovery momentum all the way through December. However, retail sales posted a sharp drop in November, and jobless claims signal deteriorating labor market conditions, which raises concerns about the real economy.
Target Portfolio Allocations (as of 22 December 2020)
For illustrative purposes only. We are not soliciting or recommending any action based on this material. There can be no assurance that the above allocations will be in any account at the time this information is presented. This material must be read in conjunction with the Disclosure Statement.
John Yovanovic, CFA, Head of High Yield Portfolio Management
Fundamentals Fundamentals are still on a glidepath down into second-half 2021. Third-quarter earnings season showed that revenues generally exceeded expectations and earnings beat forecasts across the board, particularly in basic materials and communications. Fundamentals are stable here but are stalled near term and improving into 2021. While sequentially the 2021 fundamental path is higher, we see potential for disappointment at the rate and quality of improvement priced into markets.
Valuations Continued risk-seeking behavior grinds Bloomberg Barclays US Corporate High Yield Index OAS (option-adjusted spreads) to 380 basis points (bps), near our 2021 valuation target (according to Bloomberg Barclays as of 16 December). Spreads are fair near term, though the view on 2021 is that total returns will be positive on an absolute basis and quite attractive relative to the other options.
Technicals Flows are neutral, with spreads breaching +400 OAS in December with passive outflows and small active inflows (Bloomberg Barclays as of 21 December). Primary issuance remains robust as investors continue to reduce cash balances. Primary issuance set a record at $437 billion year-to-date (YTD), exceeding the prior record of $388 billion in 2010 (based on JP Morgan Securities new-issue data as of 11 December). We still see buying on any dips, and technicals remain firm, though ETF inflows have tapered at current levels.
Leveraged Finance Allocation Decision
We maintain our allocation of 40%. We maintain portfolio beta of 1.0 and are fine holding risk there, taking advantage of security selection opportunities that still exist. Valuations are fair in the near term, but technicals and visibility to a recovery should lead to further spread tightening next year.
Investment Grade Credit
US Dollar Investment Grade Credit
Dana Burns, Portfolio Manager, US Dollar Investment Grade Fixed Income
Fundamentals Fundamentals have slowly improved against the backdrop of a gradually reopening global economy. In the near term, the lack of a stimulus package and increasing Covid-19 cases could dent prospects.
Valuations Credit spreads continue to tighten and overall are now trading through long-term averages. Nevertheless, select credits continue to offer value. We still see attractive opportunities at the long end of the curve.
Technicals The technical backdrop for credit is strong due to lower estimated supply for 2021, ongoing foreign demand, and tenders for outstanding issues.
Non-US-Dollar Investment Grade Credit
Roberto Coronado, Portfolio Manager, Non-US-Dollar Investment Grade Credit
Fundamentals Negative. It’s difficult to know how badly economies and corporate issuers will be affected by the current (softer) lockdowns. Similarly, it’s hard to predict how effective the fiscal support will be in keeping small businesses alive and people employed. We need to wait and see how strong the second Covid wave proves to be this winter and how long the current restrictions will last.
Valuations Neutral. Credit spreads have rallied since March and are now around fair value. We continue to be positive over the medium term as we believe spreads can still move tighter due to the technical picture.
Technicals Positive. The technical picture has continued to be very positive thanks to 1) continuous buying from the European Central Bank through the corporate sector and pandemic emergency purchase programs (CSPP and PEPP), and 2) lower-than-expected supply since the end of the second quarter.
Investment Grade Credit Allocation Decision
We maintain our allocation of 20%. Technicals continue to support the market, with notable support from foreign investors who still enjoy favorable hedge-adjusted yields. Credit spreads have continued to trade tighter, although attractive opportunities remain in the market. As a result, we expect security selection to drive alpha generation in the coming months.
Anders Faergemann, Portfolio Manager, Emerging Markets Fixed Income
Fundamentals Our constructive outlook remains intact, supported by China-led recovery and declining default expectations. China growth typically leads emerging market (EM) growth by about three months, and the economic boost usually lasts 12 to 18 months. EM debt levels are up with the pandemic, but we expect them to stabilize and trend lower for at least half of the countries in our universe over the next two years.
Valuations The EMBI Global Diversified Index is trading at +354 bps, investment grade (IG) at +152, and high yield (HY) at +615 (according to JP Morgan as of 21 December). The November rally reduced the attractiveness of short-term valuations, but our fundamental outlook argues for more spread tightening on a 12-month horizon, particularly across HY, where we also advocate selectivity. We believe EM remains attractive versus other asset classes, offering a pickup over US credit markets.
Technicals We expect strong technicals to dominate next year on the back of strong demand for yield and reduced sovereign supply. Inflows continue unabated, reversing all the outflows from earlier in the year and ending in positive territory for 2020.
Steven Cook, Co-Head of Emerging Markets Fixed Income
Fundamentals Third-quarter results are mostly in, and we are more bullish on fundamentals, as leverage has peaked and at a lower level than anticipated. Third-quarter revenue and EBITDA were up 16% and 23% quarter-over-quarter, respectively (JP Morgan as of 10 December). Last-12-month leverage in IG increased to 1.7x (+0.2x versus 2019) and HY to 2.9x (+0.3x), driven by the y/y decline in EBITDA, given net debt was down 7% y/y in the third quarter (JP Morgan as of 10 December). Expectations are for leverage to be flat to marginally lower in the fourth quarter of 2020, and to retrace back below year-end 2019 levels by the end of 2021 given the continued recovery in EBITDA, along with limited expected capex growth resulting in flat or lower debt levels.
Valuations We are neutral on valuations. CEMBI Broad Diversified spreads-to-worst tightened a further 44 bps in the month, with HY (-83 bps) outperforming IG (-16 bps), and are now 20 bps wide to the pre-Covid 250-bp level in February (JP Morgan data as of 16 December). While we are neutral across IG and HY over the short term, we retain a bullish tilt on both in the longer term as spreads versus other fixed income asset classes are attractive, especially when paired with the positive fundamental and technical backdrop.
Technicals Supply was a muted $11.8 billion month to date, while YTD supply of $490 billion is flat y/y (based on JPMorgan data as of 14 December). While gross supply is expected to be marginally higher next year, net supply is expected to be similar to this year. We are more bullish over the short term amid strong demand, as cash levels are high and offers are hard to come by. While we anticipate a busy January, we expect primary market issuance to be well-digested.
Emerging Markets Allocation Decision
We maintain our allocation of 20%. We maintain our buy-on-dips approach and remain constructive on the EM outlook for 2021, with fundamentals and technicals leading the way. Valuations are slightly stretched but remain attractive on a relative value basis against the US and in absolute terms over a 12-month horizon, particularly for EM high yield.
Andrew Budres, Portfolio Manager, Securitized Products
Fundamentals Record-low interest rates are not abating even when the 10-year note drifts higher. There is buffer room in the primary/secondary spread to keep mortgage rates low throughout 2021.
Valuations Mortgage-backed securities (MBS) spreads have been stuck in a neutral zone given the contrast between record supply and the MBS purchase operations.
Technicals If there is a near-repeat in 2021 of the net new supply that occurred in 2020, we should expect a perfect neutralization of supply by Fed buying.
Securitized Products Allocation Decision
We maintain our allocation of 20%. Unless the economy surprises massively to the upside, mortgage rates could stay extremely low for all of 2021, leading to a repeat of the supply technical of 2020. Based on the most recent Fed statements as of 16 December 2020, it appears the Fed’s buying pace will continue throughout 2021, which should neutralize the amount of possible new net supply of MBS in 2021. As a result, we maintain our neutral outlook on the asset class.
Dmitri Savin, Portfolio Manager, Portfolio and Risk Strategist, Emerging Markets Fixed Income
Fundamentals The factors weighing on the US dollar remain intact for the short term. Zero-bound rates, a possible increase in Fed purchase maturities, and fiscal easing should make for cheaper hedging, weighing on the US dollar outlook. In Europe, we look to policymakers to increase their verbal interventions, which could slow the euro’s appreciation.
Valuations We favored the euro on the back of the break of the 1.20 technical level, targeting an overshoot to 1.25. However, we believe the euro/US dollar rate should find a stable range around 1.15 by the end of 2021 and still view a break above 1.20 as a temporary overshoot rather than a new trend.
Technicals According to International Monetary Market (IMM) data through 13 December, the percentage of currencies that are net short versus the US dollar is currently 40% (Canadian dollar, Australian dollar, Russian ruble, and Brazilian real). This is typically more consistent with US dollar net positioning closer to neutral, and thus does not indicate a highly stretched, broad-based dollar short base.
Non-US-Dollar Currency Allocation Decision
We maintain our 0% non-dollar allocation. The continued rise in risk sentiment after the US presidential election, combined with vaccine deployment, has affirmed the market consensus of short-term dollar weakness. Yet on a 12-month horizon it remains difficult to distinguish between the (weaker) outlook for the US dollar and a similar outlook for the other G3 currencies, the euro and the Japanese yen.
Our Central and High Growth Case Scenario Probabilities Increased While Our Recession Case Scenario Probability Decreased During the Month
Fixed Income Scenario Probabilities – Next 12 Months (as of 22 December 2020)
Source: PineBridge Investments. For illustrative purposes only. Any opinions, projections, forecasts and forward-looking statements are based on certain assumptions (which may differ materially from actual events and conditions) and are valid only as of the date presented and are subject to change.
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.
Investing involves risk, including possible loss of principal. The information presented herein is for illustrative purposes only and should not be considered reflective of any particular security, strategy, or investment product. It represents a general assessment of the markets at a specific time and is not a guarantee of future performance results or market movement. This material does not constitute investment, financial, legal, tax, or other advice; investment research or a product of any research department; an offer to sell, or the solicitation of an offer to purchase any security or interest in a fund; or a recommendation for any investment product or strategy. PineBridge Investments is not soliciting or recommending any action based on information in this document. Any opinions, projections, or forward-looking statements expressed herein are solely those of the author, may differ from the views or opinions expressed by other areas of PineBridge Investments, and are only for general informational purposes as of the date indicated. Views may be based on third-party data that has not been independently verified. PineBridge Investments does not approve of or endorse any republication of this material. You are solely responsible for deciding whether any investment product or strategy is appropriate for you based upon your investment goals, financial situation and tolerance for risk.