Fixed Income Asset Allocation Insights: Keeping Some Powder Dry to Tap Opportunities
Credit markets got off to a strong start in January but ended on a more tentative note, with credit spreads trading roughly flat overall as investors weighed opposing market dynamics. On the positive side were improving recovery prospects due to vaccine rollouts, other pandemic-fighting initiatives, and a higher likelihood of fiscal stimulus, both in response to Covid and as an infrastructure-oriented economic spur. On the other side were new virus outbreaks and resulting shutdowns. Although valuations remain around fair value, a combination of improving fundamentals and strong ongoing demand from yield-seeking global investors should continue to support the market as investors look beyond shorter-term risks.
While we remain constructive on fixed income markets, we are monitoring additional risks that could derail the economic recovery, such as central bank policy errors and political instability in Europe, particularly in Italy. Against this backdrop, we are taking profits in some fully valued investment-grade credit names and moving into shorter-term high-quality government securities. This provides the dry powder needed to take advantage of attractive new opportunities that will likely crop up amid the increased volatility we are starting to see in credit markets.
US Macro View
Markus Schomer, CFA, Chief Economist
Raising the bull case but retaining a bearish tilt We continue to upgrade our scenario probabilities, and this month for the first time are raising our bull case by five percentage points to 10%, “financed” by a reduction in the central case. The central case would indicate:
Moderate growth (1%-3%): We see GDP growth in a range around the 2% long-term potential rate.
Moderate inflation (1%-3%): Headline and core inflation should trend around the 2% Fed target.
Main drivers: A gradual transition from policy-driven to private domestic demand-driven economic growth is underway, supported by low interest rates.
Unemployment: Labor markets are recovering from the Covid recession, with wage growth in line with productivity growth.
Fed actions: Policy rates are at or below the r-star neutral rate, with equilibrium real funds rate at 0%-0.25%.
With the election finally behind us, the accelerating rate of vaccinations and the prospect of more fiscal stimulus spending are reasons to raise the bull case. Yet, with other parts of the world economy falling behind the US recovery pace and Covid-19 trends only just rolling over, we maintain a bearish tilt in the probability distribution.
We are looking ahead to the year’s second half, when we’re likely to move out of the mechanical phase of the recovery and into the start of the post-Covid cycle.
There is a growing divergence between increasingly bullish surveys and weak activity indicators.
Market movers Biden. The first indication of what to expect from US politics in coming years will be Biden’s success in helping to craft a bipartisan stimulus bill. If he prevails, fiscal policy is likely to remain accommodative for a while. If not, we may see a re-run of the last cycle’s austerity wars. Covid. We are at the beginning of the end. All US Covid trends have rolled over and vaccinations are accelerating. The point at which the downward-sloping curve of the infection’s impact on GDP growth intersects with the upward-sloping vaccination curve will signal that we’re entering the post-Covid era. Surveys versus the real economy. The two January preliminary Markit purchasing managers’ indices (PMIs) showed strong gains, further confounding the weakness we saw in December payrolls and retail sales. We think the surveys are telling the story. More and more businesses are reporting better economic conditions, while some of the indications of weaker activity could merely be mean-reversals after excessive surges last year.
Target Portfolio Allocations (as of 27 January 2021)
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 Stable but stalled near-term, fundamentals will remain on a downward glide path into the second half, when they should start to improve. BofA Merrill Lynch strategists are backing into markets, discounting a low-teens EBITDA increase and cash being used for debt repayment in 2021, both of which sound reasonable. The default rate has peaked at about 6.5% and appears headed to 2%-3% (BofA/ML Research as of 15 January).
Valuations Continued risk-seeking behavior grinds high yield option-adjusted spreads (OAS) to 348 basis points (bps), near our 2021 valuation target. BB spreads still appear cheap. Spreads are fair near term, assuming total returns this year will be positive on an absolute basis and attractive on a relative basis. We continue to believe that risk premia will decline and historic valuation measures may prove too pessimistic. Looking at a variety of valuation metrics, return forecasts for the asset class are 2%-5% for the calendar year.
Technicals Flows flipped negative, with outflows of $1.4 billion year to date (YTD), based on JP Morgan Securities new-issue data (as of 15 January), as Treasury yields surprised investors with a 17-bp selloff to start the year. Primary issuance remained robust after 2020’s record $433 billion. The overall risk-on tone, punctuated by rising yields, leads to divergent quality performance. CCC rated energy, transportation, and broadcasting issues have led returns so far this year. A rates selloff has resulted in leveraged loan inflows.
Leveraged Finance Allocation Decision
We maintain our allocation of 40%. We maintain portfolio beta of 1.0 and are fine holding risk there. Valuations are fair near term, but technicals and economic recovery should lead to further spread tightening. BB and select single-B and CCC issuers look like decent value, while rate volatility has curbed investor appetite for BB duration.
Investment Grade Credit
US Dollar Investment Grade Credit
Dana Burns, Portfolio Manager, US Dollar Investment Grade Fixed Income
Fundamentals Fundamentals have demonstrated gradual improvement against the backdrop of a gradually reopening global economy. Near-term vaccine distribution issues, new lockdowns, and increasing Covid-19 cases could dent growth prospects.
Valuations Credit spreads continue to tighten and overall are now trading through long-term averages. Nevertheless, select credits still offer value. We continue to 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, 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 issues will be affected by current lockdowns, or how effective fiscal support will be in keeping small businesses alive and people employed. We need to wait and see how long the current lockdowns will last, but the damage certainly will be felt at the corporate level.
Valuations Neutral. Credit spreads are close to fair value at the index levels, but we continue to be positive over the medium term as we expect spreads to continue moving tighter in certain sectors and names.
Technicals Positive. The technical picture has remained favorable thanks to continuous buying from the European Central Bank and lower supply expectations.
Investment Grade Credit Allocation Decision
We maintain our allocation of 20%. While spreads have largely retraced last year’s widening, we continue to see value in select sectors and credits, notably in long-dated BBBs. We currently look to sell credits trading close to full value in favor of shorter-term high-quality government securities, providing us with flexibility to act opportunistically.
Anders Faergemann, Portfolio Manager, Emerging Markets Fixed Income
Fundamentals Our constructive outlook remains intact, supported by a China-led recovery and the start of vaccination campaigns globally, paving the way for a sustainable reopening of economies. We expect emerging market (EM) debt levels to stabilize and trend lower over the next two years for at least half the sector. We’ll be looking for winners and losers in post-pandemic growth performance.
Valuations Spreads have traded in a very narrow range: the overall index at +355 bps, investment grade (IG) at +150, and high yield (HY) at +617 (based on JP Morgan data as of 22 January). The November-December rally reduced the attractiveness of short-term valuations, but our fundamentals outlook argues for more spread tightening on a 12-month horizon, mostly across HY, where we also advocate being selective. EM remains attractive versus other asset classes, offering a pickup over US credit markets.
Technicals Strong technicals continue to dominate on the back of solid demand for yield and reduced supply. January saw strong inflows across hard and local currency.
Steven Cook, Co-Head of Emerging Markets Fixed Income
Fundamentals Fourth-quarter reporting should confirm whether leverage peaked in the third quarter, with company guidance possibly affirming the deleveraging outlook. We expect leverage to return to 1.7x (IG 1.4x and HY 2.5x) this year on the EBITDA recovery and a decrease in net debt. Default rate expectations are 2.5%, compared to 3.5% in 2020.
Valuations We are neutral on valuations as spreads are virtually flat on the month, with the spread-to-worst on the CEMBI Broad Diversified Index at 270 bps. Expected returns are lower purely due to the upward revision in year-end US Treasury expectations, but there is still room to overshoot on spread tightening given the strong technicals.
Technicals On a year-over-year (y/y) basis, full-year 2020 supply was marginally higher at $497 billion, while net supply was down 40% to $53 billion. IG gross supply increased 14% y/y to $334 billion, but HY declined 18% y/y to $163 billion (based on JP Morgan data as of 6 January). We expect supply to increase 5% to $522 billion this year and net supply to be relatively muted at $78 billion. January primary issuance was robust, as expected, and supply was easily digested. Demand remains strong due to inflows based on relative spread pick-up and a positive fundamental outlook.
Emerging Markets Allocation Decision
We maintain our allocation of 20%. We tactically reduced risk over the November-December rally to be able to step in at better levels. We remain constructive on EM for 2021, with fundamentals and technicals leading the way. Slightly stretched valuations remain attractive against the US on a relative basis and in absolute terms over a 12-month horizon, particularly for EM high yield.
Andrew Budres, Portfolio Manager, Securitized Products
Fundamentals We have seen the first slight hike in mortgage rates, as the 10- year rose by more than one percentage point. Mortgage rates rose about one-eighth of a point on the Freddie Mac survey rate, but most participants believe originators have buffer room to keep the mortgage rate low (Freddie Mac US Mortgage Market Survey as of 14 January 2021).
Valuations Mortgage-backed securities (MBS) performance has been strong since the last Federal Open Market Committee (FOMC) meeting. Investors are recalibrating for the Fed to continue buying throughout 2021.
Technicals Extremes on both sides have cancelled each other out. Perhaps another massive supply of MBS in 2021 will be counteracted by Fed buying of $480 billion.
Securitized Products Allocation Decision
We maintain our allocation of 20%. Spreads have tightened since December’s FOMC meeting, where it made clear that asset purchases should continue throughout 2021. Valuations appear rich, but actual carry/returns are better than model yields because of Fed involvement. Against this backdrop we have a neutral outlook, with a slight tilt toward spreads trading tighter.
Dmitri Savin, Portfolio Manager, Portfolio and Risk Strategist, Emerging Markets Fixed Income
Fundamentals While the US dollar outlook is mixed short-term as risk assets continue to recover from the 2020 deluge and demand for safe havens declines, the currency should eventually find support from a domestic environment that is stabilizing economically and politically. Over time, and above all, improving US growth dynamics should support the exchange rate, as in the past. Yet until a clear view forms around the Fed’s response, market conditions may contain the US dollar’s strength.
Valuations We believe the US dollar will regain its composure against the euro and the Japanese yen once real yields start to rise and break-evens tighten, countering the dominant trend in 2020. We will use any technical-driven euro/US dollar overshoot toward 1.25 to position for a reversal. Ultimately, we believe the US dollar should end 2021 stronger than it started, with a year-end forecast of 1.175.
Technicals According to International Monetary Market (IMM) data through 24 January, US dollar net positioning remains near decade lows. This is partly a consequence of euro positioning trending back toward record levels reached this summer, but also a result of Japanese yen and Swiss franc net positions creeping higher.
Non-US-Dollar Currency Allocation Decision
We maintain our 0% non-dollar allocation. Typically, the US dollar weakens when real yields decline and break-even rates widen, as seen in the fourth quarter of 2020. We expect US dollar strengthening later in 2021 once real yields start to rise and break-evens consolidate or tighten. The main risk to this out-of-consensus call would be a policy error by the Fed.
Our High Growth Case Scenario Probability Increased While Our Recession Case Scenario Probability Decreased During the Month
Fixed Income Scenario Probabilities – Next 12 Months (as of 27 January 2021)
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.