Fixed Income Asset Allocation Insights: Staying Defensive in a World of Risk

Credit market weakness continued in September as investors wrestled with how far the Federal Reserve will go with rate hikes before inflation, the economy, or the Fed itself throws in the towel. So far, the central bank has remained steadfast, with Chair Jerome Powell early in the month reiterating his commitment to douse raging prices, indicating a further tightening of monetary policy. Mid-month, the higher-than- anticipated core measure of the Consumer Price Index1 solidified investors’ view that hawkish central bank policies would continue, igniting a broad market selloff. True to its objective, the Fed increased the federal funds rate by 75 basis points (bps) at its 22 September meeting2 and fed funds futures are now pricing in another 75-bp hike in October. In addition to rate hikes, the Fed’s efforts to trim its balance sheet also have begun to reduce liquidity globally.

Meanwhile, the eurozone faces continued pressure from the ongoing conflict in Ukraine, rampant inflation, and energy security concerns as winter approaches. In the UK, new Prime Minister Liz Truss announced tax cuts and spending increases, sending the sterling to an all-time low against the US dollar before a quick policy reversal was announced in early October.

While wider spreads have made valuations more attractive, we continue to maintain our defensive tilt. Spreads do not yet fully reflect the likelihood of a recession or any meaningful probability of a hard landing. Despite the valuation advantage of Europe, we are also maintaining our preference for US dollar assets, as fundamental risks are substantially higher for Europe.

US Macro View

We are increasingly relying on the Fed to back away from its overly aggressive rate-hike plans to avert recession. We still expect that a turn in the inflation cycle and tight labor markets will prompt a rebound in real income growth, which should sustain real consumption next year. The worst GDP growth may already be behind us, with the first half’s two negative quarters.

Market movers Jackson Hole. Powell didn’t use the Fed’s annual meeting to signal a pivot. On the contrary, he used it to restate the case for more aggressive tightening, ignoring rising recession risk and growing evidence that the inflationary environment is changing. We may have seen the peak in Fed hawkishness, and a pivot may just have been postponed. In essence, we view the Fed’s dot plot on rates with skepticism. Data flow. The numbers have been clear: Economic activity is not close to contracting, consumer confidence is improving, labor markets remain tight, and inflation is slowing. Those factors, the holy grail of central banking, are staring the Fed in its face, yet it may choose to crash the economy anyway. Holding on. Current data tilt toward the case for a slowdown, but no recession. Surveys are improving, labor market data remains strong, and hard economic indicators show continued expansion. We expect GDP growth to rebound in the second half, underscoring the improving trend. The recession talk is for 2023, but by then we expect rebounding real income growth to stabilize consumption.

Leveraged Finance

John Yovanovic, CFA, Head of High Yield Portfolio Management 

Fundamentals While second-quarter earnings showed commodity-linked issuers were well off cyclical peaks, defaults remain very low but are creeping upward, to 1.20%.3 Leverage remains below long-term averages, while earnings estimates are starting to come down. Higher base rates are affecting the cash flow of floating-rate issuers. The outlook remains decent but there is no escaping central bank tightening and a slowing global economy.

Valuations Spreads have remained range-bound with volatile trading. We believe the near-term trading range in terms of high yield (HY) option-adjusted spreads (OAS) will remain at 400 to 600. Fundamentals are in good shape, and our 3% default rate forecast remains intact. The macro picture, while not scary, clearly signals headwinds into 2023. Loan valuations are moderately more attractive; investment-grade (IG) collateralized loan obligation (CLO) tranches even more so.

Technicals HY flows have reversed on recent volatility, with average weekly outflows of about $3 billion over a recent four-week period. HY outflows year-to-date (YTD) are $49 billion. The primary market picked up in September and priced $2.1 billion of issuance before volatility weighed on markets. Liquidity continues to be below average, with dip buyers of decent credits. JP Morgan estimates that low issuance leaves the market undersupplied despite negative fund flows. (Technicals based on JP Morgan Securities data as of 9 September 2022.)

Leveraged Finance Outlook

This current environment, volatile for equities, is fine for credit. Yield matters, and the 9.5% to 10% yields in leveraged finance appear to compensate for the risks. We expect spreads to remain range-bound in an environment devoid of positive catalysts. We are biased to add risk from here, but not this year.

Investment Grade Credit

US Dollar Investment Grade Credit

Dana Burns, Portfolio Manager, US Dollar Investment Grade Fixed Income

Fundamentals Overall, fundamentals remain solid, but margin pressure and concern over global growth are cause for concern. Aggressive Fed tightening makes the prospect of a soft landing for the US economy less likely.

Valuations While select credits and sectors remain attractive, we would expect to see near-term spread widening. Attractive opportunities remain in the primary market.

Technicals The technical backdrop has softened, with decreased foreign demand due to high hedging costs. Nevertheless, supply is expected to be lighter for the remainder of the year.

Non-US-Dollar Investment Grade Credit

Roberto Coronado, Portfolio Manager, Non-US-Dollar Investment Grade Credit

Fundamentals Neutral. Overall, companies continue to beat expectations, and net leverage is slightly below 2020 levels, keeping balance sheets in good shape. We will monitor how inflation affects the bottom line.

Valuations Positive to neutral. Credit spreads are attractive, but risks to the downside remain, so we are staying defensive. For now, we continue to view sector and security selection as the route to outperformance.

Technicals Neutral. Technicals improved slightly over the last month amid small inflows into the asset class and slowing supply due to macro volatility over rates. Technicals, however, remain fragile, and liquidity remains challenging.

Investment Grade Credit Outlook

A stronger dollar has led to increased hedging costs for foreign investors. Nevertheless, support for US investment grade credit continues due to greater all-in yields and demand for higher-quality dollar-denominated assets. Given the market’s level of uncertainty, we do not believe this is the time for broad risk-on positioning. Instead, we favor maintaining marginally defensive positioning within asset classes. Additional rallies will provide a good opportunity to reduce risk.

Emerging Markets

Sovereigns

Anders Faergemann, Portfolio Manager, Emerging Markets Fixed Income

Fundamentals While cautious on China’s growth prospects over the next six months amid uncertainty over its property market woes and zero-Covid strategy, we remain optimistic about a mild recovery, albeit from a lower base, over a 12-month horizon starting in the second quarter of 2023. Even so, growth drivers will be different than in previous rebounds, suggesting that emerging market (EM) countries that are more focused on domestic growth and less on export-oriented growth will fare better.

Valuations Sovereign spreads were range-bound during August but moved back above 500 bps in mid-September, in tandem with tighter US financial conditions and general risk aversion.4 Markets continue to disproportionately punish political risk and uncertainty in this environment; current valuations are discounting higher default rates to a degree greater than warranted by our fundamental analysis, even assuming weaker growth and limited market access.

Technicals Risk sentiment has reversed recent inflows into the asset class, yet the technical picture remains robust. Net issuance remains negative year-to-date.5 Despite this strong picture, we expect overall risk appetite to remain low, with elevated global risk and external headwinds weighing on EM demand.

Corporates

Steven Cook, Co-Head of Emerging Markets Fixed Income

Fundamentals Second-quarter results thus far continue to be slightly better than expected, with 25% beating our expectations and 9% missing. The revisions to guidance have been upward on balance thus far, but the outlook into next year is more neutral.

Valuations Over the last month, CEMBI BD spreads have widened 3 bps, with investment grade (IG), down 1 bp, outperforming high yield (HY), up 5 bps. We have adjusted our scores closer to neutral given the outperformance last month versus US IG (-34 bps) and US HY (-58 bps). Month-to-date outperformance in IG has been driven by Asia spreads outperforming the rest. Longer term, the spread pickup remains relatively attractive given the fundamental and technical backdrop. (Valuations and technicals, below, based on JP Morgan data for the JP Morgan CEMBI Broad Diversified Index as of 26 September 2022.)

Technicals Year-to-date (YTD) supply of $192 billion is down 56% year-over-year (y/y) and is the lowest YTD supply over the last 10 years. YTD net financing is negative $150 billion, assisted by $58 billion of tenders, buybacks, or calls. JP Morgan has lowered its full-year 2022 supply forecast to $260 billion from $400 billion, net issuance to negative $34 billion, and net financing to negative $218 billion.

Emerging Markets Outlook

EM growth is holding up better than developed market (DM) growth, signaling a widening of the EM/DM growth gap in favor of EM in 2023. EM sovereign spreads offer pockets of value against US high yield, yet EM returns remain vulnerable to broader risk aversion. We see longer-term value in EM corporates, but near-term macro uncertainty and recent tightening versus the US could lead to some short-term softness.

Securitized Products

Andrew Budres, Portfolio Manager, Securitized Products

Fundamentals Less than 1% of the outstanding mortgage market has an economic incentive to refinance an existing loan. The mortgage-backed securities (MBS) index is at an extremely low negative convexity on a historical basis, but fundamentals are not driving MBS performance. (Source: Bloomberg, based on the Morgan Stanley Truly Refinanceable Index, as of 27 September 2022.)

Valuations MBS spreads are now in the 97th percentile historical wide versus IG bonds. (Source: Bloomberg Finance L.P. as of 27 September 2022.)

Technicals MBS spreads have ignored Fed Chair Powell’s assertions that asset sales are not on the horizon. Lack of bank buying is turning out to be a strong drag on performance.

Securitized Products Outlook

Despite Fed assertions that asset sales are not imminent, volatility remains high. Buyers of MBS have disappeared, and on a nominal basis, spreads have widened more than during the pandemic and are approaching the same delta in spread as during the 2008 financial crisis.

Non-US-Dollar Currency

Dmitri Savin, Portfolio Manager, Portfolio and Risk Strategist, Emerging Markets Fixed Income

Fundamentals While the current environment remains supportive of the US dollar – bolstered by US exceptionalism, the yield differential, and a higher geopolitical risk premium – these factors are waning and may eventually move against the dollar as we start to look toward the second half of 2023.

Valuations We kept our 12-month euro/US dollar forecast at 0.9300 but may adjust it higher depending on the outcome of Europe’s energy transition and a potential repeat of the 2011/2012 European debt crisis. We moved our 12-month forecast for the US dollar/Japan yen to 140 from 147, as support for the US dollar may be waning due to recession fears.

Technicals According to JP Morgan and International Monetary Market (IMM) data as of 25 September, net euro positioning has shifted from short to long versus the US dollar on the back of significant short covering. Net British pound positioning also improved versus the US dollar. As a result, US dollar net length, as measured by its five-year z-score, fell from +0.74-sigma to +0.4-sigma.

Non-US-Dollar Currency Outlook

We believe the US dollar can retain its “least-dirty shirt” status for a while, but we are increasingly aware that its strength rests on the lack of alternatives to the dollar in the short-term.

Our Central and Recessionary Scenario Probabilities Increased for the Month

Fixed Income Scenario Probabilities – Next 12 Months (as of 28 September 2022)

Source: PineBridge Investments. For illustrative purposes only. We are not soliciting or recommending any action based on this material. 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.