Fixed Income Asset Allocation Insights: With or Without Fiscal Help, Recovery Should Carry On

Credit markets rallied sharply in November, led by demand for higher-risk asset classes on news of vaccine developments and clarity around the results of the US presidential election. The boost in investor optimism comes despite the current surge in Covid-19 infections in the US and Europe and uncertainty about the magnitude and timing of additional fiscal stimulus.

Although the prospect of fiscal relief remains unclear, central banks continue to provide support and have indicated that their accommodative measures will remain in place for the foreseeable future, keeping rates lower for longer. On top of the policies currently in place, the European Central Bank (ECB) announced it will implement additional measures in December. As has been the case in the past, we see the potential for such accommodation to more than offset the impact of a smaller fiscal package and slower economic growth.

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 After raising our central case scenario probability by five percentage points to 70% in October, becoming slightly less bearish, we note that strong November purchasing managers’ indices (PMIs) suggest the recovery is holding up better than expected in the fourth quarter. Nevertheless, we maintain a significant bearish tilt on concerns that the current Covid surge could still force re-closings and given the risk of a fiscal cliff in December. Our central case still calls for GDP growth in a range around its 2% long-term potential rate and headline and core inflation trending around the 2% Federal Reserve target. We see a gradual transition away from policy-driven economic growth to growth spurred by domestic, private demand supported by low interest rates. We also see labor markets recovering from the Covid recession and wage growth in line with productivity growth. Fed policy rates should be at or below the r-star neutral rate, with the equilibrium real funds rate at 0% to 0.25%. Looking ahead, the risks of a meaningful slowdown in the first quarter of 2021 are rising unless Congress extends unemployment programs and provides state bailouts.

Market movers Divided government.  Markets have moved on from pre-election nerves to apparent happiness with a divided government, based on past good experience. But that could also mean a return to fiscal austerity. In addition, the increasingly hostile Democratic-Republican divide could result in sharp state and local spending cuts and rolling debt-ceiling crises. Vaccines.  While certainly welcome, all the good news on vaccines – e.g., more contenders moving from research to approval, and brighter prospects for global distribution – was expected and had been part of everyone’s central case. As a result, it shouldn’t add more bullishness. How real is the US recovery?  So far, it’s very real. The latest PMIs showed the recovery continued to pick up in November despite the intensifying third Covid wave. Consumer confidence surveys highlight the deteriorating outlook, but assessment of current conditions improved. We see no evidence right now that the US recovery is losing steam prematurely.

Target Portfolio Allocations (as of 25 November 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.

Leveraged Finance

John Yovanovic, CFA, Head of High Yield Portfolio Management 

Fundamentals Fundamentals remain on a downward glidepath into the second half of 2021. However, recent earnings reports generally have beaten expectations, particularly in basic materials and communications, and revenue expectations also are higher than anticipated. Fundamentals are stable but stalled in the near term and should improve into 2021.

Valuations Post-election euphoria rallied all risk assets, with option-adjusted spreads (OAS) on the Bloomberg Barclays US Corporate High Yield Index at 426, pushing through the low end of the range (according to Bloomberg Barclays data as of 24 November). Sectors including media/broadcasting, transports, energy, and leisure have outperformed. Even moving our default rate estimate for 2021 down to 4% results in a 400 OAS target, but risk premia likely will shrink for all asset classes (based on Bloomberg data and PineBridge calculations as of 19 November). Spreads are fair in the near term, and our constructive view on 2021 is that total returns will be positive on an absolute basis and quite attractive relative to other options.

Technicals Flows followed the risk-on sentiment in the wake of recent optimistic vaccine announcements. Primary issuance is now in the $10 billion per week range (based on JP Morgan Securities new-issue data as of 13 November). Inflows totaled $4.56 billion in the week of 11 November, making for positive flows of $44.2 billion year to date (YTD), according to fund flow data from AMG/Lipper as of 13 November. We still see buying on any dips; technicals remain firm.

Leveraged Finance Allocation Decision

We maintain our allocation of 40%. Spreads are now closing on our 2021 target as positive news on vaccine development provides confidence. Valuations are fair in the near term, but the technical backdrop 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 demonstrated incremental improvement against the backdrop of a gradually re-opening economy. In the near term, the lack of a stimulus package and rising Covid-19 cases could affect 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 the remainder of 2020, Fed buying, tenders, and foreign demand.

Non-US-Dollar Investment Grade Credit

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

Fundamentals Negative. It is difficult to predict how adversely economies and corporate issuers will be affected by the current wave of softer lockdowns. Similarly, the effectiveness of fiscal support in keeping small businesses alive and people employed is another big unknown, dampening sentiment. Markets will need to see the severity of the winter’s second wave and how long current restrictions will last.

Valuations Neutral. Credit spreads have rallied since March and now are around fair value. We continue to be positive for the medium term as we believe spreads can still move tighter given the technical picture.

Technicals Positive. Technicals have remained very positive, thanks to continued demand from the ECB through its bond-buying programs and lower-than-expected supply since the summer slowdown.

Investment Grade Credit Allocation Decision

We maintain our allocation of 20%. Expected supply for 2021 should be closer to historical averages, providing a positive technical backdrop heading into next year. Valuations remain around fair value, although we continue to see attractive opportunities and expect security selection to drive alpha generation in the coming months.

Emerging Markets

Sovereigns

Anders Faergemann, Portfolio Manager, Emerging Markets Fixed Income

Fundamentals We expect more upbeat emerging market (EM) growth on the back of China’s recovery. Growth in China typically leads EM growth by about three months, and the economic boost usually lasts 12 to 18 months. While EM debt levels rose as a result of pandemic spending, as they did in developed markets (DMs), the increase is only about half as large – 60% versus 120% (based on IMF data as of October 2020). We expect debt levels to stabilize and trend lower for at least half the DM countries over the next few years.

Valuations Despite the intra-month post-US-election and vaccine-driven rally – with the EMBI Global Diversified Index trading at +382 (tighter by 40 points), investment grade (IG) at +163 (tighter by 17 points), and high yield (HY) at +673 (74 points tighter) – our better fundamentals outlook argues for more spread tightening ahead, particularly in HY. There, valuations remain attractive over a 12-month horizon, offering 8%+ total return potential (PineBridge as of 28 October 2020). While IG may be priced to perfection, it may still grind tighter as the chase for EM yield continues.

Technicals We expect strong technicals to prevail next year as demand for yield remains solid. We saw a significant pickup in inflows over the last few weeks and a dash from issuers to raise money as the year draws to a close.

Corporates

Steven Cook, Co-Head of Emerging Markets Fixed Income

Fundamentals With most third-quarter earnings thus far having beat or met expectations, we have tweaked our scores to be slightly more bullish. Using Latin America as an example, since it’s the first region to report results, we are now positive on 45% of corporates in the region, neutral on 46%, and negative on 9% (PineBridge estimates as of 25 November). Our credit trends for the region now have a positive skew, mainly due to the improvement in HY. Default rate expectations are 2.8% for next year (based on JP Morgan data as of 25 November).

Valuations We are slightly more bullish on short-term valuations, as spreads on the CEMBI Broad Diversified Index tightened by 34 basis points (bps) over the last month to 318 bps (JP Morgan as of 17 November). We still have a bullish tilt, particularly over the longer term, given that the spread pickup over other fixed-income asset classes has not changed materially over the month and is still attractive compared to historical levels. Combining this with the positive fundamental and technical outlook, we still think valuations are attractive.

Technicals October supply of $54 billion was in line with levels last year, and the primary market has just reopened after a quiet two weeks. Year-to-date supply of $460 billion is tracking below last year, but could exceed last year’s total of $492 billion at this rate (based on JP Morgan data as of 17 November). The technical outlook remains bullish, as demand remains strong over both the near term and further out amid renewed investor interest and muted net issuance expectations for next year.

Emerging Markets Allocation Decision

We maintain our allocation of 20%. We are more constructive on EM fundamentals into 2021 and expect ongoing strong technical support, leading to further spread tightening. We are continuing to buy on dips due to the positive fundamental and technical outlook.

Securitized Products

Andrew Budres, Portfolio Manager, Securitized Products

Fundamentals Pandemic-induced record-low interest rates are flowing through to mortgage rates, causing a surge in home sales and home prices that has benefited the consumer. However, the rise in home sales paired with record-low mortgage rates has boosted the supply of mortgage-backed securities (MBS) – a headwind to MBS investors. That said, MBS investors are benefiting from very low interest rate volatility in this environment.

Valuations MBS spreads have been stuck in a neutral zone given the contrast between record supply and MBS purchase operations.

Technicals Heading into winter’s slower mortgage activity, we still see very robust data. This level of origination would usually be a drag on valuations but the Fed is able to neutralize most of the impact.

Securitized Products Allocation Decision

We maintain our allocation of 20%. As we head into winter, when housing demand usually slows, we still see upside surprises that could lead to more mortgage supply. The Fed will be watching supply numbers and continue its buying operations into 2021. As a result, we maintain our neutral to slightly conservative outlook on the asset class.

Non-US-Dollar Currency

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 and fiscal easing, which should make for cheaper hedging, as well as market expectations of curve steepening. But the consensus view is that this theme won’t play out due to European policymakers’ reluctance to allow a much firmer euro.

Valuations We were neutral on G3 positions into the US election and will monitor the 1.15-1.20 euro/US dollar range for any technical breaks to establish a more tactical stance. However, we believe the currency relationship should find a stable range around 1.15 by the end of 2021, viewing a break above 1.20 as a temporary overshoot rather than a new trend.

Technicals According to International Monetary Market (IMM) data through 22 November, overall positioning in the futures space continues to signal a preference for low yielders. Compared to the last five years, positioning in Swiss francs (+1.8-sigma z-score), euros (+1.4), and Japanese yen (+1.0) remains materially above multi-year averages, likely reflecting, at least in part, this year’s collapse in interest rate differentials.

Non-US-Dollar Currency Allocation Decision

We maintain our 0% non-dollar allocation. The broader rise in risk sentiment in the wake of the US elections, combined with better-than-expected vaccine news, has affirmed the market consensus of short-term dollar weakness. However, we maintain some optimism that the US growth recovery will take shape by the end of the 12-month forecast, arguing in favor of a reversal of the negative US dollar trajectory by the second half of 2021.

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 25 November 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.