Fixed Income Asset Allocation Insights: Spreads Look Fair to Tight as Markets Price in a Soft Landing

Heading into the fourth quarter, the economic outlook appears more promising than most expected at the beginning of the year. In the US, a resilient consumer, tight labor market, and moderating (if still sticky) inflation have bolstered economic conditions. Jobless claims have continued to fall, and inflation, while stubborn, is at least moving in the right direction. Issuer fundamentals also look to be in good shape despite expectations for a slowdown as the lagged effects of restrictive monetary policy take hold.

Valuations already account for much of these improvements, however, with spreads at fair value or tight across most credit assets. The Federal Reserve has signaled the end of its tightening cycle, with one more rate increase possible before the end of the year, but it will likely maintain higher rates for longer.

While the end of the tightening cycle is welcome news for many, tighter conditions for longer could create additional stress in the market, particularly for weaker borrowers. In addition, some cracks are showing in the economic backdrop. Job openings have decreased, indicating companies are pulling back from hiring new workers, consumer confidence has fallen amid nascent employment concerns, and credit card losses are rising at the fastest pace in nearly 30 years as the benefit of increased savings from Covid-era policies fades. Investors also must consider the impact of auto strikes, the end of student loan forbearance, and a potential government shutdown. Despite these downside risks, current projections are for a soft landing with the potential for a mild recession, as the most extreme downside scenarios no longer seem as likely.

The picture outside of the US looks weaker. In Europe, the ECB announced its 10th consecutive interest rate hike, bringing the main deposit facility to a record 4%. The central bank has projected this to be the final hike while emphasizing that policy will remain restrictive for as long as necessary, given that inflation remains well above target. Meanwhile, the economic outlook for the region has deteriorated. Business sentiment in Germany continues to decline, and the German economy is projected to contract this year; the wider picture is also bleak, with eurozone business activity declining to its lowest level since November 2020. In China, concerns about weakness in the property sector persist, and the fundamental picture now looks weaker, with a rebound expected to come later than originally expected, likely in late 2023 or early 2024.

Against this backdrop, we view current spreads as fair value to tight. However, given high all-in yields, we expect any selloff to be met by increased demand, limiting the downside case. We view fixed income broadly as attractive in this higher-yielding environment, but with base rates high and central banks expected to maintain higher rates for longer, we view floating-rate assets as most attractive. With a higher probability of a more benign economic outlook, we believe higher-yielding credit assets are likely to outperform over the next 12 months. In addition, while the investment grade outlook is favorable, Treasury bill yields are approximating credit index yields, so it’s not surprising that investors are shifting exposure to T-bills. From a regional perspective, we favor the US, as spread differentials between Europe and the US have narrowed despite the divergence in the outlook. Meanwhile, valuations within emerging market (EM) debt look attractive at a high level, but when adjusting for the most stressed portions, we view the asset class as closer to fair value.

Our Asset Class Outlooks

Click each asset class to learn more about the fundamentals, valuations, and technicals driving our outlook.

Investment Grade Credit

We expect credit spreads to remain largely rangebound as the end of the Fed’s rate-hike cycle nears. We believe the economy will experience a slowdown that will reveal itself more firmly in the first half of next year as the lagged effects of policy actions and their outcomes take hold. More volatility in credit spreads and interest rates is likely, but both should be relatively muted. We expect to see attractive entry points in the next several months, creating additional opportunities to add risk.

Securitized Products

Over the long term, we are bullish. FDIC portfolio sales are now completed, removing a huge headwind. Investors can now focus on the cheapness of mortgage-backed securities (MBS). However, more caution is warranted within CMBS. The maturity wall in 2023 is manifesting itself, as loans are opting to take extensions, which is not an auspicious signal.

Leveraged Finance

Earnings remain resilient, and corporate fundamentals are starting from a very solid point. On the other hand, issuer fundamentals are going to deteriorate from here; the question is how steep the trajectory. The balance of risk/reward feels appropriate, but credit is attractive mainly on a relative basis versus other assets; carry is king. We remain of the view that a soft landing is mostly priced in, and the probability of that outcome is increasing. This leaves us content with current exposure and a buyer at the margin.

Emerging Markets

The Fed’s being at or close to the end of its hiking cycle is favorable to EM sentiment. However, the impact of this may be felt further out. In the short term, we continue to favor EM local markets, especially those that have begun or are nearing a creditable rate-cutting cycle. The strong EM disinflation theme is strengthened by the weak yuan and outright deflation in China. This should add further support to local yield compression.

Non-US-Dollar Currency

The US dollar is clearly benefiting from a regime of loose fiscal policy and contractionary monetary policy. While tailwinds from the fiscal stimulus may wane in 2024, it’s hard to see the same factors turning into headwinds without policy intervention. In parallel, the return of US exceptionalism may drive the US dollar stronger into year-end, though positioning argues against any outsized moves.

Segment Snapshots

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.

Investment Grade Credit

US Dollar Investment Grade Credit

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

Fundamentals Fundamentals remain firm, with some companies looking to better-than-expected third-quarter earnings. Margin pressure due to higher energy and labor costs persists, and a stronger dollar has added to this more recently.

Valuations After the recent spread tightening, the broad market looks slightly less attractive, although select credits continue to offer opportunities. Market appetite for primary issuance, and the long end in particular, remains supportive.

Technicals Domestic demand from traditional investors, notably pensions, remains strong. Lower supply and a lack of bonds available for sale continue to support the long end. Concern over higher rates has lent support to shorter-maturity corporates.

Non-US-Dollar Investment Grade Credit

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

Fundamentals Neutral. Companies in general continue to beat expectations, while net leverage is slightly below 2020 levels overall; management teams, however, are providing cautious outlooks, citing limited visibility into future sales and margins.

Valuations Neutral. We see credit spreads close to fair value and expect the index to trade within a range in the coming weeks. In our opinion, the probability of large index moves in either direction is low. For that reason, we view sector and security selection as the key to outperformance.

Technicals Neutral. Flows remained mixed in recent weeks after strong inflows in the first half of the year. That said, primary supply has also slowed, so the technical picture remains stable.

Securitized Products

Andrew Budres, Portfolio Manager, Securitized Products

Fundamentals We see too much interest rate volatility, as the 10-year note set a new high for the year. Mortgage models need a pause in rates to calibrate cash flow assumptions.

Valuations MBS is now three standard deviations wide to investment grade bonds looking back 10 years. The major holdback is interest rate volatility.

Technicals Technicals have improved as the banking turmoil drifts further into the past. Newly proposed bank capital rules did not change capital treatment for agency MBS.

Leveraged Finance

John Yovanovic, CFA, Head of High Yield Portfolio Management 

Fundamentals Last-12-month (LTM) par default rates continued to improve, to 2.0% in August, and defaults are lower than the prior year. We still see default rates peaking in the 3.5% area, though persistently robust market conditions and the potential for a soft landing could mean we don’t get there. Upgrade/downgrade ratios remain balanced for high yield (HY) but skewed much more negatively for leveraged loans (LL).

Valuations A soft-landing macroeconomic outlook for 2024-2025 and resilient capital market conditions make us rethink 400-600 bps as an appropriate range for option-adjusted spreads, particularly if our default outlook proves too pessimistic. With short-term interest rates expected to remain unchanged over the near term, yields on loans are still attractive at over 10%.

Technicals New issues remain historically low in both the US HY and LL markets. We continue to see bond-for-loan refinancings, but several such bond deals have been downsized given strong loan demand, and we have seen a few loan-for-bond refinancings as well. We do not expect a material increase in the second half of 2023 given current yield levels and low leveraged buyout activity.

Emerging Markets

Sovereigns

Anders Faergemann, Portfolio Manager, Emerging Markets Fixed Income

Fundamentals We are marginally more negative on fundamentals, with China’s rebound postponed to late 2023 or early 2024. Domestically driven credits are, however, still holding up well, as shown by EM purchasing managers’ indices (PMIs) sitting well above their developed market counterparts. Forthcoming International Monetary Fund (IMF) assistance and rising reform momentum are also assisting improvement in fundamentals. EM rate-cutting cycles should last for roughly the next 18 months, leading to lower local currency yields. While the repayment profile for EMs looks bulky over the next two years, it’s mostly driven by one credit (Turkey) – excluding this, the profile is more or less flat.

Valuations We have shifted our valuation outlook and trend further negative – HY spreads have seen a significant repricing lower, driven by the distressed debt bucket as default probabilities and exit yields were recalibrated down. HY spreads are about 150 bps lower than the highs reached in March, with a total return of 3.73% year-to-date for the EMBI. Similarly, despite the small bounce higher, IG spreads are still at their tightest since 2007 at 187 bps. The EMBI index is at 468 bps. Despite valuations being tight, value can be unlocked as the Fed starts to communicate cuts – and the market anticipates inflows.

Technicals Our technical outlook and trend have deteriorated. While we still have a positive view, we now expect a positive net financing number this year, a reversal from our prior negative expectations.

Corporates

Kim Keong, Trader, Emerging Markets Fixed Income

Fundamentals Most of the companies in our coverage have reported second-quarter earnings, and the results were broadly neutral but with a skew toward misses from certain sectors: commodity-related, pulp and paper, and real estate. We found that negative credit trends in HY rated companies jumped more than for IG companies, especially in LatAm and Asia. However, as noted previously, LTM net leverage ticked up 0.1x to 1.2x since 2022, which is still below pre-pandemic levels. Announcements of some policy changes in China’s property sector should support the companies operating in Tier 1 and 2 cities, which represent roughly half the market’s transaction value. We continue to look out for further stimulus to support the space.

Valuations Over the last month, the CEMBI BD spread to worst widened by 12 bps, with HY underperforming IG. In IG, the widening was broad-based, with CEEMEA and the riskier BBB bucket underperforming. In HY, the underperformance came from Asia, specifically in the Hong Kong real estate and Macau gaming sectors. In contrast to last month, China has been the best performer due to some recovery in the property sector. In relative value terms, EM indices underperformed DM in both IG and HY over the past month, and the BBB and C rating buckets widened the most. To date in 2023, EM IG lagged by 19 bps and EM HY lagged by 83 bps. (Valuations and technicals, below, based on JP Morgan data for the CEMBI Broad Diversified Index as of 18 September 2023.)

Technicals August was the slowest month in primary markets for the year at $10.6 billion. With scheduled and unscheduled cash flows, net financing was down $13 billion for the month. Activity has since picked up, with $19 billion printing month-to-date in September. Given the scheduled cash flow of $32 billion for the month, net financing could be close to flat. YTD gross supply is $180 billion, which is 6% lower versus the prior year, and net financing is at -$108 billion. JP Morgan increased its supply forecast for the year from $253 billion to $273 billion, mainly from Turkish issuers and opportunistic major corporate issuers in LatAm. However, the overall supply figure remains one of lowest in recent years, and the full year net financing number is relatively unchanged at -$118 billion.

Non-US-Dollar Currency

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

Fundamentals Divergent paths in economic growth between the US and Europe have become more evident, bolstering demand for the dollar. Fiscal support alongside surprisingly resilient consumer spending in the US are the primary drivers behind US upside growth surprises, while Europe, and Germany in particular, has been hit harder than anticipated by China’s downturn and Germany’s failed energy transition policy.

Valuations We have changed our 12-month EUR/USD forecast to 1.0500 from 1.1250 amid the resurgence in US exceptionalism and the Fed being on hold for longer than the ECB. We have kept our 12-month USD/JPY forecast at 1.4250 to reflect countervailing forces between the current yield differential and scope for the Bank of Japan to exit yield curve control.

Technicals According to JP Morgan and International Monetary Market (IMM) data as of 10 September 2023, US dollar net shorts have continued to unwind at a rapid pace, with two-thirds coming off since the trough at the end of July. US dollar net positioning now stands at -$7.2 billion, or -0.5 sigma.