Fixed Income Asset Allocation Insights: Remaining Patient in Emerging Markets
Robert Vanden Assem, CFA,
Head of Investment Grade Fixed Income and Chairman of Fixed Income Asset Allocation Team
The worsening Turkish currency crisis has led to fears of contagion within emerging markets (EM) debt, widening the EM/US spread differential to historic levels. That is due in part, however, to US investment grade (IG) and high-yield (HY) bonds benefiting from stronger-than-expected earnings, a relatively light new issuance calendar and positive fund flows from retail mutual fund and ETF investors. With our target allocations unchanged, we continue to favor EM debt, which we expect to benefit from attractive valuations, positive trade developments and a moderation in US dollar strengthening. We also continue to find attractively priced IG and HY credits.
US Macro View
Markus Schomer, CFA, Chief Economist
We see moderate GDP growth of 1% to 3%, which brackets the long-term potential rate, and moderate inflation (1% to 3%), which also brackets the Fed target. Min economic drivers are moderate gains in consumption and housing, modestly positive fiscal spending, rebounding business investment and a gradual increase in wage growth as full employment is approached. Expect two to three gradual Fed rate hikes in each of next few years alongside gradual balance sheet tapering and an equilibrium real funds rate of 0%-0.50%.
Consumer Spending. Latest income revisions show stronger consumer fundamentals and a 6% savings rate, not a record low 3%. But more than 2/3 of savings came from capital income concentrated among higher earners, suggesting that saving in middle and lower income groups remains low and spending dependent on job growth.
Fed rate hikes. September’s FOMC meeting could be pivotal. A fourth 2018 rate hike was added to guidance in June. After an upgraded economic assessment in August, the Fed could upgrade inflation and growth forecasts for 2018-19 and add a fourth rate hike to 2019 guidance.
Trade. Despite a seeming US-Mexico deal, trade tensions continue to simmer as the Trump administration readies a new round of tariffs on $200 billion in China imports? Could that and duties on EU autos be this year’s October surprise?
Target Portfolio Allocations (as of 23 August 2018)
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, Portfolio Manager, High Yield Bonds
Julie Bothamley, Portfolio Manager, Leveraged Loans
Sales and earnings estimates remain strong for the next two quarters. Buy side remains relatively disciplined on credit despite a notable lack of supply.
They remain in a 310 to 370 option-adjusted spread trading range and likely will remain there, implying a default rate of ~2%. Value looks fair to full with the yield curve and collateralized loan obligation/loan spread effects as headwinds and strong earnings as a tailwind. An increase in loan supply has pushed new-issue spreads higher than those of similarly rated outstanding loans and has brought repricing activity to a halt.
Positive overall due to volatile flows and continued light primary calendar, but loan technicals weakened as supply outpaced relatively strong demand. Trade war fears and commodity price movement continue to have outsized influence day to day.
Investment Grade Credit
US Dollar Investment Grade Credit
Dana Burns, Portfolio Manager, US Dollar Investment Grade Fixed Income
Corporate fundamentals remain firm and initial Q2 earnings have been strong. Concern over trade wars remain, but ultimately we believe there will be a positive resolution for US firms.
Select credits remain attractive. Following the recent snap-back in credit spreads, however, the value proposition isn’t as compelling as it was at the close of June.
The technical backdrop for IG credit has improved due to the return of foreign buying and reduced supply and inventory. However, lower all-in yields following the recent rate and spread rally and increased September supply may weigh on spreads.
Non-US-Dollar Investment Grade Credit
Roberto Coronado, Portfolio Manager, Non-Dollar Credit
Neutral/Positive. No major changes in credit metrics in Europe, as leverage has not increased while merger-and-acquisition activity and shareholder-friendly policies remain under control. Bank capital remains strong and they have been reporting better results, on average.
Neutral. Credit spreads at index level have widened considerably year to date (YTD) and now are in line with the five-year average. We continue to prefer the banking sector due to improving fundamentals and attractive yields but are mindful of political and global trade risks.
Neutral/Negative. Central bank purchases continue to support the market in euros but the end of quantitative easing is approaching. Supply should increase in September and the only offsetting factor could be inflows from foreign investors.
Anders Faergemann, Portfolio Manager, Emerging Markets Fixed Income
EM growth has softened a bit, while inflation remains low. The Chinese authorities remain very focused on growth, and the yuan depreciation will help. Growth in the rest of Asia has continued to slow down at the margin. In Europe, the Middle East and Africa (EMEA) and Latin America, growth is stable, apart from Turkey and Argentina, where the impact of recent currency weakness will be fully seen over the next months.
Spreads are 30 basis points (bps) wider on the month, and at +364 are somewhat attractive versus their level in the post-crisis period. More value in HY, which has underperformed recently.
After solid inflows in the second half of July, EM bond fund outflows resumed in August. Coupons and amortizations will be $7 billion in September and $24 billion by the end of the year, but the new issue pipeline is building.
Steven Cook, Portfolio Manager, Emerging Markets Fixed Income
Fundamentals remain solid with most 2Q results beating or meeting estimates. The focus remains on the possible impact of foreign exchange moves in higher beta countries, but default rates are still expected to be 2.6% this year (0.9% YTD), helped by 70% of maturities over the next two years being IG.
Corporate Emerging Markets Bond Index (CEMBI BD) spreads tightened 25 bps in July to <300 bps, but have since risen by 38 bps, driven by HY (+90 bps month to date), Turkey (+700 bps), Argentina (+180 bps), and Russia (+115 bps). Asia has been the exception. Overall, however, we still view valuations as attractive.
Technicals, plagued by poor liquidity, were supported by a drop in supply — $14.4 billion in July (vs $46.1 billion in July 2017) and a 20% decline year-over-year through August. Net issuance of $12 billion YTD (vs $142 billion for 2017) is supportive, but we are wary of outflows on negative sentiment and US dollar strength.
Andrew Budres, Portfolio Manager, Securitized Products
Negative convexity is in an extremely low historic range due to interest rates having risen enough to take most of the MBS universe out of the refinance zone.
MBS will drift wider into lower rates, but that is from risk valuations not convexity events. Spreads should tighten into selloffs.
While the Fed unwinds its purchase program, paydowns remain extremely low. Organic net supply is coming in at a much lower pace than last year.
Non-US Dollar Currency
Dmitri Savin, Senior Vice President, EM Fixed Income Portfolio Strategy/Risks
Our bias is toward a stronger US dollar as short-term growth dynamics and persistent divergence in monetary policy outlooks between the Fed and the European Central Bank clearly favor the US dollar for the foreseeable future.
The DXY index is about 1.7% off of YTD highs and far below post-election levels. Current valuations could provide an attractive entry point for investors.
A head-and-shoulders formation supporting the US dollar vis-à-vis the euro was confirmed with the drop below 1.1500. The only factor preventing the US dollar from rallying quicker is heavy market positioning.
Our Scenario Probabilities Were Unchanged During the Month
Fixed Income Scenario Probabilities – Next 12 Months (as of 23 August 2018)
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.