Fixed Income Asset Allocation Insights: As Coronavirus Fears Rattle Markets, Surprise Fed Cut Lends Support
Robert Vanden Assem, CFA, Head of Investment Grade Fixed Income and Chairman of Fixed Income Allocation Team
After investors initially dismissed the potential economic impact of the COVID-19 outbreak at the beginning of February, the global spread of the virus during the back half of the month heightened fears of a pandemic. This led to an equity market selloff and brought Treasury yields to record lows. While the virus is likely to depress global GDP growth in the first quarter to the first half of 2020, we remain cautiously optimistic about the fundamental picture, as we believe the economic impact is likely to be short-term in nature and may be further offset by additional stimulus and policy support. Indeed, the Federal Reserve made a surprise 50-basis-point (bp) rate cut on 3 March, noting that “the magnitude and persistence of the overall effect on the US economy remain highly uncertain” and that “the committee judged that the risks to the US outlook have changed materially.” Against this backdrop, we believe more patient positioning is prudent and our fixed income allocations remain unchanged, although recent spread widening has made higher-risk assets look more attractive absent a recession, which is not our base case.
US Macro View
Markus Schomer, CFA, Chief Economist
We continue to expect moderate GDP growth of around 2%, with headline and core inflation trending around the 2% Fed target. The main drivers are steady consumption driven by low unemployment and moderate business investment, driven by low interest rates. The labor market is at full employment, with wage growth in line with productivity growth. The Fed’s rate cut brought policy rates down to a range of 1.00%-1.25%.
COVID-19. How much further the novel coronavirus will spread is the big question. All experts seem to be saying the infection is far from peaking, but the near-term evolution of the crisis is highly uncertain.
Elections. There is so much focus on the COVID-19 crisis that markets may be overlooking election risks. It seems unlikely that either party will be in control of both the White House and Congress, but President Trump has opened the door for a more unconstrained executive branch and a reduced constraining role for Congress.
Fed moves. The Fed surprised markets with a 50-bp rate cut on 3 March, noting that while fundamentals of the US economy remain strong, “the coronavirus poses evolving risks to economic activity.” We think the Fed has left the door open for further action if economic damage already in the system hits the data and triggers downward revisions to US GDP forecasts.
Target Portfolio Allocations (as of 27 February 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.
John Yovanovic, CFA, Head of High Yield Portfolio Management
Julie Bothamley, Portfolio Manager, Leveraged Loans
Halfway through earnings season, results are mixed but improving. Financials and industrials are doing quite well, while the basics, communications, consumer, and technology segments are mixed. The overall theme is consistent with a 2020 improvement story, though the coronavirus will weigh on first-half results. Markets want to look through any bad news unless it’s in energy, where the capitulation trade continues.
Option-adjusted spreads (OAS) were blown up to 425 bps by recent equity weakness. Lower quality led the way, with CCC and B underperforming. Valuations are now fair to cheap, though any increase in US Treasury yields would be a headwind. In loans, single-B issuers still appear somewhat attractive when compared with their BB counterparts.
We see positive technicals across leveraged finance. High yield technicals remain firm on strong corporate earnings reports. New issuance remains strong with most of the deals oversubscribed. New-issue volumes for collateralized loan obligations (CLOs) increased sequentially from January, though year-to-date numbers are down year-over-year.
Investment Grade Credit
US Dollar Investment Grade Credit
Dana Burns, Portfolio Manager, US Dollar Investment Grade Fixed Income
Fundamentals remain well supported, given a healthy economic backdrop and manageable corporate leverage. However, concerns about coronavirus-related disruptions are mounting.
Credit spreads have widened as concerns surrounding COVID-19 have grown. However, solid year-over-year earnings and a stable economic backdrop continue to support valuations.
The technical backdrop for credit remains supportive due to lower net supply, reduced foreign exchange (FX) costs, and strong demand for developed market investment grade debt.
Non-US-Dollar Investment Grade Credit
Roberto Coronado, Portfolio Manager, Non-US-Dollar Investment Grade Credit
Neutral. We see no major changes in credit metrics in Europe, as leverage has not increased while M&A activity and shareholder-friendly policies remain under control. Banks continue to have a strong capital base and have been reporting stable results, on average.
Slightly positive. Credit spreads are not far from fair value, but we expect them to go tighter thanks to the new buyer in town, the European Central Bank (ECB). We currently favor communications, consumer non-cyclicals, banks, and insurance.
Positive. The start of the new quantitative easing program provides a strong technical tailwind for the market. We have continued to see inflows into European credit, but these have been partially offset by coronavirus uncertainties.
Investment Grade Credit Allocation Decision
We maintain our allocation of 20%. Despite the emerging risk from COVID-19, fundamentals should remain relatively sound, and demand for credit will likely continue to be fueled by the global search for yield and accommodative central bank policies.
Anders Faergemann, Portfolio Manager, Emerging Markets Fixed Income
The theme of emerging markets (EM) growth outpacing developed markets growth may have been put on ice, with China’s GDP due to take a hit in the first quarter and creating knock-on effects on certain regions or commodity producers. However, we see this as temporary and expect growth to pick up. Improving fundamentals and rising credit trends, particularly in Latin America, along with the fiscal boost in Asia and further EM central bank accommodation, are supporting this view.
EM spreads (+319 bps in February) are off December-January lows as the coronavirus’ impact on growth weighs on the outlook. High yield spreads widened into the attractive territory, while investment grade spreads, albeit wider, remain on the expensive side.
With spread cushion amid improving fundamentals, EM debt has experienced decent inflows this year. Year-to-date supply has been similar to last year, cash levels are high, and we are heading into the record coupon and amortization payment period in March and April, making the technical outlook very supportive.
Steven Cook, Co-Head of Emerging Markets Fixed Income
The year-end 2019 numbers released so far have been unsurprising. High yield names moved slightly less neutral, evidence that analysts are moving toward more credit selection (positive or negative), while in investment grade, credit trends were flat on the month, including in Asia, where the coronavirus is being felt the most. Given our bias toward stronger credits, coupled with the “too early to call” impact of the coronavirus at this stage, we are leaving our scores unchanged.
While spreads widened slightly in January as the world contemplated the coronavirus, the moves were quickly reversed as Asian investors quickly bought into any weakness in their regions. Metals and mining names widened the most, reflecting declines in iron ore and other metals. Again, the overall moves were not material, and we left our scores unchanged.
New issuance set a monthly record in January at $77 billion, with Asia pricing $41 billion and LatAm pricing $21 billion. Net supply, at $43 billion, was well-digested by the market. Despite the record month of supply, the seemingly insatiable demand for EM assets amid the hunt for yield provided a strong technical backdrop to this market.
Andrew Budres, Portfolio Manager, Securitized Products
Something that could make “refi 2020” different from “refi 2019” is that the high-WAC (weighted average coupon) phenomenon has diminished. The 2018 and 2019 borrowers were ripe for rapid refis, while models are now indicating a slightly lesser response (for now).
Nominal spreads are at wides for the year. On a relative basis versus investment grade, some cross-over buyers could migrate to mortgage-backed securities (MBS).
Most recent bank data indicate that banks are adding MBS at a brisk pace to start the year. Bond inflows are setting new records, so there is a strong passive bid for MBS in benchmark portfolios.
Securitized Products Allocation Decision
We maintain our allocation of 35%. Lower interest rates and the notorious negative convexity led to spread widening, but it wasn’t as bad as last year. MBS is not immune to more widening, but we think the worst has probably passed.
Dmitri Savin, Portfolio Manager, Portfolio and Risk Strategist, Emerging Markets Fixed Income
Growth stabilization, modest inflation expectations, and accommodative central banks had provided a Goldilocks environment for risk assets, yet developments surrounding the COVID-19 virus have hampered the positive momentum.
A pause in Europe’s growth recovery in parallel with the weaker China outlook could hamper the euro’s chances of reversing some of last year’s losses. We maintain a neutral outlook for the 12-month period, but the euro does appear vulnerable to new losses against a broad range of currencies. LatAm currencies currently offer attractive entry levels compared with their fundamental fair values.
According to International Monetary Market (IMM) data through 23 February, since the onset of the coronavirus, US dollar net long positions had been added continually in each of the past five weeks, though overall net positioning remains well off peak longs from 2019.
Our Recession Case Scenario Probability Increased While Our Central Case Scenario Probability Decreased During the Month
Fixed Income Scenario Probabilities – Next 12 Months (as of 27 February 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.
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.