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Bond investors had a tough 2022 but today see relatively high yields and refreshed diversification potential
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Comparing carbon emissions in US and European CLO portfolios
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Following the cycle path: update on the latest credit risk indicators
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July Issue
Why have yields continued to rise?
Macro insight
Ingredients in the mix for a more appetising 2023
INVESTMENT OUTLOOK
Multi-asseT credit: 2023 could be a year of two halves
CREDIT
Bear-case scenario most likely as recession risks loom larger
Macroeconomics
High quality bonds are primed to bloom in 2023
INVESTMENT GRADE
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Investment outlook
credit
Is the 60/40 portfolio dead? Don’t count on it
Asset allocation
Be cautious – the Fed is unlikely to pivot in 2023
Short-duration bonds
Is EM debt a silver lining to the global slowdown?
EMERGING MARKETS
Loans look-through: A year for income?
LOANS
Credit Risk Monitor: Risk is back on
The bond bear steepening: what does it mean going forward?
Macro analysis
Mortgage-backed securities: Priced for imperfection?
Real ESTATE
A resilient US banking system weathers the SVB crisis
BANKING SECTOR
JH Explorer in Brazil: A changed Lula in search for growth
Soft or hard landing: does it matter for investment grade bonds?
Investment grade
REAL ESTATE
JH Explorer in Egypt: The IMF is back in town
Credit Risk Monitor – ‘Brick on elastic’ gives way in banking
Market outlook
Tighter financial conditions: be careful what you wish for
Yield revival entices investors back to bonds
The Fed doesn’t blink
INTEREST RATES
Policy tightening is likely to be felt more by weaker borrowers, underscoring the need for careful credit assessment
Are emerging markets decoupling from the rest of the world?
Bank failures in 2023: Fallen rogues or canaries in the coalmine?
Investment STRATEGY
Late to the party: Are the best of money market returns behind us?
Interest rates
The Fed reaches its predicted terminal rate – now what?
As inseparable as mac and cheese: multi asset credit and loans
MULTI ASSET
INVESTMENT STRATEGY
Can multisector make sense for a core bond allocation?
Diversification
Portfolio pivot? Balancing defense and offense
MARKET OUTLOOK
Fixed income outlook: step back and mind the gap
BONDS
The power within: high yield bonds can be decarbonised
SUSTAINABILITY
ESG in fixed income: a marathon, not a sprint
‘Unconscious uncoupling’: The drift of UK inflation
INFLATION
Where next for corporate debt?
CORPORATE DEBT
Credit: Are red lights flashing?
Decarbonisation: Follow the money?
Emerging markets: The bright spot in a global storm?
EMERGING markets
European loans in a sweet spot for higher income
Dissecting the cycle: growth over-optimism and inflation over-pessimism
Real estate
Flip flop: what investors can learn from Zillow’s failed house-flipping business
The Fed’s inflation fight: there’s no victory declaration yet
Fixed maturity bond portfolios: an effective combination
Fixed income
Read the full article for more analysis of how sticky inflation is likely to be
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Jim Cielinski believes 2023 should bring relief on rates as central bankers recognise their servings of policy tightening are dampening inflation
Andrew Mulliner, CFA Head of Global Aggregate Strategies | Portfolio Manager
ARTICLE AUTHOR
Anyone who has made a béchamel or white sauce will recognise the dilemma facing central bankers. At first the combination of milk, butter, and flour remains a runny liquid. You stir over the heat, but it refuses to thicken. So you add more flour. Nothing happens. You add more flour. Still no response. The temptation is to keep adding flour, but there is a risk. The compounding effect of all that flour, together with the heat, creates a reaction, and all at once the sauce turns far too thick and lumpy. Central bankers’ policy tightening is the flour and the transmission mechanism (how that tightening feeds through to the economy) is the heat. The outlook for the global economy in the year ahead is lumpy as tighter financial conditions provoke material growth slowdowns and recessions. Yet, for many parts of the fixed income market, 2023 could prove to be a far more appetising year.
“The pain in fixed income markets has arguably been frontloaded, much like the US Federal Reserve frontloaded its interest rate hikes”
Figure 1: US inflation and interest rate history
Too hot to handle: dampening excesses in the economy
The past year was unpleasant for fixed income as inflation soared and the distortions to asset prices created by quantitative easing unwound. As central banks stepped back from repressing yields, price discovery returned. Bond yields rose sharply, producing some of the worst total returns in the history of fixed income (1). Yet, the pain in fixed income markets has arguably been frontloaded, much like the US Federal Reserve (Fed) front loaded its interest rate hikes with consecutive 75 basis-point increments. We should not expect the same in 2023. The starting point of higher yields and wider credit spreads should offer a healthier outcome for bond investors. How central bankers calibrate monetary policy to control inflation without causing too much economic damage will dominate markets and we can expect market volatility to persist around their announcements. Previous inflationary episodes are instructive. As Figure 1 shows, the fast pace of US rate hikes in 2022 has only previously been seen under Fed Chairmen Arthur Burns in the mid-1970s and Paul Volcker in 1979 and 1980 – both periods of rampant inflation.
Source:Bloomberg, FRED, 31 January 1960 to 11 November 2022. Federal funds effective rate %, PCE = Core Personal Consumption Expenditures Price Index inflation (excluding energy and food) year-on-year (YoY) % change, CPI = Headline Consumer Price Index inflation YoY % change.
Authored by the Global Structured Debt Team, who are led by:
Seth Meyer Portfolio Manager
Brent Olson Portfolio Manager
ARTICLE AUTHORS
JANUARY 2023
Two things are worth noting:
Both Burns and Volcker began easing when the economy weakened only to raise rates again when inflation remained high. This may incline today’s Fed to retain rates at a high level to avoid repeating this mistake. Rates have historically not peaked until inflation moves below the fed funds rate. So while we expect the Fed to slow the pace of hikes and pause rate increases in coming months, a cut will have to wait until inflation moderates significantly.
• •
For these reasons, and because we expect the US economy to outperform most other developed market economies, we think the Fed will remain tough on tackling inflation. In Europe, the European Central Bank (ECB) and the Bank of England (BoE) may pause their tightening earlier, but even there a resolute focus on inflation will likely keep the hawkish rhetoric flowing for longer than the economies can tolerate.
Sticky business: will inflation recede?
Several factors kept inflation stuck at a high level in 2022, including supply chain problems, the Russia-Ukraine conflict and, in the US, the pass-through of shelter costs in the Consumer Price Index. These should fade, with goods prices leading the decline and base effects making it hard to sustain high year-on-year inflation numbers. We expect inflation in the US to soften but remain above the Fed’s target 2% rate. Europe’s reliance on imported oil and gas aggravates the inflation outlook there, but progress in diversifying energy imports and reducing energy use mean further shocks would be linked to weather or geopolitics.
Jim Cielinski Global Head of Fixed Income
(1) This outlines a global standardised framework to measure GHG emissions from private and public sector operations.
Burns hikes
Volcker hikes
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Multi-asset credit: 2023 could be a year of two halves
Read the full article for the outlook on different fixed income asset classes
The challenge facing investors is deciding which part of the pool to swim in next year, as 2023 could become a tale of two halves, argues Head of Secured Credit Colin Fleury
Navigating the uncertain waters of 2023 requires some caution given that inflation is still running hot and central banks remain in a battle to tame it. In our view, policy tightening effects are yet to fully filter through to consumers and corporate performance. Excess consumer savings in the US, for example, have dipped to lows post their pandemic boom, but spending is softening rather than rolling over. Third-quarter corporate earnings have held up better than expected. We are seeing only early signs of corporate headcount reductions or pressures being felt by individuals as they tackle higher debt service costs from a rising interest rate environment. We have not yet seen the effects come materially through in the performance of the companies we invest in or the collateral pools of consumer credit or mortgages that back securitised assets. That is still to play out, with other risks to the global outlook such as China property sector and COVID challenges and the Russia-Ukraine conflict bubbling in the background.
Fundamentals are treading water
Given such corporate and consumer resilience, we are yet to see a material weakening in credit fundamentals, and markets are not fully pricing in the accompanying recession risk. Spreads have also been supported by an unusual supply-and-demand backdrop, with generally limited debt issuance in 2022. We believe that 2023 could become a tale of two halves, with spreads widening through mid-year as the economic reality of recession seeps through and more appropriately price recession risk. We expect more clarity on the outlook to emerge later in the year. This could include more definitive signs that inflation is getting under control and a pivot from central banks away from policy tightening. Currently the US jobs market, for example, appears to not be cooling enough, given mixed data. Non-farm payrolls growth is starting to moderate, but average hourly earnings ticked up in the November 2022 release.
Figure 1: Mixed signals from US jobs market
Source: Refinitiv Datastream, Janus Henderson Investors, 15 November 2022.
John Kerschner, CFA Head of US Securitised Products; Portfolio Manager
Colin Fleury Head of Secured Credit; Portfolio Manager
Credit
Better yields, more inviting pools
A broad repricing of risk-free yields has made credit more attractive. Regardless of which investment pool you swim in, in our view, it feels sensible to start the year on the safer side. This may mean shifting portfolios ‘up in quality’ by, for example, looking at high-grade securitisation, such as AAA- or AA-rated collateralised loan obligations, and other more senior parts of securitisations in Europe and the US. Nevertheless, the risk of further spread widening will have passthrough even to the high-quality end of the market. So, understanding how much recession risk is priced into spreads today is key for investors. In our view, high grade securitisations are pricing in greater recession risk than other credit markets, particularly as recent rallies on optimism about potential policy pivots (a pause or a slowdown in the pace of interest rate hikes) has seen spreads retrace from their recent wides, US high yield bonds being just one example.
“We are yet to see a material weakening in credit fundamentals, and markets are not fully pricing in the accompanying recession risk”
John Pattullo and Jenna Barnard, Co-Heads of Global Bonds, believe the confluence of attractive yields and an inflection point in rates should make 2023 an opportune year for high quality investment grade and government bonds
Every so often, ideal conditions present themselves. For the titan arum – the world’s largest unbranched flower – it can be anything between two to 10 years between blooms, but when it flowers, the results are impressive. We think high quality investment grade bonds, especially government bonds, are in a similar sweet spot heading into 2023, as a confluence of attractive yields and an inflection point in rates opens up the potential for strong returns.
Figure 1: Yields on government bonds
2023 is an inflection point
Bethany Payne Portfolio Manager
For bond markets, policy tightening in 2022 to tackle inflation was painful as yields rose. Yet the price correction lifted government bond yields back to levels not seen in more than a decade. It was a similar story with investment grade corporate bonds where both credit spreads and yields moved higher.
Attractive yields
Attractive income levels on bonds, however, are only half the picture. We think 2023 will also be an inflection point for the rates cycle – as central banks shift their policy in response to declining inflation and an economic downturn. This means that while we like short-dated bonds, there may be an opportunity cost to holding only short-dated bonds and that is potentially foregoing bigger capital gains from holding longer-dated bonds as rates decline. Bond yields have often overshot when core inflation spikes heading into an economic downturn. This decoupling of government bond yields from economic prospects occurred in late 2022 as bond yields rose despite manufacturing new orders declining (Figure 2). We expect government bond yields to recouple with the economic data. From above 4% in the fourth quarter of 2022, we think the US 10-year government bond yield could be close to 2% by the end of 2023. This could lead to strong capital gains on government bonds and should also have positive implications for better quality investment grade corporate bonds, since these bonds are typically sensitive to rate moves.
Source: Bloomberg, Janus Henderson Investors, Institute for Supply Management (ISM) manufacturing new orders, US 10-year government bond yield, 30 November 1972 to 30 November 2022.
(1) Source: Bloomberg, Janus Henderson Investors, ICE BofA US Corporate Index, ICE BofA 1-3 Year US Corporate Index, at 30 November 2022. Note. The calculation of the breakeven is the yield to worst divided by the modified duration. Basis point (bp) equals 1/100 of a percentage point. 1 bp = 0.01%, 100 bps = 1%. Yields may vary and are not guaranteed.
Read the full article for analysis of why employment figures are likely to take a downward turn
The rapidity and magnitude of central bank tightening caused yield curves to flatten and invert, meaning that shorter-dated bonds are paying similar (if not higher) yields than longer-dated bonds. This is creating a rare opportunity for investors to earn a higher income from holding shorter-dated bonds than longer-dated bonds, while also being exposed to less interest rate risk For example, at the end of November 2022, yields would have to rise by a further 282 basis points (a so-called breakeven) to wipe out the positive total return from shorter-dated US 1-3 year investment grade corporate bonds. This compares with a breakeven rise of 78 basis points for US investment grade corporate bonds in general (1).
“While we like short-dated bonds, there may be an opportunity cost to holding only short-dated bonds”
(1) ECB, June 2022.
(2) Janus Henderson Investors, April 2022.
Figure 2: ISM new orders versus US 10-year government bond yield
Past performance is no guarantee of future results.
Bond yields overshoot when core inflation spikes into growth downturns (circled)
Source: Bloomberg, Generic US Government Bond 10-year yield, Generic UK Government Bond 10-year yield, Generic Germany Government Bond 10-year yield, 1 January 2020 to 29 November 2022.
Yields may vary and are not guaranteed.
There is no guarantee that past trends will continue or forecasts will be realised.
John Pattullo Co-Head of Global Bonds; Portfolio Manager
Jenna Barnard Co-Head of Global Bonds; Portfolio Manager
ISM new orders 6m change
US 10-year yield 6m change (rhs)
Investment GRADE
Read the full article to find out how the carbon intensities of US and European CLOs compare
Getting a comprehensive carbon picture for non-traditional assets can be challenging. Head of Secured Credit Colin Fleury and portfolio manager Denis Struc look at climate-related risks in collateralised loan obligation (CLO) portfolios
The growing importance of assessing the carbon impact of investment portfolios is clear, with increasing ESG standards and reporting requirements globally. However, the scale of the challenges that need surmounting can vary greatly depending on the type of investments. Gathering estimated emissions data for a portfolio of traditional equities or bonds in large global corporations is considerably more straightforward than non-traditional assets, such as a portfolio of loans to smaller and often privately-owned companies or securitised products. This is because a handful of ESG data providers have developed ESG scoring approaches and carbon emissions data capture that is typically focused on traditional asset classes. A typical ESG data provider covers less than 5% of the secured loans market, as measured by the European and US Credit Suisse indices. We have therefore developed bespoke methodologies to estimate emissions from secured loans and corporate credit in general, which can then be applied to collateralised loan obligation (CLO) portfolios.
Such emissions are defined more generally under the greenhouse gas emissions (GHG) Protocol (1)
Denis Struc Portfolio Manager
Greg Wilensky Head of U.S. Fixed Income
Michael Keough Portfolio Manager
Bespoke approach to measuring carbon
Gathering reported corporate carbon emissions across many companies globally and grouping them into granular and representative peer groups forms the basis of our methodology in estimating emissions. This allows us to obtain a reliable average estimation of carbon emissions attributable to a well-defined set of sectors and sub-sectors. Using estimation, we can then efficiently overlay carbon analysis on any portfolio with corporate credit exposure. As we continue our direct corporate engagement efforts, our estimates will gradually be replaced by reported carbon numbers from more companies, further refining our analysis.
“Using estimation, we can efficiently overlay carbon analysis on any portfolio with corporate credit exposure”
Accounting for carbon in CLOs
CLO transactions, being primarily comprised of portfolios of corporate secured loans, naturally fit the approach described above, allowing us to have an early and comprehensive view on the carbon make up of these investments. The largest proportion of carbon emissions in CLO transactions are those related to the underlying corporate borrowers in the CLO collateral pools and are captured at the aggregate level in Scope 3 emissions. In this analysis, we focus on Scope 1 and 2 emissions of those underlying corporate borrowers, represented through the Weighted Average Carbon Intensity (WACI) measure. This information is then aggregated at each CLO overall portfolio level, thus representing Scope 3, or ‘financed emissions’, attributable to these CLO transactions.
Scope 1 accounts for direct emissions from sources that are owned and controlled by an organisation. These would include heating (fuel combustion on site) and company vehicles. Scope 2 accounts for indirect emissions from purchased electricity, heat or cooling, which is used by an organisation. Scope 3 accounts for all other indirect emissions, which are a consequence of the activities of an organisation from sources it does not control (i.e., emissions from downstream and upstream activities such as goods or services that are bought or sold, as well as ‘financed emissions’ attributed to investment portfolios of financial institutions such as banks and asset managers).
• • •
sustainability
Read the full article for more on the different scenarios and which is most likely
Our latest scenario analysis does, however, highlights the more positive outlook for core fixed income
Welcome to the latest edition of our bond market forecast analysis. This report is based on the scenario analysis run by the Global Bonds Team to guide fixed income asset allocation decisions. Each report tries to assess the expected returns potentially delivered by the major fixed income sectors based on a range of modelled outcomes (see appendix for a full description of our methodology).
Jason England Portfolio Manager
Scenarios considered
We adopt a scenario-driven approach to identify the relative attractiveness of fixed income sectors. Our aim is not to perfectly forecast returns to the nearest basis point (as that is not possible), but to understand the range of return outcomes and gauge the resilience of that performance across probable scenarios. Our base case over the year to end of 2023 is that the global economy enters a recession. The speed at which central banks have hiked rates will feed through to the real economy including the housing markets, and consumer spending power weakens as real incomes are eroded by inflation. With tight labour markets, unemployment is not expected to rise as significantly as it did during COVID, but demand destruction results in weak GDP and falling inflation. Although stronger consumer spending stateside and the country’s lower sensitivity to energy price swings helps insulate the US from the worst of the downturn we model, we still expect the US to fall into a recession. Various leading indicators have already signalled that recession is likely. A soft landing is still possible in the US, but the chances are receding. Overall, these two scenarios – recession and soft-landing – account for over 75% of the probability distribution. Inflation falls in all scenarios from current levels to between 1.7% and 4.5% in a year’s time.
Central banks remain laser-focused on current inflation
Across all four scenarios modelled, inflation has either peaked or will do so by early 2023, and fall back sharply from current levels, but to differing degrees. Broad money growth has collapsed (unlike in the inflationary 1970s when it stayed above 10%), supply/demand imbalances that pushed up prices are correcting (e.g. freight rates, used car prices), housing markets are showing price falls and the base effects of energy price rises should bear down on year-on-year inflation numbers (albeit with a longer lag in UK/Europe). Forward looking indicators such as real money supply growth, PMI new orders, and the inverted yield curve point to a sharp downturn ahead, reflecting the lagged effects of tighter monetary policy. Inflation-linked bond real yields made new highs for this cycle since our last report, signalling a tightening of financial conditions. Ultimately, current central bank policy means more rate hikes until inflation shows a more pronounced downward trend, which will be met with demand destruction and a squeeze in real and discretionary incomes.
Figure 1: Fading money growth suggests inflation is heading lower
Source: Refinitiv Datastream, Janus Henderson Investors, 31 January 1965 to 30 November 2022. G7 Consumer Price Index, year-on-year % change, G7 Broad Money growth, year-on-year % change. G7 countries are Canada, France, Italy, Japan, Germany, UK and US. Broad money is the stock of physical cash, bank deposits, money market funds and other monetary instruments held by the private sector.
Helen Anthony CFA Portfolio Manager
Matthew Argent Client Portfolio Manager
macroeconomics
Read the full report for more on the cycle indicators and issuer fundamentals which are informing the outlook for 2023
Credit had a better fourth quarter, delivering positive total returns as spreads tightened on optimism at the apparent passing of peak inflation. A risk-on start to 2023 followed, supported by China reopening hopes and some cooling in the US labour market, but the global economic outlook remains uncertain
As spreads contracted in Q4, our cycle indicator is suggesting that this rally is unlikely to be sustainable. We expect fundamental weakness to proliferate as we move through 2023. Optimism in a central bank retreat has allowed markets to reopen, but this too may prove fleeting. As inflation retreats, real rates will rise, and an inability to borrow at heavily subsidised levels of real rates will worsen the default outlook. We are not out of the woods yet, although the decline in inflation is a critical prerequisite to the elusive soft landing that investors cherish. If a soft landing occurs, correlations within credit could increase. If a hard landing, we would expect to see further dispersion as we go through into the second half of 2023. Careful security selection and building resilience into credit portfolios will be key to navigating this part of the credit cycle.
MARCH 2023
Read the full article for more on defaults and where they are likely to be concentrated
Hard or soft landing? Pivot or pause? While prospects for the global economy remain in the balance, David Milward considers a more predictable element for fixed income investors
Given 2022 was a poor year for fixed income, investors may be re-evaluating credit given the attractive yields on offer today versus history. Higher yields reflect both aggressive tightening by central banks and wider spreads. Such asset allocation decisions are being influenced by conviction towards a hard or soft landing for the global economy – with markets pricing in the optimistic scenario. It’s too early to make a call on this, in our view, and uncertainty lies ahead on growth, inflation and policy. The driver of returns in 2023 thus could be cash interest payments, and investors should be cognisant of this arguably more predictable component. While bond yields have risen, the underlying income (as measured by average coupon) generated in European high yield is at a post global financial crisis (GFC) low given the low yield environment seen for most of the last 15 years (Figure 1). By contrast, European secured loans, as floating rate assets, now generate coupons close to post GFC highs as rising short-term rates lift the cash coupons paid by borrowers.
David Milward Head of Loans, Portfolio Manager
Cash yields in the European loan market now exceed 6% and are expected to increase further as expected central bank tightening is fully reflected in short-term cash rates (Figure 2). With European rates forecasted to rise by around 100bps this year, such income generated for a loan portfolio provides a significant cushion to returns if spreads widen from here.
Loans
Figure 1: Cash interest receipts in European loans supersede high yield
Source: Bloomberg, ICE BAML, Credit Suisse, as at 31 December 2022. ICE BofA Euro High Yield; Credit Suisse Western European Leveraged Loan Index (CS WELLI).
Greg Wilensky CFA, Head of US Fixed Income, Portfolio Manager
Jeremiah Buckley CFA, Portfolio Manager
Source: Janus Henderson Investors, Bloomberg, ICE BAML. Notes: Data is based on 1-month Libor up to 31 December 2020, then SONIA, ESTR, SOFR 1-month rates to 31 December 2022. Forward rates based on overnight index swap (OIS) curves as at 18 January 2023.
Figure 2: Cash rates are expected to rise further
There is no guarantee that past trends will continue, or forecasts will be realised.
USD Cash
EUR Cash
GBP Cash
EU High Yield
EU loans
A more difficult economic backdrop
Investor concerns around rising defaults are understandable, but we’re not anticipating a material spike in defaults this year. Moody’s forecast sub-investment grade defaults to rise to 4% this year (1) in Europe – which is in line with recent averages. While this is a notable increase, it’s certainly not a major negative for the market. It will be important to avoid companies with over-levered balance sheets and limited pricing power in this environment. It is also worth noting that both US and European loans have higher recovery rates (2) than their equivalent high yield markets.
Figure 3: Loans have higher recovery rates than high yield
US high yield
Trailing 12-month par default rate
Trailing 12-month recovery rate
Trailing 12-month default loss rate
US loans
Western European high yield
Western European loans
1.3%
1.1%
0.1%
1.9%
54.7%
61.2%
38.5%
61.8%
0.6%
0.4%
0.06%
0.73%
Source: Credit Suisse, 30 November 2022.
(1) As at 15 December 2022.
(2) Recovery rate is the extent to which principal and accrued interest on defaulted debt can be recovered, expressed as a percentage of face value. HY = high yield.
Spreads are offering adequate compensation for rising default risk, as reflected in current loan discount margins (DMs) – a type of yield-spread calculation designed to estimate the average expected return of a variable-rate security. For example, the 3-year DM of 6.61% (3) for European loans offers a significant cushion against potentially rising defaults.
(3) A measure of the cushion available to absorb any defaults within the portfolio of loans for each tranche of CLO debt. The structures typically allow a portfolio to hold up to 7.5% CCC-rated assets with no consequence (ie. the loans continue to be valued at par for OC purposes). If this limit is breached, then the excess must be priced at market value for the OC tests.
Read the full article for more on where emerging markets may rebound this year
As we move closer to the end of the US hiking cycle, the outlook for emerging markets (EMs) looks brighter in 2023. The Emerging Markets Debt (EMD) Hard Currency (HC) team explore whether EMD HC could become the silver lining amid the global slowdown
The fortunes for EMs next year are largely dependent on the path of inflation, US Federal Reserve (Fed) hawkishness and the depth of the global slowdown. As risk appetite is a key driver of capital flows and thus EMD HC performance, this really matters for investors and is largely defined by the global environment. As US CPI appeared to have peaked in October, this saw a widespread rally across risk assets as optimism was revived – perhaps too much so – for a long-awaited pivot. Overly gloomy markets reversed as global risk aversion halved in November, according to our proprietary JHI Risk Aversion Index (RAI). The EMD HC asset class therefore saw the strongest monthly return since the 1990s (1).
Surpassing peak US inflation was pivotal for markets as it signalled that the end of the US hiking cycle could be on the horizon (in our view by the middle of next year). US Treasury yields tend to hit cycle highs when the Fed pauses hiking (2) and so a peak in yields also comes with less risk of a strong dollar in 2023. Such strength has hampered EM performance – given economies’ exposure to dollar-denominated debt. This is because a stronger dollar has predominantly been accompanied by wider EMD HC spreads. A more constructive environment for the asset class could therefore materialise next year, as risk appetite tends to lift once the hiking is over and uncertainty subsides. The interplay between inflation and economic growth will be key to how investors perceive EM – and ergo valuations – and whether the Fed manages to orchestrate the soft landing it hopes for.
Figure 1: Risk aversion on a downward trajectory
Source: Janus Henderson Investors, Macrobond, 30 November 2009 to 30 November 2022. First principal component of a broad set of asset prices, i.e. a commonly shared risk component that is not asset class specific which we interpret as a broader representation of market sentiment. A lower score indicates risk aversion has fallen across global assets.
Thomas Haugaard Portfolio Manager
Sorin Pirău Portfolio Manager
Brighter relative growth prospects for EM
As the storm clouds amass for the global slowdown in 2023, investors will likely be considering where to seek shelter. According to the IMF/WEO projections, the EM-US growth differential is set to grow in 2023 and 2024 as EM emerges as relatively unscathed in the broader global slowdown (Figure 2). Structural drivers for EM growth – such as technology and demographics – are more favourable relative to developed markets (DMs). The latter also face the more difficult retracement from years of very loose monetary and fiscal policies. In contrast, EM economies did not have the same firepower to spend while they are also generally ahead in their tightening cycles. This suggests EMs may have monetary policy buffers to draw on in a slowing global economy. The rising EM-US rate differential could be a positive tailwind for tighter EMD spreads as it makes EM relatively attractive from a fundamental perspective.
Source: International Monetary Fund (IMF) and World Economic Outlook (WEO) projections, October 2022, Macrobond.
Figure 2: EM-US growth differential to rise
Bent Lystbæk Portfolio Manager
Jacob Ellinge Nielsen Portfolio Manager
“The rising EM-US rate differential could be a positive tailwind for tighter EMD spreads as it makes EM relatively attractive from a fundamental perspective”
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
2023
2024
7.5
5.0
2.5
0.0
-2.5
-5.0
-7.5
4.0
3.5
3.0
2.0
1.5
1.0
0.5
EM-US growth
Euro Area
Advanced
Percent
World
United States
(1) Source: Bloomberg, monthly total returns according to the J.P. Morgan EMBI Global Diversified Index (EMBIGD), 30 November 2022.
(2) Source: Goldman Sachs Investment Research, Haver Analytics, 28 November 2022.
Read the full article for more on how the market is seemingly ignoring Chairman Powell’s hawkish assertions
Jason England and Daniel Siluk argue that investors need to brace themselves for higher-for-longer interest rates and that a conservative approach toward duration is merited
After a tumultuous 2022, fixed income investors are seeking grains of optimism wherever they can find them, and a modest – but ultimately short-lived – rally off the year’s lows suggested they had unearthed a few. In contrast, we maintain our stance that caution continues to be merited as the calendar turns to 2023. Over the past two years, both policymakers and investors have gotten plenty wrong. Bonds’ recent rally was premised on inflation having peaked and the expectation that the Federal Reserve (Fed) will pivot toward a dovish stance once the US economy slows. While we acknowledge that the worst of inflation is likely behind us, we cannot ignore that its stickiest components – namely wages – remain elevated. We believe the task of guiding inflation back toward the Fed’s 2.0% objective will take longer than the market expects. Consequently, it’s our view that a 2023 policy pivot is not in the cards
Daniel Siluk Portfolio Manager
Not yet out of the woods
The path of inflation, interest rates, and the economy will continue to play a significant role in the bond market until greater visibility into these forces emerges. The chances are slim that the inflation and interest rate disruptions of 2022 will be repeated. Yet, 2022’s resetting of rates has left bonds better positioned to withstand additional shocks. After several years, a fixed income allocation once again has the potential to offer diversification against swings in riskier asset classes, as well as levels of income generation that investors feared had been consigned to the annals of history.
“We think a pivot is unlikely. Fed Chairman Jerome Powell has been resolute in his messaging that guiding inflation back toward 2.0% is his highest priority”
Getting realistic
Some adjustment has been made in resetting expectations as consensus has coalesced around the global economy slowing in 2023. In the US, annualised quarterly economic growth is forecast to range between 0.0% and 1.0% over the year. At these levels, any downside surprise could tilt the economy into recession. This potential outcome is partly responsible for the bond market’s recovery, as bulls expect it would force the Fed to pivot. But we think a pivot is unlikely. Fed Chairman Jerome Powell has been resolute in his messaging that guiding inflation back toward 2.0% is his highest priority. Inflation falling from 9.0% to 5.0% is the easy part, as the baseline effects from strong pandemic-era demand for goods rolls off. The hard part will be getting from 5.0% to 2.0%, especially as the contribution of the wage-heavy services component to overall inflation has increased in recent months. We don’t see any path toward 2.0% inflation that doesn’t involve quelling the demand for labour, which feeds directly into upward wage pressure. As alluded to in the Fed’s most recent projections, the central bank is willing to pay the price of a slowing economy and higher unemployment to maintain credibility and – importantly – avoid the mistakes of the 1970s when a premature dovish pivot only increased inflation’s volatility.
Read the full article for more on why a 60/40 portfolio may be beneficial in the years ahead
Jeremiah Buckley and Greg Wilensky discuss why, despite a challenging year in 2022, they believe the long-term benefits of stock-bond diversification remain intact
“The rumors of my death have been greatly exaggerated.” – Mark Twain (1835-1910) While returns on financial assets in 2022 left many investors frustrated, those holding balanced portfolios have reason to feel particularly aggrieved, having just experienced their worst year of returns since the Global Financial Crisis (GFC). Investors who hold balanced portfolios (typically a 60/40 allocation to stocks and bonds) generally do so because the strategy has, over time, yielded better risk-adjusted returns by limiting drawdowns versus equity-only strategies. The key tenet underlying the balanced approach is that stocks and bonds have historically tended to move in opposite directions during times of financial market stress. The 60/40 portfolio boasts an impressive track record: Prior to 2022, it delivered positive returns in 35 of the previous 41 years. But in 2022, the strategy didn’t work as investors have come to expect, recording a -16.9% return as the Bloomberg US Aggregate Bond Index (US Agg) logged its worst year on record, and the S&P 500® Index simultaneously experienced its seventh-worst year since the Great Depression. Naturally, many investors have started to question whether the game is up, and if traditional stock-bond diversification is dead? Has the multi-decade symbiotic relationship between stocks and bonds come to a bitter and abrupt end?
Correlations: 2022 was not that unusual
As the debate over the balanced portfolio’s future rages on, critics of the 60/40 portfolio have pointed to the sharp increase in the correlation between stock and bond returns in 2022. Their argument? If bonds and stocks are now moving in lockstep with one another, of what use are bonds as a diversifier? In our view, however, investors would do well to consider a longer-term view of correlation. As shown in Figure 2, over the past 30 years, stock-bond correlations have fluctuated significantly on a 1-year rolling basis, and on a 3-year rolling basis have remained either positive or negative for long periods of time. Yet, despite the short-term swings, stock-bond correlation has on average been close to zero. It is not unusual for correlations to rise over the short term and, as such, we do not see evidence to substantiate a theory that the fundamental relationship between stocks and bonds has broken down.
Figure 1: Stocks and bonds have simultaneously experienced negative calendar-year returns in only five of the past 95 years
Source: Bloomberg, Morningstar, NYU Stern, as of December 31, 2022. Notes: S&P 500 Index total returns and 10-year US Treasury Bond total returns, 1928-2022. Blue squares represent years in which both stocks and bonds were down, orange squares represent years in which stocks were up and bonds were down, or bonds were up and stocks were down, or both stocks and bonds were up.
Returns: 2022 was a rarity
In our view, it is vital for investors to grasp how rare 2022 was from a return perspective. Much of the move down in asset prices was triggered by the Federal Reserve’s (Fed) aggressive rate hikes (4.25% within the calendar year) as it sought to rein in runaway inflation. But, as shown in Figure 1, the combined effect of the rate hikes on stocks and bonds was highly unusual, as they both ended the year down for only the fifth time since 1928.
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US 10-year Treasury calendar year return
S&P 500 calendar year return
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Stocks down, bonds up
Stocks up bonds up
Stocks up bonds down
Source: Janus Henderson Investors, as of December 31, 2022. Note: Rolling correlation of S&P 500 Index and Bloomberg US Aggregate Bond Index using monthly
Figure 2: Stock-bond correlation (1990 – 2022)
Past performance does not predict future returns.
It is common for correlation to fluctuate, but on average it has been close to zero.
1-year rolling correlation of S&P 500 and US Agg
3-year rolling correlation of S&P 500 and US Agg
Average correlation of S&P 500 and US Agg
“We do not see evidence to substantiate a theory that the fundamental relationship between stocks and bonds has broken down”
Read the full article for analysis of how the four recessions compare to today
James Briggs and Tim Winstone look back at previous Eurozone economic downturns for their impact on investment grade corporate bonds and whether parallels exist with today
Soft or hard? That’s the dilemma facing markets, and we’re not talking about cheese. Can central banks engineer a soft landing for the economy or will they provoke a hard landing with a deep recession? We take a look at previous economic downturns in the Eurozone and whether there might be lessons for today’s euro investment grade (IG) corporate bond market. During the last 25 years the Eurozone has had four contraction/recessionary episodes, as represented by periods of negative quarterly real gross domestic product (GDP) growth. The automatic assumption might be that holding government bonds over corporate bonds would be a good strategy in a period of economic weakness. History suggests that is only true in hard landings. The four eurozone economic contractions are:
APRIL 2023
Figure 1: Total and excess returns of Euro investment grade corporate bonds during economic contractions (annualised figures)
Source: Janus Henderson, Bloomberg, ICE BofA Euro Corporate Index, total returns and excess returns in euro. All economic contraction periods are inclusive (Iraq War = Q1 2003, Global Financial Crisis = Q2 2008 to Q1 2009, Eurozone debt crisis = Q4 2011 to Q1 2013, COVID = Q1 2020 to Q4 2020). Annualised figures convert the cumulative return for a period into an an annual rate. Past performance does not predict future returns.
James Briggs ACA, CFA, Portfolio Manager
Tim Winstone CFA, Portfolio Manager
To correct for the fact that recessions do not just start and finish at the same time for all companies, i.e. some corporates will be affected earlier or later by economic weakness, in Figure 2 we expanded the period around the contractions to cover the preceding six months and the following six months. This turns total return positive in all the longer periods and tends to soften the extremes of excess return, i.e. lowers strong positive excess return and reduces negative excess return.
April 2023
15%
“In three out of the four periods, holding investment grade corporate bonds was more rewarding than holding government bonds”
2003 Iraq War (Q1 2003 short contraction) 2008/9 Global Financial Crisis (Q2 2008 to Q1 2009 deep recession) 2011/13 Eurozone Debt Crisis (Q4 2011 to Q1 2013 protracted shallow recession) 2020 COVID Pandemic (Q1 2020 to Q4 2020 V-shaped recession)
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The ICE BofA Euro Corporate Index is a basket of Euro investment grade corporate bonds. Returns data is available for both total return (combined income and capital movements) and excess returns. The excess return isolates the portion of performance that is attributed solely to credit and is equal to the corporate bond(s) total return minus the total return on a risk-matched basket of government bonds. It essentially displays the excess return on an index that comes from the additional yield that corporate bonds accrue over government bonds of the same maturity and the effect of any change in credit spreads over the period. Figure 1 shows that in three out of the four periods, holding investment grade corporate bonds was more rewarding than holding government bonds. Incidentally, investment grade bonds also outperformed equities (as represented by the MSCI Europe ex UK Total Return Index) in three out of the four periods (the exception being the 2011-13 debt crisis) (1).
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2003 Iraq War
2008/9 Global Financial Crisis
2011/13 Eurozone Debt Crisis
2020 COVID
Total return
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Figure 2: Total and excess returns of Euro investment grade corporate bonds during economic contractions plus six months either side (annualised figures)
12%
8%
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Iraq War
Global Financial Crisis
Eurozone Debt Crisis
COVID
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(1) Source: Janus Henderson, Bloomberg, MSCI Europe ex UK, ICE BofA Euro Corporate Index, total returns in USD. Periods as per Figure 1. Past performance does not predict future returns.
Given the uncertainty in the market about whether we will experience a hard or soft landing, the previous episodes are instructive. They reveal that it has historically made more sense to own investment grade corporate bonds over government bonds in all but the most severe economic contractions.
Read the full article for more on the likely ramifications of the SVB receivership
John Jordan explains how a well-capitalized US banking system is constructed to alleviate a run on deposits such as what occurred with Silicon Valley Bank
In the wake of Silicon Valley Bank (SVB) falling into receivership, markets have understandably been attempting to identify other institutions or segments of the broader economy that may be at similar risk. Importantly, we view the US banking system as well capitalized. What occurred at SVB, in our view, was the result of the combination of its unique depositor base and the portfolio of longer-dated securities held on its balance sheet. Even a healthy banking system such as that of the US is at risk of a bank run, a situation in which depositors seek to withdraw funds – for reasons founded or unfounded – that can far exceed a bank’s cash on hand. This is perhaps the most fundamental reason why banks are heavily regulated; governments are not keen on seeing a country’s citizens lose their savings. The US banking system is designed to have the mechanisms and processes in place to mitigate this risk and, in the event of a bank run, resolve it in the least disruptive manner possible. These mechanisms were fortified in the wake of the Global Financial Crisis (GFC). What occurred with SVB was primarily due to interest rate risk, given last year’s historic rise in policy rates. While our team of analysts are thoroughly analysing all segments of the banking and broader financial sector to identify other potential sources of stress brought on by higher rates, we believe that the US banking system is resilient and that most institutions can weather this bout of idiosyncratic volatility.
John Jordan Portfolio Manager | Research Analyst
Banking sector
“A favoured destination for risk capital was early-stage technology or biotech companies. Such funds turbocharged SVB’s deposit base”
In response to the global pandemic, authorities unleashed a wave of liquidity. Much of it was channelled into risk capital seeking a home. A favoured destination was early-stage technology or biotech companies. Such funds turbocharged SVB’s deposit base. The tech sector’s recent slowdown, however, not only dried up venture-backed companies’ sources of funding, but also forced them to draw down their accounts to meet payroll and other expenses. These withdrawals accelerated early this year; in response, SVB management announced it would sell certain securities and raise additional capital. In a different environment these moves likely would have been sufficient to fortify SVB’s finances. However, given the concentrated nature of SVB’s deposit base, the initial concerns over its balance sheet snowballed, resulting in last week’s run on deposits.
A convergence of forces
Read the full article for more, including analysis of Brazil’s likely debt-to-GDP ratio
President Lula faces a Brazil that is very different to when he first came to office in 2003. Thomas Haugaard explores the outlook for Brazil and the three constraints influencing Lula’s pursuit of his populist agenda
We have just returned from a five-day trip to Latin America, spending three days in Brazil (Rio, Brasilia and São Paulo) followed by two days in Argentina (Buenos Aires). Rio de Janeiro and Buenos Aires are known for their bustle and energy, with a mix of cultures from across the world seen in everything from dance to food. Arriving a week before the famous Rio Carnival was scheduled to begin, the streets were already teeming with people as preparations mounted for the big event. We met with a broad set of experts including local investors, independent political and economic consultants as well as political actors. Sentiment across the board was negative overall. There was a clear lack of conviction among locals, who generally could not understand why foreign investors appear much less concerned and even somewhat constructive on the outlook for Brazil.
A changed Lula
Before the October 2022 election, there was a strong sense that Lula da Silva, who was gunning for the role of president for a third time, would adopt a market-friendly approach, leaning to the centre and committing to responsible fiscal policies and more broadly to stability-oriented macro policies that characterised the previous Temer and Bolsonaro administrations. The consensus from our meetings is that Lula has so far disappointed on all possible accounts, including looser fiscal policy, acting as an ineffectual pseudo Minister of Finance (with Haddad the actual MoF having limited success so far in constraining Lula) as well as pressuring the central bank to cut interest rates.
“He now has a determination to support economic growth quickly, almost at any cost”
This Lula appears not to be the same president he was in the past. He now has a determination to support economic growth quickly, almost at any cost to secure popularity. Without significant checks and balances this could mean:
As the former President Dilma Rousseff put it: “Public spending is life!” A high degree of uncertainty surrounds checks and balances given Lula’s majority in both chambers of Congress and the alignment of the Supreme Court with his Workers Party (PT). With former president Bolsonaro likely returning to Brazil soon, we could see a more concerted resistance to the above policy agenda from Congress; the coalition in Congress are, in our view, fragile and sensitive to populist policy initiatives.
More fiscal spending including quasi-fiscal spending via state-owned banks; Plans to loosen the fiscal framework; and Amplifying this fiscal lever with a monetary one regardless of the inflationary backdrop.
Admiring the view from our hotel, we recalled our last visit in 2016, when Brazil was managing its way out of a deep recession and political crisis following the impeachment of President Dilma Rousseff, who was Lula’s anointed heir back in 2010.
This Lula appears not to be the same president he was in the past. He now has a determination to support economic growth quickly, almost at any cost to secure popularity. Without significant checks and balances this could mean:.
Read the full article to learn about the other elements that are currently priced into MBS
John Kerschner and Nick Childs explain why they believe key risks are now largely priced in to fixed income markets, with selective areas – particularly mortgage-backed securities (MBS) – presenting an opportunity to provide favourable risk-adjusted returns
Fixed income investors have welcomed a positive start to 2023 after a very tough year in 2022. Last year, as inflation soared, bond prices were hit simultaneously with rising interest rates and widening credit spreads. The trifecta of upward inflationary pressure, hawkish central banks, and the negative impact of the Russia/Ukraine conflict resulted in the Bloomberg US Aggregate Bond Index (Agg) registering its worst year since 1999. As painful as this sharp drawdown was for investors’ portfolios, in our view, a lot of bad news is now priced in. While there is potential for more volatility, we believe there are opportunities in selective areas of fixed income, particularly in mortgage-backed securities (MBS). As shown in Figure 1, relative to US Treasuries, MBS underperformed in 2022 to a degree not seen since the Global Financial Crisis (GFC). Further, MBS spreads have widened significantly relative to alternative investment-grade credit, as highlighted in Figure 2.
Sorin Pirău CFA, Portfolio Manager
John Kerschner CFA, Head of US Securitised Products | Portfolio Manager
Nick Childs CFA, Portfolio Manager
What is currently priced into MBS?
1.High levels of interest rate volatility
MBS performance is largely affected by interest rate volatility. Higher volatility equates to greater uncertainty around refinancing and mortgage prepayments, which is the primary fundamental risk for MBS. With so much uncertainty surrounding QT, inflation, and expected rate hikes, interest rate volatility has been above historical norms since early 2022. Figure 3 shows that the ICE BofA MOVE Index, a measure of interest rate volatility, has been elevated above 100 for the longest stretch seen in the last decade.
Figure 1: MBS Index excess return over U.S. Treasuries (rolling 12m)
Source: Bloomberg, Janus Henderson Investors as of January 31, 2023. Bloomberg U.S. MBS Index excess return (12-month) versus the U.S. Treasury curve. Note: Market-value weighted average 12-month excess return. Measure of performance of a spread security over that of an equivalent Treasury security. The 12-month return is calculated using the previous month end.
Extent of MBS underperformance in 2022 not seen since 2008.
Source: Bloomberg, Janus Henderson Investors. Current coupon MBS spreads versus Market CDX North America Investment-Grade Index, as of January 31, 2023.
Valuations on MBS look attractive relative to investment-grade alternatives.
Figure 2: MBS current-coupon spreads relative to investment-grade (IG) credit spreads
The MOVE Index has crossed over the 100-point mark only three times in the last 10 years, and only for brief periods. During such times of high volatility, the prices of bonds with embedded or theoretical options (like MBS) are affected to a greater degree than comparable non-option bonds, because the prepayment option (the ability to refinance the mortgage) held by the borrower increases in value with higher interest rate volatility. We think that as the market gains more clarity around the trajectory of inflation and the Fed’s future rate hikes, it is likely that rate volatility will recede to more normalized levels. To the extent that MBS are penalized in a higher volatility environment, all else being equal, their optionality should provide a tailwind for price appreciation if we move back to lower levels of volatility.
Source: Bloomberg, Janus Henderson Investors, ICE BofA MOVE Index, as of January 31, 2023.
If interest rate volatility continues to come down, it should be a positive for MBS.
Figure 3: Interest rate volatility as measured by the ICE BofA MOVE Index (2012-2023)
1.High levels of interest rate volatility MBS performance is largely affected by interest rate volatility. Higher volatility equates to greater uncertainty around refinancing and mortgage prepayments, which is the primary fundamental risk for MBS. With so much uncertainty surrounding QT, inflation, and expected rate hikes, interest rate volatility has been above historical norms since early 2022. Figure 3 shows that the ICE BofA MOVE Index, a measure of interest rate volatility, has been elevated above 100 for the longest stretch seen in the last decade.
Read the full article for analysis of Egypt’s likely debt and GDP trajectory
Sorin Pirău from the Emerging Markets Debt Hard Currency Team considers how Egypt has changed since the last visit in 2018 and the challenges and opportunities ahead
Since our last visit to Egypt in October 2018, many things have changed, while others remain the same. The depreciation of the Egyptian pound finally took place, albeit only after large FX reserves were deployed in a futile attempt to defend what turned out to be an unsustainable dollar peg. And the traffic is better given improved infrastructure, but also perhaps due to fuel price hikes discouraging driving. However, as in 2018, Egypt finds itself in yet another International Monetary Fund (IMF) programme, having earned the unwelcomed distinction of being the second largest debtor to the Fund after Argentina (1).
IMF funding support was granted through an Extended Fund Facility (EFF) (2) late last year after Egypt committed itself to a permanent shift to a flexible exchange rate regime (3) – in other words an FX rate determined by the relative supply and demand in the forex market with little to no intervention from the Central Bank of Egypt (CBE). It also committed to fiscal and structural reforms to preserve macroeconomic stability and restore reserves through investment flows from FDI as one example. Given that the committed funding is relatively small this time compared to its last EFF in 2016, the programme is expected to act as a catalyst for additional funding from “friendly” countries from the GCC (Gulf Cooperation Council). These countries have already committed to renew existing deposits at the CBE to support the country over the next four years. Our discussions with public sector officials from various institutions like the Ministry of Finance, CBE, National Bank of Egypt and the Sovereign Fund of Egypt, as well as representatives from the IMF, revolved around the three pillars of the EFF:
“Sentiment on the ground was that most of the FX imbalances have been cleared and the currency has now reached a more sustainable level”
FX reserves stabilise
After the devaluation over the past year that saw the Egyptian pound lose half of its value, sentiment on the ground was that most of the FX imbalances have been cleared and the currency has now reached a more sustainable level. The abolition of the requirement to use letters of credit (LCs) for imports contributed to the significant ease of foreign goods stuck at ports and revived liquidity in the FX markets. Positively, the direct provision of dollars from CBE’s FX reserves to various state-owned enterprises (SOEs) has ceased, while subsidised lending to these entities is being gradually withdrawn. FX reserves have therefore stabilised and have been growing over the past five months. But for FX gross reserves to more than double to reach the IMF’s projection of US$78 billion by June 2027 (4) remains challenging. For this target to be hit, the country’s key sources of FX will need to be firing on all cylinders over the next few years:
The flexible exchange rate regime (and the associated rebuilding of FX reserves), Fiscal consolidation, and The enactment of long-delayed structural and governance reforms.
Thanks to improved infrastructure, the traffic was much better this time around compared to 2018
Net exports should be helped by Egypt’s increasing gas exports, which last year pushed fuel export receipts to a net surplus position of roughly US$4.5 billion (5). Increased gas demand in Europe bodes well for Egypt’s plans to ramp up capacity at its two liquefied natural gas (LNG) plants. The depreciation of the pound should have a contractionary impact on foreign good imports, while at the same time incentivising more domestic production. Remittances are expected to continue flowing at a healthy pace of around US$32 billion annually (6), making Egypt the fifth largest recipient of such flows after India, Mexico, China and the Philippines (7). Tourism has recovered to over 80% of its pre-Covid level (8) and accounted for a significant portion of foreign currency income over the last fiscal year.
(1) Source: HSBC, IMF, 13 January 2023.
(2) When a country faces serious medium-term balance of payments problems because of structural weaknesses that require time to address, the IMF can assist through an Extended Fund Facility (EFF). Compared to assistance provided under the Stand-by Arrangement, assistance under an extended arrangement features longer programme engagement – to help countries implement medium-term structural reforms – and a longer repayment period. (3) According to the IMF, the flexible exchange rate would help absorb external shocks and help rebuild reserves while gradually reducing inflation.
(4) Source: International Monetary Fund, January 2023. (5) Source: FactSet, Central Bank of Egypt, Suez Canal Authority, 30 June 2022. (6) Source: Central Bank of Egypt, 30 June 2022. (7) Source: Migration Data Portal, 6 January 2023. (8) Source: Central Bank of Egypt, 30 June 2022.
(1) Source: HSBC, IMF, 13 January 2023. (2) When a country faces serious medium-term balance of payments problems because of structural weaknesses that require time to address, the IMF can assist through an Extended Fund Facility (EFF). Compared to assistance provided under the Stand-by Arrangement, assistance under an extended arrangement features longer programme engagement – to help countries implement medium-term structural reforms – and a longer repayment period. (3) According to the IMF, the flexible exchange rate would help absorb external shocks and help rebuild reserves while gradually reducing inflation. (4) Source: International Monetary Fund, January 2023. (5) Source: FactSet, Central Bank of Egypt, Suez Canal Authority, 30 June 2022. (6) Source: Central Bank of Egypt, 30 June 2022. (7) Source: Migration Data Portal, 6 January 2023. (8) Source: Central Bank of Egypt, 30 June 2022.
Read the full article for discussion of the interest rate implications and the likelihood of recession
The latest meeting of Janus Henderson’s Fixed Income Investment Strategy Group discussed how the recent banking crisis was likely to have exacerbated recession risks
A key requisite for central bank policy success has been to tighten financial conditions, slow the economy and thus dampen inflation. In other words, it was widely expected that central banks would need to break things to restore price stability. Bank collapses in March threw an obstacle into the mix by reigniting concerns around financial stability – the Global Financial Crisis (GFC) casts a long shadow. So what impact might the recent banking stress have on credit and rates?
Jim Cielinski CFA, Global Head of Fixed Income
MAY 2023
Tighter credit conditions
Several participants raised the point that there had been little to no increase in debt growth among US investment grade (IG) corporates since 2021. This could store up economic trouble ahead since credit creation is a key element in economic expansion. Weaker earnings growth also suggested leverage (debt/earnings) ratios were likely to deteriorate in coming quarters, although interest cover remained high (1). Members noted the close positive correlation between tighter lending standards and economic growth, with the latter often following lending standards with a two-quarter lag. In late March, Goldman Sachs estimated that the banking tensions and tighter lending conditions were likely to shave 0.25-0.5% off US gross domestic product (GDP) growth and imply a roughly 0.3% drag on Euro Area GDP (2). Given the fallout in the US regional banking sector, there was concern that many small firms are reliant on regional banks for capital access, so if the relationship shown in Figure 3 holds, it could hasten recession.
Figure 1: Credit conditions were tightening well beforethe recent bank woes
Source: Refinitiv Datastream, Federal Reserve Senior Loan Officer Opinon Survey(US commercial and industrial loans to large and medium firms, net % domesticbanks tightening lending standards, net % domestic banks reporting stronger demandfor credit), Q4 1990 to Q4 2022.
Source: European Central Bank, December 2002 to December 2022.
Percentage balance of banks reporting growing loan demandand tightening credit standards
Figure 2: ECB Bank Lending Survey shows similar credit tightening by banks
Source: Refinitiv Datatstream, Federal Reserve Senior Loan Officer Opinion Survey(US commercial and industrial loans to small firms, net % domestic bankstightening lending standards), US real gross domestic product growth year-on-year(yoy) % change, Q4 1989 to Q4 2022.
Tighter lending standards for small firms will slow GDP growth
Figure 3: Economies are built on credit creation
Debate centred on how banks were likely to react to the crisis, with an expectation that lending standards would tighten further. After all, credit conditions were tightening well before the recent crisis erupted, with banks already tightening lending standards and reporting weaker demand for borrowing through the second half of 2022.
Worryingly, the trends in the US were evident elsewhere. Europe displayed a similar squeeze, with credit standards heading back into the tight territory seen during the 2011 Eurozone Debt Crisis. Demand for loans had dropped sharply and it would be worth observing if the recent bank trauma caused this to persist.
(1) Deutsche Bank, Global Credit Chart Book, 9 March 2023.
(2) Goldman Sachs, March 2023. There is no guarantee that past trends will continue, or forecasts will be realised.
(1) Deutsche Bank, Global Credit Chart Book, 9 March 2023. (2) Goldman Sachs, March 2023. There is no guarantee that past trends will continue, or forecasts will be realised.
Read the full article for more on banking sector health and how to position your portfolio
Head of US Fixed Income Greg Wilensky and Portfolio Manager Michael Keough discuss the risks recent bank failures pose to markets and how investors might position their portfolios accordingly
2023 started with three important themes: An aggressive Federal Reserve (Fed) tightening cycle, inflation still above target, and economic releases showing resiliency. With that backdrop, markets were contemplating a range of economic outcomes, from a soft landing to a hard landing to no landing. But in March, things got even more “interesting.” There is a saying, “The Fed hikes until something breaks,” and last month, something broke as Silicon Valley Bank (SVB) and Signature Bank (SBNY) failed and the Swiss government had to force a takeover of Credit Suisse by UBS. The implications of these events will be important to what plays out in the markets and economy in the months ahead. While the final impact of these events is yet to be seen, our main takeaway is that we think the chances of a recession have increased, and the timing thereof might be pulled forward. In our view, this impacts how investors should be positioned for the evolving environment.
Jim Cielinsk CFA, Global Head of Fixed Income
Investment strategy
Greg Wilensky CFA, Head of U.S. Fixed Income | Portfolio Manager
Coming into 2023, we believed high-quality fixed income’s key characteristics of income and diversification had returned after the great reset in rates in 2022, and we felt investors would once again be well served by a core bond allocation. While we did not envision large bank failures, we did feel strongly that fixed income was a necessary portfolio construction tool, as the Fed’s tightening cycle to slow the economy and bring down inflation could create risks. In March, we saw fixed income deliver on what clients needed from their bond allocation.
Source: Bloomberg, as of March 31, 2023. Past performance is no guarantee of future results.
Figure 1: Core fixed income served as a ballast through March’s banking sector stress
The recent turmoil in the banking sector came as a surprise to markets, as most participants viewed the sector as high quality after it spent the past 15 years building up robust capital positions following government regulation in the aftermath of the Global Financial Crisis. Difficulties in the banking sector can have a significant impact on expectations for the economy, the central bank tightening cycle, and market returns. In our view, at times like these, high-quality fixed income can bring much-needed defensive characteristics to a portfolio. As shown in Figure 1, as equities sold off amid the banking sector stress in March, core fixed income largely moved inversely and provided the ballast investors have come to expect from their bond allocation.
Bonds are back as the ballast
While investors can appreciate the diversification benefits exhibited by bonds in recent weeks, the pressing question is whether recent bank failures are idiosyncratic events that will be contained or the early signs of a systemic banking crisis? We believe it is still too early to tell for sure, but for now they appear idiosyncratic, as the banks that failed had risks and challenges that were quite distinct from the broader banking sector. That said, we do think that idiosyncratic events have the potential to become more systemic, particularly if investors and depositors continue to look for the weakest lamb in the flock, so to speak. Irrespective of whether it’s based on truth or rumour, the loss of faith in an institution can swiftly bring about its demise if it results in a run on the bank.
Bank failures: Idiosyncratic events or systemic crisis?
“As equities sold off amid the banking sector stress in March, core fixed income largely moved inversely”
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Correlation: -0.45
S&P 500® daily return
Bloomberg U.S. Aggregate Bond Index daily return
Read the full article for more on the opportunities in fixed income
Recent market events have proved unsettling but volatility offers opportunities. This is particularly the case in fixed income where yields are at levels not seen for more than a decade. Here, we explore why investors are likely to increasingly allocate to fixed income
Investors endured a dismal 2022, as the impact of rising rates sent shockwaves through both fixed income and equity markets. As global bond markets slumped to the worst year on record, investors were left with nowhere to hide, with equities also ending the year in negative territory. In fact, this was just the fifth time in almost a century that investors suffered a simultaneous sell-off in bonds and stocks.
The return of income
Figure 1: It is rare for equities and bonds to sell off together
Source: Bloomberg, Morningstar, NYU Stern, as of December 31, 2022. S&P 500 Index total returns and 10-year U.S. Treasury Bond total returns, calendar years in US dollars, 1928-2022. Blue represents years in which both stocks and bonds were down, orange represents years in which stocks were up and bonds were down, or bonds were up and stocks were down, or both stocks and bonds were up
Source: Bloomberg, Janus Henderson Investors, 31 December 1989 to 21 March 2023.
Bloomberg Global-Aggregate Total Return Index Value Unhedged USD
Figure 2: Progression of cumulative return (%) of global bonds by trading days in years 1990-2023
Source: Bloomberg, Refinitiv Datastream, Macrobond, Janus Henderson Investors Analysis, as at 16 March 2023 and 31 December 2021. 20-year average uses month end data points between 28 February 2003 and 28 February 2023. Indices used: Global HY = Bloomberg Global High Yield Index, $ Emerging Market Debt (EMD) = J.P. Morgan EMBI Global Diversified Index, Local EMD = J.P. Morgan GBI-EM Index, Global Investment Grade (IG) = Bloomberg Global Aggregate Corporate Index, High yield equities = MSCI World High Dividend Yield Index, US 2year, US 10y, UK 10y, Germany 10y, Japan 10y = Bloomberg Generic Government Bond yields, Global equities = MSCI All Countries World Index, Nasdaq 100 = Nasdaq 100. Yield to maturity for government indices, yield to worst for corporate bond indices, dividend yield for equity indices.
Figure 3: The revival in yields leaves most markets yielding above their 20-year averages
We are already witnessing signs of a sustained fixed income sentiment shift, with the enticing yield opportunity – both on an absolute level and relative to equities – powering substantial investor inflows so far this year.
While last year’s bond market rout was painful, investors have renewed optimism in 2023, with the asset class offering yields not seen in more than a decade. However, after the synchronised slump for bonds and equities, there are mounting fears fixed income’s traditional role of providing downside protection in risk-off periods has been permanently upended. On the contrary, we retain our faith in fixed income, and believe the compelling characteristics of bonds – as an all-important counterweight to equities, as well as able to offer attractive income – remain intact. Looking forward, we expect investors to increasingly allocate to fixed income in light of the asset class’s improved outlook. 2023 has already got off to a stronger start for the asset class.
Yields may vary over time and are not guaranteed.
With the extreme inversion of government bond yield curves, even two-year sovereign bonds from the US government are offering yields around 4%. In the credit space, global investment grade yields have risen sharply from an average 2% to 5% since the beginning of 2022, while global high yield has jumped from around 5% to 9%. Within securitised credit, an area of the market that felt the full force of last year’s sell-off, yields of 4-10% are compelling given the securities are largely investment grade quality with floating rates.
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Read the full article for why we believe Powell was right not to pause rate hikes
Portfolio Manager Jason England explains why the Federal Reserve (Fed) opted to raise rates and highlight the threat posed by persistently high inflation despite recent upheaval in the banking sector
After nearly two weeks of speculation, with a few pointed sentences Federal Reserve (Fed) Chairman Jerome Powell reaffirmed that the Federal Open Market Committee’s (FOMC) highest priority remains price stability, while also acknowledging that recent banking sector upheaval and its impact on credit availability are developments they cannot dismiss. By shifting the focus back to inflation and a tight labour market despite indications of a slowing economy, Chairman Powell provided the context for the FOMC’s 25 bps rate hike to a range of 4.75% to 5.00%. Even with the focus squarely on inflation, we believe the impact of the banking turmoil was already evident in Chairman Powell’s statement. In his Congressional testimony only a few weeks previously, he hinted that rates would likely have to rise higher than the market anticipated. Taking him at his word, futures prices responded by implying the terminal rate would climb as high as 5.75% in mid-2023. Fast forward to Wednesday 22 March and his message morphed to a less-certain “some additional policy firming may be appropriate.”
All eyes on the mandate
Given the recent developments in the banking sector, we had suspected that the Fed could have considered a 2023 pivot, as lenders’ health can materially impact financial conditions. Chairman Powell, however, dismissed that scenario, noting that the FOMC does not see a rate cut occurring this year. In fact, the Fed’s much ballyhooed DOTS survey revealed that respondents see the fed funds rate finishing 2024 at 4.3% – slightly higher than the 4.1% suggested in its December survey. We interpret this as the Fed being willing to leave rates at their cycle high for longer than what the market is currently pricing in. Such a pause would give the central bank time to assess the impact of previous rate hikes and other tightening initiatives. We believe the Fed was correct in shifting the conversation back toward its battle with inflation. Even before most people had ever heard of Silicon Valley Bank (SVB), the Fed was faced with striking a delicate balance between reducing inflation and inflicting as little harm as possible on the economy. That battle has not gone away.
Source: Bloomberg, as of 22 March 2023.
While banking sector turbulence has sent 2-year Treasury yields lower, sticky inflation could reverse that trend
Citing “robust” job gains keeping stickier drivers of inflation – e.g., wages – elevated, Chairman Powell emphasised that there is much work to be done in achieving the Fed’s objective of 2.0% inflation. This meeting’s update to the Summary of Economic Projections reflected the Fed’s modestly hawkish thinking. Estimates for 2023 headline and core inflation were revised upward to 3.3% and 3.6%, respectively. The challenge facing the Fed is acutely illustrated in the incongruity of paltry 2023 gross domestic product growth of 0.4% and the year’s unemployment rate being revised down to 4.5%.
“Powell emphasised that there is much work to be done in achieving the Fed’s objective of 2.0% inflation”
Credit Risk Monitor: ‘Brick on elastic’ gives way in banking
Read the full report for more on the cycle indicators and issuer fundamentals that inform our understanding of the economic outlook
The US Federal Reserve will continue to tighten until something breaks. The lagged effect of policy means that it may take a long time for it to take effect – like pulling a brick with elastic – but when it does, it moves quickly
This ‘brick on elastic’ gave way in banking. Nevertheless, corporate credit excess returns were positive over the quarter despite the end of quarter volatility. Overall spreads tightened in high yield and traded sideways in investment grade. Credit spreads continue to dance around, however, buffeted by policy and economic expectations. Bad economic news can readily be interpreted as suggesting earlier rate cuts (bad news = good news), but eventually deteriorating fundamentals are likely to catch up (bad news = bad news). Volatility creates opportunities and, as markets debate potential turning points in rates and the probability of recession, we are likely to see increased dispersion among rating quality, sectors and individual credits. A selective approach remains vitally important.
Read the full article for more on the merits of EM debt hard currency
A new era of growth decoupling means diverse return drivers can be accessed through emerging markets debt hard currency, says Thomas Haugaard
Post-COVID inflationary pressures have laid the groundwork for a possible decoupling in global monetary policy. Although each central bank reacted differently to the pandemic, the common policy reaction has been to tighten monetary policy to tame rising prices. Slowing growth indicates we may well be nearing the end of this tightening cycle. Since emerging market (EM) economies were relatively more proactive in policy tightening, we believe they could lead developed market (DM) peers in easing, as seen in Angola and Costa Rica.
JUNE 2023
Source: Macrobond, IMF, Janus Henderson, as at 7 March 2023.
Figure 1: GDP growth rate difference between EM and the US
Policy-driven headwinds are more significant for DMs than EMs, where the feedthrough of monetary policy to the economy is greater given higher indebtedness. Stronger commodity prices are also more favourable for some EMs, which can benefit from the China rebound as intra-EM trade has flourished. Emerging markets growth is expected to decouple from the rest of the world including the US. Growing three times as fast as DMs, these economies are expected to account for nearly 80% of global growth over 2023 and 2024 (1). Structural growth drivers such as technological innovation and an expanding working age population help underpin this. After all, 86% of the global population resides in EM and developing economies (2).
“These economies are expected to account for nearly 80% of global growth over 2023 and 2024”
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(1) Source: IMF World Economic outlook, April 2023. Gross domestic output in percent change (constant prices).
(2) Source: IMF World Economic outlook, April 2023.
(1) Source: IMF World Economic outlook, April 2023. Gross domestic output in percent change (constant prices). (2) Source: IMF World Economic outlook, April 2023.
Read the full article to learn the second reason to be wary of money market funds
There may be benefits to moving out of money market funds and into duration assets as the Federal Reserve (Fed) ends its rate-hiking cycle, say Seth Meyer and Lara Reinhard
After the pain of 2022’s great interest-rate reset, investors are now enjoying time in the sun in the form of higher yields. This is evidenced by the roughly $600 billion of asset flows into money market funds in 2023 so far. Additionally, our Portfolio Construction and Strategy (PCS) Team’s proprietary database of investor portfolios shows allocations to money markets have increased 240% in 2023 from the year prior. While the lure of seemingly easy returns in money market funds might be hard to resist, we think there could be a hidden danger to this approach as the US Federal Reserve (Fed) looks set to pause or end its rate-hiking cycle. An allocation to money market funds may serve investors well for their short-term liquidity needs, but we do not advocate for using them as a proxy for a broad fixed-income allocation, for a couple of reasons.
Lara Reinhard CFA, US Head of Portfolio Construction and Strategy
Seth Meyer CFA, Head of Fixed Income Strategy, Portfolio Manager
ASSET ALLOCATION
1. The case against money markets once the federal funds rate peaks
While it may seem counterintuitive, increasing duration when the federal funds rate peaks has historically resulted in better outcomes than taking the easy money in money market funds. As shown in Figure 2, in each of the previous six rate-hiking cycles, once the federal funds rate has peaked, duration assets have outperformed (except for 2006, when they performed very much in line). This makes sense to us as well, as rising rate environments typically result in a cooling economy and subsequent rate cuts to boost economic activity.
Source: Bloomberg, Investment Company Institute (ICI), Janus Henderson Investors, as of 12 May 2023.
Figure 1: Late to the party
Some of the best periods to add duration have historically been around the time short-term rates peak. This makes sense as peak rates have typically been followed by falling rates, which is inherently good for duration risk. Ironically, the times when it has been best to add duration has also been when money market funds look most enticing. As shown in Figure 1, in both the current and previous hiking cycles, flows into money market funds have lagged the peak in the federal funds rate, which means investors are piling into these funds after their yields have already started to fall.
“The times when it has been best to add duration have also been when money market funds look most enticing”
Figure 2: 12-month forward returns once the federal funds rate peaks
Peak growth in money market funds typically lags the peak in the federal funds rate
Duration assets have historically outperformed money markets once the Fed stops hiking.
Source: Bloomberg, Janus Henderson Investors, as of 10 May 2023. Each date represents date of the peak in the federal funds rate during a Fed hiking cycle. 12-month forward returns are calculated from the month of the peak in the federal funds rate for that cycle. Peak federal funds rate for each cycle: August 1984: 11.75%, Feb 1989: 9.75%, Feb 1995: 6.00%, May 2000: 6.50%, June 2006: 5.25%, Dec 2018: 2.25%.
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Read the full article for more on the possibility of a Fed pivot
By raising interest rates to 5.25%, the Federal Reserve (Fed) has bought itself time to assess how far persistent inflation has been quelled, says Jason England
In the game of chicken between the US Federal Reserve (Fed) and the bond market that has been going on since last year, the US central bank won out by reaching its stated terminal rate of 5.25% for this tightening cycle. Still to be determined is how long the upper limit of the federal funds rate remains at this level. The Fed has been adamant that it is premature to consider a rate cut – expecting the 5.25% level to stick through the end of 2023 – whereas the market divines that rates will slide to 4.50% by December. Leading into the May meeting, many market participants were eager to categorise the well-telegraphed 25 basis point (bps) increase as a dovish hike. We don’t think that’s the case, as Fed Chairman Jerome Powell and other voting members rightly recognise the risks posed by inflation to consumers’ purchasing power and price stability across the economy. Consequently, we see this week’s decision as a modestly hawkish pause that will allow the Fed to gauge previous rate increases’ impact on further lowering inflation.
And now the hard part
Many have suggested that with several leading indicators – namely an inverted US Treasuries yield curve – already signalling weakness, the Fed may stick to its tendency of transitioning to rate cuts in relatively short order. Probabilities based on futures markets imply a cut by as soon as July. We do not think that will be the case, however. Historically, quicker pivots have occurred when the central bank prematurely turned dovish, such as during the 1970s and early 1980s. This only allowed inflation to become more embedded, setting the stage for policy having to ultimately become even more restrictive.
Source: Bloomberg, as of 3 May 2023. *CPI XYOY = CPI urban consumers, less food and energy (YoY% change).
Components of Consumer Price Index
We have long stated that it would be much easier to lower inflation from its 9.1% peak to 5.0%, based on the US Consumer Price Index, than it would be to get from 5.0% to the Fed’s 2.0% objective. For perspective, the Fed’s preferred measure of inflation – the Core Personal Consumption Expenditure Price Index – has fallen a more muted 5.4% to 4.6%. Standing in the way is the persistent nature of this bout of inflation, especially the stickiness of service-sector wages due to a historically tight labour market.
“Standing in the way is the persistent nature of this bout of inflation, especially the stickiness of service-sector wages”
While both headline and core inflation have fallen, services – with their notoriously sticky wage component – have become a much larger component of overall price increases.
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Read the full article for analysis of the current opportunities in loans
Following a period of strong performance, loans are continuing to present opportunities as interest rates rise, say David Millward and Tim Elliot
When we established our Multi-Asset Credit (MAC) strategy more than 10 years ago, we had very clear views around the style of portfolio we were intending to deliver for clients. The strategy was based on constructing a portfolio that had the following key characteristics:
Tim Elliot Portfolio Manager
Figure 1: Loans have offered attractive risk-adjusted returns
“The mainstay of our floating rate exposure in this strategy will always be secured loans”
There are other types of floating rate assets available, namely ABS and Floating Rate Notes (FRNs). However, asset backed securities are primarily used as a risk dampener or investment grade (IG) credit alternative, and are not ultimately expected to deliver the return being targeted. FRNs have a place in the portfolio, but the overall FRN market is modest in Europe and tiny in the US. So whilst these instruments have their place, the mainstay of our floating rate exposure in this strategy will always be secured loans. The syndicated secured loans market in the US totals approximately US$1,400bn, whilst in Europe it is close to €400bn. Long-term returns from loans in the US and Europe stack up very well versus other fixed income asset classes (Figure 1), highlighting the significant contribution this asset class has made to our MAC strategy.
Figure 2: Loans liquidity has remained on par with conventional bonds
Risk-adjusted returns across fixed income sectors
US market bid offer spread
Investment Grade
Low interest rate exposure to ensure that at least 70% of the portfolio was invested in floating rate assets, thus minimising sensitivity to changes in government bond yields Diversification away from traditional fixed income assets, with the inclusion of two well-known asset classes, namely secured loans and asset-backed securities (ABS) Defensive senior and secured bias – seeking to minimise downside risk and losses derived from defaults by investing in assets that sit at the top of an issuers debt stack and additionally benefit from being secured.
Combine these criteria with the level of returns we wanted to deliver for our investors, and it was clear that secured loans should form a key component of the strategy. Our allocation to this asset class has varied between 39% and 51% since inception in 2012.
Source: Janus Henderson, Bloomberg, Barclays, ICE BofA, Credit Suisse, Credit Suisse, 30 April 2013 to 30 April 2023.
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Many observers suggest loans are less liquid than, say, high yield bonds. Whilst this is true for small loan issues, typically found in the private credit market, this is definitely not the case for the broadly syndicated larger loans that we invest in for MAC. Comparing bid/offer spreads in the syndicated loan market with those of the high yield market, objectively a good proxy for market liquidity, shows a very similar trend across these two asset classes, both in the US and Europe (Figure 2).
Aren’t loans illiquid?
High Yield
Source: Janus Henderson, MSCI, IHS Markit, as at 11 January 2023.
Past performance does not predict future performance.
European market bid offer spread
The perceived illiquidity comes from the fact loans are not traded via an exchange and thus the settlement process is somewhat extended. As our analysis shows, however, this does not mean that there is a lack of buyers offering a fair price for these assets. A consequence of this delayed settlement process is that any fund with a sizeable allocation to loans will need a structure that accounts for the delay in receiving cash from the sale of loans when funding redemptions. We have chosen to address this by applying a short notice period for dealing in our MAC strategies.
Read the full article for more on fixed income markets today, including why time lags continue to affect inflation data
Terminology from London and Washington DC's rapid transport systems can offer insight into the outlook for fixed income markets, says Jim Cielinski
Delivered in firm voices, the safety announcements are hard to miss. “Step back” insists Washington’s Metro, while London’s Underground compels you to “mind the gap”. Both are commands worth heeding not just for one’s personal safety when travelling but as useful instructions in helping understand the risks and opportunities in today’s fixed income markets.
JULY 2023
Step back #1
Figure 1: Pricing pressures dissipate as global supply chain pressures ease
Source: Refinitiv Datastream, Federal Reserve of New York, April 1999 to April 2023. Supply chain pressure index is normalised, such that zero indicates an average value, with positive values representing greater pressure, negative values less pressure (in standard deviations). S&P Global Manufacturing Purchasing Manager Index (PMI) Manufacturing Output Prices, a figure above 50 indicates rising prices while a figure below 50 indicates falling prices.
Fixed income markets have moved a long way in 18 months, and it is worth reflecting where they have come from. In 2022, they were understandably unloved as concerted monetary tightening by central banks led to a sharp rise in yields and fall in bond prices. Today, sentiment towards bonds is very different. Global flows into fixed income are firmly in positive territory. EPFR Global reports US$152 billion entered fixed income funds year to date (1). The principal driver is the income available: Yields of nearly 5% are achievable on 1-year US Treasury Bills and even 1-year German Bunds yield 3.2%, a world away from the negative yields on offer as recently as May 2022. The higher yields cascade down the quality spectrum, with the average yield on global investment grade corporate bonds offering 5.1% and high yield (sub-investment grade) bonds offering 9.0% as represented by the ICE BofA Global Corporate Index and the ICE BofA Global High Yield Index (2). With the economic outlook uncertain, investors are once again finding attractions in an asset class offering income, relative capital security and a potential diversifier to equity holdings. We expect this to continue.
All of this makes trying to get a handle on economic and corporate performance challenging as year-on-year comparisons remain distorted. Is disinflation a welcome sign that supply chains are back to normal or an early warning of demand destruction? These are all factors that policymakers are grappling with and may incline them to wait for clear trends in data before changing policy.
(1) EPFR Global, year to date to 17 May 2023.
(2) Bloomberg, Generic 1 year US Government Bond, Generic 1-year German Government Bond, ICE BofA Global Corporate Index, ICE BofA Global High Yield Index. Yields as at 31 May 2023. Yields may vary over time and are not guaranteed.
(1) EPFR Global, year to date to 17 May 2023. (2) Bloomberg, Generic 1 year US Government Bond, Generic 1-year German Government Bond, ICE BofA Global Corporate Index, ICE BofA Global High Yield Index. Yields as at 31 May 2023. Yields may vary over time and are not guaranteed.
“In many sectors across the world, revenues and costs remain out of kilter as tourism and leisure spending bounces back yet goods spending fades”
The past is still affecting us. We may think that the Covid emergency ended a while ago, but its effects linger. It was only in the first quarter of this year that China moved to fully reopen. In many sectors across the world, revenues and costs remain out of kilter as tourism and leisure spending bounces back yet goods spending fades. Stimulus checks and accumulated savings during Covid are only just now being exhausted. The supply chain disruption that contributed to rising costs in the last couple of years has reversed.
Step back #2
Read the full article for more on decarbonisation in the mining and oil sectors
The high yield asset class’s exposure to industrials need not hold it back from decarbonisation, argue Brent Olson, Tim Winstone and Natasha Page
Take a snapshot of the global investment grade corporate bond market and the global high yield corporate bond market and chances are that the high yield bond sector will have a higher weighting to industrials. As Figure 1 shows, that rings true today.
There is some logic to this. First, the high yield market tends to be more exposed to cyclical sectors where greater variability in earnings often leads to credit rating agencies giving a sub-investment grade rating to the company. Second, companies needing to raise finance for big projects tend to take on more leverage, which is again something that can lead to a lower credit rating. Third, companies raising capital for the first time or for new or exploratory projects such as mines or oil fields will often find that they are rated high yield until their operations are more proven. Today, the industrial sector makes up approximately 85% of the global high yield corporate bond market compared with 55% of investment grade corporates (as at 31 May 2023). Moreover, energy, basic industry, capital goods, automotive and transportation – which comprise some of the most carbon-intensive sub-sectors such as oil and gas, mining, machinery, packaging, and air transportation – constitute around 35% of the high yield universe (1).
Figure 1: Sector weights within global high yield and investment grade corporate bond universe
Source: Bloomberg, Investment grade = ICE BofA Global Corporate Index, High yield = ICE BofA Global High Yield Index, sector weights as at 31 May 2023.
A pragmatic approach to decarbonisation
Unless a fund has blanket exclusions for specific areas, it is difficult to avoid carbon-intensive borrowers in high yield without heavily narrowing the investment universe. Moreover, many of these companies provide products and services that are either necessary for the global economy to function or will be required through the transition to a low-carbon economy. In our opinion, a pragmatic approach is to recognise that many of these companies operate in hard-to-abate sectors. Rather than avoiding them we focus on (a) encouraging them to do better through engagement and (b) allocating capital to those that are best managing environmental, social and governance (ESG) risks and opportunities – these companies are best positioned to succeed in the future. It is this practical, research-based and forward-looking approach that treats ESG factors in the same way we do any other fundamental, financially material factor that we believe can help us to identify good credits.
Natasha Page Director of Fixed Income ESG
“It is difficult to avoid carbon-intensive borrowers in high yield without heavily narrowing the investment universe”
(1) Source: Bloomberg, sector weights for high yield relate to ICE BofA Global High Yield Index and for investment grade ICE BofA Global Corporate Index, as at 31 May 2023.
(2) Source: Refinitiv Eikon, ratings correct as at 20 June 2023.
An example of a company whose bonds we hold and that is making considerable efforts to decarbonise is Fortescue Metals Group (FMG). Its decarbonisation efforts are reflected in our ‘Yellow’ proprietary ESG rating. FMG is a mining company that extracts iron ore. S&P Global Ratings gives the company a credit issuer rating of BB+, while Moody’s similarly applies Ba1, at the top-end of the sub-investment grade credit rating scale (2). While mining is an industry that scores poorly overall from an ESG perspective, we view this company as making demonstrable efforts to address its environmental impact.
Extracting efficiencies
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Read the full article for more on the key ESG themes going forward
As ESG investing suffers a backlash, Janus Henderson is sticking to its principles, says Natasha Page
In the US, the subject of ESG has been heavily politicised, resulting in some extreme consequences for the investment communities in certain parts of the country. In Europe, there has been some cooling towards ESG, largely driven by energy security concerns, but it is still very much a priority across the continent. Curiously, one fact to point out is that flows in 2022 into ESG corporate credit funds held up better than flows into non-ESG equivalents, including in the US, and this trend has continued so far into 2023. I think it is important to remind ourselves that ESG is not only about E, or environmental, which has been, essentially, the focus of controversy in the US. It is also very much about S, social, and G, governance factors, both of which are absolutely instrumental in ensuring that a company is a long-term business success.
So, thinking about what has changed. It makes it harder to talk about ESG, which goes back to my point earlier, that as a manager of client money, we are reminded to keep in mind what clients actually want. But we also need to show our clients the meaning behind ESG and that it doesn’t harm investors. In fixed income at Janus Henderson, our ESG investment philosophy is integration over exclusion. This means that we allocate capital to issuers with varying ESG profiles, not only ESG leaders. We actively engage with companies with higher ESG risk profiles to understand how they are managing these risks. This gives us an opportunity to be more forward looking. It helps us identify improving stories and, at the same time, it creates an opportunity to support transition. In reality, imposing a blanket exclusion on higher polluting sectors, for example, does not help solve for the broader environmental issues, whereas understanding transition and progress does. We work with companies, therefore, to ensure that the most financially material ESG risks are being managed thoughtfully and progressively. We do this through engaging with them and following up on those engagements.
“We need to show our clients the meaning behind ESG and that it doesn’t harm investors”
The traditional and original association of engagement and stewardship has largely been with equity holders through their voting rights. However, as bondholders, we help companies access markets for financing their business activities and therefore have a great ability to play a key role in stewardship of our investee companies. For us in fixed income, engagement is integral to our ESG assessment and ultimately feeds into our investment decisions. We see ESG engagement as fulfilling a dual objective: to ensure we understand how a company is addressing financially material ESG risks and to facilitate positive change. For instance, by challenging a company’s targets and commitments, we help promote transition. We also bring into our engagement with companies the most topical ESG themes prevalent in the markets; those that investors are concerned with and that are financially material for companies’ business profiles.
ESG engagement at JHI Fixed Income
We constantly monitor the developments of the most topical ESG trends and issues that investors are concerned about. Ultimately, these are driven by broader societal influences and investor sentiment. But for us, it is important to make sure that we focus on what is important to our clients. So, we speak to clients and analyse what questions they raise and what they focus on. For 2023, we have noted the themes of biodiversity, human rights and labour relations, with a focus on supply chain management, and ESG governance. These are the more prominent themes for 2023 from our perspective.
Key themes for 2023 and beyond
Read the full report for more on the outlook for markets
An economic downturn presents challenges for markets, but are the risks already priced in? Our Market GPS mid-year outlook explores investment trends and portfolio implications for the second half of 2023
Investors entered 2023 anticipating calmer markets after last year’s historic inflation, rise in interest rates, and the expectation that a higher cost of capital would weigh on economic growth. Recently added to the list was turmoil within the banking sector. While regulators’ actions have likely stemmed the risk of contagion, enough assumptions were undone to beg the question of whether markets have entered an even more challenging environment. We believe they have. The global economy is clearly late cycle, with central banks coming to the end of rate hikes. Many investors adopt a defensive posture when facing an economic downturn. Yet, with a probable soft patch so well telegraphed – and potentially somewhat priced in – we think investors, while acknowledging further downside risk, could soon go on offense, especially as this stage of the cycle may present opportunities for active security selection that can benefit from idiosyncratic risk.
Adam Hetts CFA, Global Head of Portfolio Construction and Strategy
Matthew Bullock EMEA Head of Portfolio Construction and Strategy
Source: Bloomberg, as of 30 April 2023. P/E ratio = price-to-earnings ratio.
Equities: Quality matters – even more
At the beginning of the year, we stated that, as the global economy faced a mid-cycle adjustment, equity investors should prioritize quality, which we define as companies with sound balance sheets and stable cash flows. That message is truer than ever. As customers’ access to credit weighs on revenues and higher input costs squeeze margins, 2023 earnings may drift toward the lower end of consensus range. The current breadth of risks heightens our concern about how those risks may impact stocks. Yet, rather than seeking to avoid risk, investors could use volatility to take advantage of the dislocations that can occur between a stock’s price and a company’s underlying fundamentals. For example, higher rates and volatility have created opportunities within the technology sector. We expect to see a greater dispersion of returns over the mid-term based on companies’ ability to execute operationally and maintain profitability in a slowing economy. With headwinds apparent, healthcare also merits consideration. Biotechnology, in our view, holds particular promise as do profitable small- and mid-cap companies that could outperform early in a recovery.
Historical and current price-earnings ratios in select markets
Mario Aguilar De Irmay CFA, Senior Portfolio Strategist
Sabrina Denis Senior Portfolio Strategist
“With many global indices tilted toward the US, benchmark-tracking investors could be exposed to a notable economic slowdown”
Market GPS blends the thinking of our investment teams and our Portfolio Construction and Strategy (PCS) Team. The PCS Team performs customized analyses on client portfolios, providing differentiated, data-driven diagnostics. By combining the insight of our investment teams with the client focus of PCS, our goal is to help you position your portfolio for the route ahead.
A similar dynamic is at play geographically. With many global indices tilted toward the US, benchmark-tracking investors could be exposed to a notable economic slowdown as tighter credit conditions potentially magnify the impact that the Federal Reserve’s (Fed’s) rate-hiking campaign will have on growth. We believe the potential for attractive returns exists in the US, but investors should be afforded the opportunity to determine for themselves their level of exposure by country.
Leaning into Europe
While P/E ratios are at above-average levels in the US, many European countries still trade at significant discounts.
While focusing on quality during the downturn, investors should also think ahead by considering attractively priced cyclical exposure in markets that are most likely to lead the way out of recession. We believe Europe could fit this criterion. There are risks, but if the current trajectory continues, the cyclical nature of European stocks means they could be well positioned to outperform as the economy moves toward recovery.
Higher rates mean that a bond allocation again can offer attractive income generation, the potential for capital appreciation, and the accompanying benefit of diversification against riskier asset classes. Consequently, we expect to see increased allocations to bonds as investors seek defensive strategies for the downturn. After a long absence, shorter-dated bonds are now offering mid-single-digit returns. And with the global economy likely slowing, longer-duration intermediate bonds hold the potential for capital appreciation. Within credit, we believe resilient investment-grade businesses are likely to weather a downturn better than more cyclically exposed issuers.
Fixed income: Take what the market is giving
Rise in interest rates required to wipe out a bond’s annual income
Shorter-duration bonds have significantly higher yield cushions than those with longer-dated maturities.
Source: Bloomberg indices, Janus Henderson, as of 30 April 2023
Read the full article for more on constructing a diversified portfolio
An active, multisector approach may help to achieve better outcomes over the long term, say John Lloyd and John Kerschner
The investable fixed income universe in the US – the largest in the world – is both broad and deep in its scope. When one considers the sheer scale of the market, and the multitude of sectors and industries represented, it can feel daunting to construct a portfolio that appropriately capitalizes on the full opportunity set. Market leadership among various sectors is also constantly changing, as shown in Exhibit 1. As such, it is difficult to accurately predict which sectors will do better than others from one year to the next.
John Lloyd Multi-Sector Credit Strategies | Portfolio Manager
Exhibit 1: Fixed income returns quilt (2013 – 2022)
How then should investors think about their bond allocations to maximize risk-adjusted returns? In our view, an active, multisector approach may help to achieve better outcomes over the long term. As investors think about constructing a diversified bond portfolio, we suggest focusing on two key objectives.
“Xxxxxxxxx xxxxxxxxxxxxx xxxxxxxxxx xxxxxxxxxxx xxxxxxxx xxxxxxxxx xxxxxxxxx xxxxxxx xxx”
Source: Bloomberg, J.P. Morgan, Janus Henderson Investors, as of 31 December 2022. Sub-asset class returns as per corresponding Bloomberg, J.P. Morgan, and Morningstar indices.
Past performance is no guarantee of future returns.
While it isn’t critical to always be fully invested across all sectors, we do think that bond investors should have access to all sectors – or, alternatively, employ managers with a mandate that allows them to invest across the broad universe. While it certainly has its merits, the Bloomberg US Aggregate Bond Index (US Agg), which has served as a proxy benchmark for a diversified bond allocation, does not accurately represent the fixed income universe, for three reasons. First, certain significant sectors are excluded from the benchmark index, such as the floating-rate collateralized loan obligation (CLO) sector, which was the best-performing investment-grade sector in the US on an annualized basis for the 10-year period ended 31 December 2022 (1). Second, the US Agg is limited in that it does not offer exposure to non-investment grade debt, such as high-yield corporates. And third, a sector’s weight in the US Agg may not be representative of its weight in the investable universe. For example, non-agency securitized assets make up over 8% of the investment-grade market but represent less than 3% of the US Agg. In our view, a flexible, multisector mandate that allows a manager to be unbound by these benchmark limitations may offer investors appropriate exposure across the market spectrum.
1. Ensure appropriate access to the entire universe
(1) Source: As shown in the final column of Exhibit 1
Read the full article on why the credit cycle continues to deteriorate and why this is not your typical credit cycle
While markets take a view that recession had been staved off and credit markets find support in seasonal technicals, credit quality risk will become more material later this year, says Jim Cielinski
Over the second quarter, markets took the view that a recession had been averted rather than delayed. Data showed growth holding up, the banking sector recovering from prior volatility and inflation moderating. Although impatience with the speed of moderation saw developed market central banks hiking rates further, spurring rises in government bond yields. Credit spreads tightened over the quarter. On the flip side, the credit cycle continued to deteriorate. Tighter financial conditions alongside weak manufacturing PMIs contributed to earnings downgrades for some industrials. Recent bankruptcy filings for small businesses may spread more broadly into capital markets. Seasonal technicals may support credit markets near term but we anticipate credit quality dispersion to become more material later in the year as companies address the 2025 maturity wall.
AUGUST 2023
A selective, nimble investment approach is paramount. Deterioration in credit quality will affect some sectors and economies more than others. It is often in the tails – the weakest 10-15% of companies – that a credit cycle unravels.
Historically, corporate credit excess returns have been positive two thirds of the time or more*, but investors must bear the asymmetry of credit markets where downside corrections can be severe. Monitoring the credit cycle and topdown risks is good risk management. The challenge for investors is that every cycle is different and requires a combination of data and judgement. No single indicator or dataset can be reliable in isolation, and the lags are uncertain. However, by considering the credit cycle within a framework and assessing the weight of evidence from some key metrics shown here, we can better understand the balance of risks and potential turning points.
Why the cycle matters
Year-on-year earnings per share growth revisions were mixed in developed markets, with the UK the laggard, while emerging markets were generally weaker. Credit quality in aggregate has mostly held up as nominal growth and revenues have held up. However, it is damage to the weakest 10-15% of companies that often causes the credit cycle to unravel. That’s what we think we are seeing now.
Earnings growth weakness expected to broaden
HIGH DEBT LOADS Key metrics: interest cover, leverage Prognosis: stock of debt high; refinancing costs higher
RESTRICTED CAPITAL ACCESS Key metrics: liquidity cycle, real borrowing costs Prognosis: liquidity withdrawal amid QT and tighter lending standards
EXOGENOUS SHOCK TO CASH FLOW Key metrics: earnings, earnings revisions Prognosis: earnings growth weakening
Central bank liquidity (%GDP) falls
G4 central bank balance sheets fall below the 2-year average
Source: Janus Henderson Investors as at 30 June 2023.
2-year average
G4 Central Banks Balance Sheet % of GDP
Net leverage and interest coverage have mildly deteriorated compared with the previous year; high yield is still showing some improvement year-on-year but has weakened in the last three months.
Issuer fundamentals are starting to deteriorate
High yield net leverage
High yield interest coverage
6.0
7.0
US Corporates Q1 2003
US Corporates Q1 2002
European Corporates Q1 2003
European Corporates Q1 2002
5.5
6.5
Data in the second quarter offered something for everyone. Bears could point to weakness in lead economic indicators, stubborn core inflation and credit metrics deteriorating. Bulls could counter with strong labour markets, declining headline inflation and a robust consumer. The resolution of the US debt ceiling impasse removed a key market risk. With recession fears scaled back, markets have been pricing in a more muted credit default cycle. Our view is more circumspect. We expect more “trouble credits” to emerge as the lagged impact of tighter policy takes effect.
Something for the bulls and the bears
Source: Refinitiv Datastream data, 30 June 2023. 2022, 2023 and 2024 data are estimates, and there is no guarantee that past trends will continue.
Amid continued global economic uncertainty, the outlook for emerging markets is looking brighter. The Emerging Markets Debt Hard Currency (EMDHC) team considers four factors when assessing the outlook for the asset class
The uncertain global macro environment is the key factor driving the outlook and trajectory for emerging markets (EM) for the remainder of 2023, but we expect to see more positive flow dynamics over the medium term on the back of a widening economic growth differential between EM and developed markets (DM). Currently, there is also considerable dispersion in credit spreads within the Emerging Markets Debt Hard Currency asset class and this could present an opportunity for active investors.
Source: Janus Henderson Investors and Macrobond, year to date to 30 June 2023. Note: The above are the teams’ views and should not be construed as advice and may not reflect other opinions in the organisation. The views are subject to change without notice. There is no guarantee that past trends will continue, or forecasts will be realised. There is no guarantee that past trends will continue, or forecasts will be realised. The views are subject to change without notice.
The never-landing US and China’s cyclical recovery
Developed markets are expected to lead the global growth slowdown, while emerging markets remain relatively resilient. The International Monetary Fund (IMF) projects that growth across advanced economies will slow from 2.7% in 2022 to 1.5% in 2023 and 1.4% in 2024, with the US seeing growth slow from 2.1% in 2022 to 1.8% in 2023 and 1.0% in 2024. Conversely, EM and developing economies are expected to expand 4.0% in 2023 – in line with the 4% figure for 2022 – and rise to 4.1% in 2024.2 Within the EM space, developing Asia is a particularly bright spot, expected to post growth rates of 5.3% in 2023 and 5% in 2024, according to the IMF, but this is dependent on speed of the China recovery. It is also important to remember that the investible universe includes frontier countries with growth rates in the mid-to-high single digits. In China, sequential growth has likely already peaked. To date, the recovery is mainly service-driven and state-led and the global slowdown is dampening exports. A broadening out of the recovery depends on Chinese consumers turning less pessimistic.
Figure 1: Economic / inflation surprise indices by region
“Developed markets are expected to lead the global growth slowdown; while emerging markets remain relatively resilient”
However, the property market slump has hurt confidence, while elevated youth unemployment and an unwillingness among households to spend their savings remain headwinds. We expect the Chinese authorities to remain path-dependent to ensure growth targets are met. This implies the use of more targeted fiscal policies (eg. property). On that basis, we conclude that the positive spill-over effects of China’s recovery on other EM countries will be more muted than in the past. Figure 1 shows on a regional basis the degree to which economic data and inflation has surprised relative to market expectations since the start of 2023. In China, we have seen disappointment on growth but inflation that has been lower than expected (CPI is now following PPI into deflationary territory). Growth in Latin America has been very resilient, significantly beating expectations so far this year. To us, this suggests we should not get too bearish on China going forward as negative surprises are already at historical highs.
Our base case is that the divergence in economic growth between EM and DM is shifting significantly higher. This is illustrated in Figure 2, which shows the widening disparity in forecasted global growth dynamics. An improving EM-DM differential has historically signalled stronger relative performance.
Figure 2: The EM-DM economic growth differential is finally shifting
Sorin Pirău CFA Portfolio Manager
Source: Janus Henderson Investors, IMF and Macrobond, as at 7 April 2023. Note: The views and forecasts are subject to change without notice. There is no guarantee that past trends will continue, or forecasts will be realised. There is no guarantee that past trends will continue, or forecasts will be realised.
Despite the headlines, many emerging markets remain relatively robust, with progress on fiscal consolidation and improving debt metrics. Also positive for EM countries, they have ample scope for monetary policy easing due to the higher starting point for real rates and improving inflation dynamics. EM inflation is falling, as evidenced by global supply chain normalisation and weakening PPI – most notably in China. EM central banks were early into the rate hiking cycle relative to the rest of the world – inflation is now falling and a number of these central banks are now closer to start cutting rates (eg. Brazil, Mexico), providing a buffer – although this is not universal. The policy response in EM to rising inflation, in our view, solidifies EM policy credibility.
The EM fundamental outlook is holding up
Read the full article for a closer look at why the team believes the credit quality in EM has stabilised and why distressed issuers are obscuring the value picture in the EM debt
Economic Surprise
UK
Sweden
Canada
Euro area
China
Asia Pacific
EM
DM
US
Latin America
Inflation Surprise
100
50
-50
-100
-150
150
HIGHER GROWTH HIGHER INFLATION
LOWER GROWTH LOWER INFLATION
Read the full article for a closer look at a roadmap to assess corporate funding and to learn more about the challenges and some key points to consider
Investors seeking to maximise the role they play in decarbonisation need to focus on how the capital they allocate enables emissions, explain Colin Fleury and Denis Struc
When solving a problem – especially one that requires consensus from diverse stakeholders – it’s helpful to have one simple and overarching goal. In the case of climate change, that ‘big picture’ goal is the reduction of carbon and other greenhouse gases (GHG) released into the atmosphere. All these emissions are enabled in some way by private or public capital, both debt and equity. That capital is provided to build plants and infrastructure, it flows through businesses to run them, and it is spent by consumers either to buy products or use services. This allocation and flow of money determines the volume of carbon we release, how it is released at each point along the production and consumption chain, and which parties are most responsible for enabling emissions.
James Briggs Fixed Income Portfolio Manager
Michael Keough Fixed Income Portfolio Manager
39 BILLION TONNES of CO e emitted per year
Source: Janus Henderson Investors. The above is illustrative rather than an exhaustive list of financing channels. *Estimated information is based on SIFMA Capital Markets Factbook data as of 2021 and includes Global Fixed Income Market Outstanding (source: Bank of International Settlements “BIS”) and Global Equity Market Capitalization (source: World Federation of Exchanges).
We need to begin by linking the capital allocated by asset managers to the activity that emits carbon emissions. The tools used by the investment industry that enable the economic activity of corporations and consumers can provide a roadmap for linking investments to carbon produced. Applying a framework to assess what activity is actually financed allows us to focus on how private capital enables emissions:
From cold cash to hot air
Direct corporate funding through equity and bonds to non-financial companies – Capital is provided to these corporations (like industrial and manufacturing companies) for building and operating physical assets, such as assembly lines, factories, fleet of boats and buildings. Direct corporate funding through equity and bonds to financial institutions – This capital provides funding to support lending operations. Indirect corporate funding through CLOs (collateralised loan obligations) – where the underlying collateral of the securitisation consists primarily of sub-investment grade corporate loans. Indirect consumer funding through other securitisation – this will often have consumer credit as underlying pooled collateral, including property mortgages, credit card receivables, and auto loans.
“All emissions are enabled in some way by private or public capital, both debt and equity”
As a significant allocator of capital, the investment management industry has a role to play in helping to reduce total carbon emissions. It is important, however, to remember that the industry wields material influence only over the specific use their capital is put to. We need to be cognisant of these “lines of influence" and understand that they vary depending on how capital is allocated. It is critical to map these lines of influence if we are to be effective in meeting our shared goal. On top of putting the industry at the centre of the net zero transition solution, this approach also makes fiduciary sense when it comes to investor capital: positioning portfolios towards investments that stand to address the net zero transition challenge should in turn lower risks stemming from the climate transition. Whilst the increase in carbon data in recent years is essential to understanding how GHG are emitted into the atmosphere and arranging emissions into various “Scopes” can be helpful, all this needs to be understood within the context of who has influence over capital that enables emissions in each circumstance.
However, investors who overlook Scope 3 have little insight into the true size of the emissions financed by their capital and potentially underestimate risks faced by their portfolios.
Non-financial corporates
Financial institutions
CLO securitisation
Other securitisation
Capital is used to build and maintain factories and production
Capital is used to finance companies and individual assets
Capital is used for consumption of goods and services and asset financing
£250 TRILLION* of allocated capital
Read the full article for a closer look at the inflation conundrum and why, for investors, there are easier markets in which to invest, and where the inflation outlook offers an earlier return to normality
A regime shift, bond yields, and reasons ranging from temporary to persistent, cause the UK to be an inflation outlier, explains Jenna Barnard
The experience of inflation among developed markets tended to be synchronous since the initial COVID shock but something odd has emerged in the UK during 2023. Inflation rates of 9-11% – levels not seen since the 1980s – made headlines. While inflation peaked and has come down rapidly in recent months across both emerging and developed markets, in the UK it has proved much more stubborn. Specifically, core inflation has continued to rise in recent months causing a profound crisis of confidence in UK monetary policy.
Inflation
Fig 1: Inflation rates across the UK, the US and the Eurozone
Source: Refinitiv Datastream, Consumer Price Index, year-on-year % change, headline inflation in bold lines, core in dotted lines, 31 May 2020 to 31 May 2023. Core inflation excludes energy and food in the US and additionally alcohol and tobacco in the UK and the Eurozone.
Core inflation (which excludes the volatile items of food and energy) typically lags headline inflation. In the UK bizarrely, it is not just services but core goods prices have started reaccelerating and core inflation is still ticking up as a result. There are a number of ways to try and explain the UK inflation conundrum ranging from benign/ temporary explanations to one of a much more problematic persistent inflation problem.
The first is it may be down to time lags and measurement quirks so no need to panic. If we look at producer price indices, these are coming down swiftly and are likely to follow through into consumer prices (although recent profit margin expansion and pass through of exchange rate costs disrupted the downward trajectory). The energy price cap drops are likely to feed into drops in the July data when it is released in August. Monthly core inflation prints are subject to huge overshoots/undershoots in either direction and it will take time to assess the true trend.
Be patient
The second is the notion that inflation was sucked into the first half of this year. Firms that set prices in response to events are referred to as “state dependent” whilst those that change prices at regular fixed intervals e.g. annually are described as “time dependent”. The Bank of England’s Decision Maker Panel (DMP) Survey of firms noted that state dependent price setting firms have been raising prices more than time dependent firms. Companies may have pushed through prices while they could in the expectation inflation would be softer later in the year. Encouragingly, when asked about price rises for next year, state dependent firms (which make up about 60% of firms) predicted lower inflation than time dependent price setters.
UK inflation has been brought forward
Jenna Barnard CFA Co-Head of Global Bonds, Portfolio Manager
“Core inflation has continued to rise in recent months causing a profound crisis of confidence in UK monetary policy”
In the decades before the GFC, UK gilts had typically yielded more than US government bonds and German government bonds. Post the Brexit vote, gilt yields tended to be lower, sitting midway between US government bond yields and German government bond yields. In 2023, they have decisively broken out of this regime and returned to being the highest yielding of the three countries. Various factors might explain this. Among them are the UK’s large fiscal deficit and its composition (the UK government needs to issue a lot of gilts and has a relatively high number of index-linked gilts that have to pay out more when inflation is higher). Faded appetite from buyers for gilts after recent political upheavals has also not helped. But most important in 2023 is the inflation outlook. The conundrum is why should core inflation have continued to rise at alarming rates in the UK?
A regime shift
Source: Refinitiv Datastream, UK Producer Price Index: output prices ex food, beverages, tobacco and petroleum; UK Consumer Price Index: non energy goods, year-on-year % change, 31 May 2016 to 31 May 2023.
Fig 2: Core consumer goods inflation curiously ticked up as producer prices moderate
The third is that the UK has become unhinged from the US and Europe and has more persistent inflation. Reasons might be due to greater trade friction post Brexit leading to higher costs and a peculiarly tight labour market. While wages in the US and Europe are moderating, this is not yet evident in the UK.
A persistent inflation problem
Consumer prices: goods ex energy (rhs)
Core producer prices
Core inflation (which excludes the volatile items of food and energy) typically lags headline inflation. In the UK bizarrely, it is not just services but core goods prices have started reaccelerating and core inflation is still ticking up as a result. There are a number of ways to try and explain the UK inflation conundrum ranging from benign/ temporary explanations to one of a much more problematic persistent inflation problem
Read the full article for more on the corportate debt overview, including industry patterns, debt servicing and sustainability, bond markets and outlook
The exact path for the global economy and corporate earnings may be very unclear, but the end of the rate-hike cycle and the return of ‘income’ mean there is a lot for corporate bond investors to be happy about, argue James Briggs and Michael Keough
Debt levels may have risen but they are very well supported, and the global economy has remained remarkably resilient. This resilience and the extraordinarily high levels of profitability companies have enjoyed in the last two years reflect vast sums of government deficit spending and central bank liquidity stimulus during the pandemic. The surge in interest rates needed to quell the resulting inflation is succeeding in most parts of the world, but it is not at all clear when and to what extent the economy will suffer the more painful consequences – higher unemployment and lower profits.
Corporate debt
Company net debt - global (constant currency)
Source: Janus Henderson, June 2023. There is no guarantee that past trends will continue, or forecasts will be realised.
Companies around the world took on $456bn of net new debt in 2022/23, pushing the outstanding total up 6.2% on a constant-currency basis to $7.80 trillion. This exceeded the 2020 peak, once movements in exchange rates were taken into account. However, one fifth of the net-debt increase simply reflected companies such as Alphabet and Meta spending some of their vast cash mountains. Total debt, which excludes cash balances, inched ahead globally by just 3.0% on a constant-currency basis, around half the average pace of the last decade. Higher interest rates helped slow appetite to borrow but have not yet made a significant impact on the interest costs faced by most large companies.
Corporate debt rose to a new record, but appetite to borrow is waning
The global economy is slowing as higher interest rates exert pressure on demand. Corporate earnings are expected to fall from their record levels as a result. Higher borrowing costs and slower economic activity mean companies will look to repay some of their debts, though there will be significant variation between different sectors and between the strongest and weakest companies. Net debt is likely to fall less than total debt as cash-rich companies continue to reduce their cash piles. Overall we expect net debt to decline by 1.9% this year, falling to $7.65 trillion.
Outlook: Debt levels set to fall as economy slows
The higher level of interest rates around the world has pushed down the market value of corporate bonds. This happens because coupons on bonds, the amount of interest paid on the original borrowed amount, are fixed, so when prevailing interest rates go up, the value of a bond must fall to keep the bond and its coupon in equilibrium with market conditions. In early May, the market value of investment grade bonds in the Bank of America/ICE index7 was 9% lower than the face value8; high-yield bonds (which are less credit-worthy) had a value 13% below the face value. Two years ago, the market value of investment grade and high-yield bonds was 9% and 3% respectively above face value.
Bond markets
Falling inflation means the medicine is working and the rate-tightening cycle is therefore nearing the end in most parts of the world, though places like the UK still have some way to go. The big question now is how long will it take before higher rates begin to generate higher unemployment, lower demand and therefore lower corporate profits? And how variable will the time lags be between different sectors and different parts of the world? In addition to the global central bank tightening cycle, one risk we are closely monitoring is the impact of the banking sector operating in a more conservative manner and preserving liquidity following the failure of several large banks. We expect them to lend less which will lead to tighter financial conditions and a drag on economic growth through the rest of 2023. As a result, investors must be prepared to navigate a wide range of economic and market outcomes. In short, the exact path for the global economy and corporate earnings may be unclear, but the end of the rate-hike cycle and the return of income mean there is a lot for corporate bond investors to be constructive about.
Outlook and viewpoint
Read the full article for more on the implications of a ‘hawkish skip’
Investors should prepare for “high for longer” rather than an imminent dovish pivot, say Jason England and Jim Cielinski
The market has framed the last few Federal Reserve (Fed) meetings as “does no increase mean skip or hold?” Having studied the painful lessons from a generation ago of pivoting too early, Fed Chairman Jay Powell reiterated that an additional rate hike remains on the table should inflation’s downward path not meet the central bank’s expectations. We believe this is another step in Fed’s well-communicated strategy, which prioritises moving slowly and analysing economic data from meeting to meeting. Importantly, the Fed continues to weigh the totality of data when making decisions. And in the months since the Fed’s last release of its Summary of Economic Projections (SEP), there has been much data to digest. Although the headline year-over-year personal consumption expenditure price index has fallen to 3.3% and its core component to 4.2%, other, more granular measures are likely providing ammunition to the Fed’s hawkish camp. The Atlanta Fed’s annual sticky consumer price index still sits at 5.3%. However, the same series’ 3-month annualised rate has slid to a more palatable 3.6%. With conflicting signals – and a still growing economy, despite 525 basis points (bps) of hikes already – we believe the Fed is justified in staying vigilant.
OCTOBER 2023
“Some” progress on inflation
Source: Bloomberg, as of 20 September 2023.
Underpinning the Fed’s circumspect tone was the newly updated SEP. Rate increases are typically effective in lowering inflation insofar as they act as a headwind to economic growth. Yet, with the median projection for 2023 gross domestic product (GDP) growth having been adjusted upward from 1.0% to a much healthier 2.1%, it shows that the long and variable lags of monetary policy may be longer and more variable this time around. We don’t think the Powell Fed will take the risk that existing cuts will be sufficient. The perhaps surprising resilience of the US economy is evident in the Fed having modified its assessment of growth from “modest” to “moderate” and now to “solid” over the past three meetings. While this supports the notion that the elusive soft landing may be possible this cycle, the hawks are not likely to rest on their laurels.
Maybe too resilient of an economy
While progress has been made on headline – and even core – inflation, higher sticky elements force the Fed to remain cautious
Read the full article for more on the lessons for investors in mortgage-backed securities
There is value in small, individual idiosyncrasies which is missed by algorithms, say John Kerschner and Nick Childs
In 2018, Zillow CEO Richard Barton excitedly announced that the online real-estate marketplace would be entering the lucrative house-flipping business. According to Barton, the plan for the new venture, dubbed Zillow Offers, entailed the company entering select US housing markets, purchasing and renovating homes, and reselling them at a profit. The firm would rely on its proprietary algorithm, or Zestimate, to forecast future home prices, which would inform how much the company should pay for the houses it purchased. Fast forward to November 2021, when Barton again made an announcement regarding Zillow Offers. This time, however, it was to let the market know that the company would be shuttering the venture after losing $1 billion in the preceding three years. So, what happened? At the root of the problem was Zillow’s attempt to value heterogeneous assets homogeneously.
Exhibit 1: Variations of MBS vs. US Treasuries
Source: Janus Henderson Investors. The factors shown are representative and are not comprehensive. For illustrative purposes only.
Aside from some obvious similarities, all houses are at least a little – and often a lot – different from others, and these differences should be considered when valuing a home. Zillow spent a lot of money to learn a hard lesson here. It is incredibly difficult, if not impossible, to value heterogenous assets homogenously. Even houses in sub-developments, which may share comparable floor plans, can vary greatly in value depending on characteristics such as fixtures and fittings, wear and tear, and location within the subdivision. The house-flipping business has always been a people-intensive one. Each home is typically evaluated, bought, renovated, and sold individually, often by an experienced person or group of people with extensive industry experience and knowledge of the local market. Zillow hoped to reduce the reliance on people in favor of a technological model, or algorithm, that they believed could automate the valuation process. But there was one major flaw in this approach: While Zillow claimed their Zestimate is an accurate algorithm, they came to realise it was not accurate enough for flipping houses. The company admitted it had repeatedly overpaid for homes it purchased and had to sell at a loss later.
Houses are not widgets
The Zillow case showed us that when it comes to non-homogenous assets like houses, it might make more sense to value these assets on a case-by-case basis. As such, we think there is value to be extracted in focusing on small individual idiosyncrasies instead of leaning too heavily on algorithms that must rely on broad assumptions regarding such idiosyncrasies. We think this principle applies to the mortgage market as well. Not only are mortgages loans against non-homogenous homes, but the mortgages themselves are also non-homogenous because they have many variables affecting their value, as shown in Exhibit 1.
The lesson for mortgage investors
A significant number of factors influence bond prices in the MBS market
100,000
80,000
60,000
40,000
20,000
7
6
Number of factors (loan type, geography, tenor, etc.)
Cumulative possibilities for loan variation
“Even houses in sub-developments, which may share comparable floor plans, can vary greatly in value”
The market is too pessimistic on inflation improvement but too optimistic on the growth environment, argue Jenna Barnard and John Pattullo
Headline inflation in the US has retreated faster than during the many inflation episodes in the 1940/50s, let alone the more persistent shocks of the 1970s. The current generation of central banks is waiting for lagging core inflation to follow, and these dynamics are just beginning to kick in to the downside in a convincing way in the US. Other developed economies have inflation cycles that lag the US by around four to six months. Meanwhile, headline jobs data is strong but it traditionally lags, especially in an inflationary downturn. Lead and coincident jobs data such as temporary employment and overtime hours continue to contract. Whilst the market debates soft vs. hard landing, there are many opportunities to generate defensive yield (i.e. not stretching down in credit quality). For example, high front-end sovereign bond yields are creating opportunities among short-dated investment-grade credits, and AAA US agency mortgage securities are yielding the same as the US BBB investment-grade bond index. For more insights on these topics and more, listen to our latest podcast:
Jenna Barnard CFA, Co-Head of Global Bonds | Portfolio Manager
John Pattullo Co-Head of Global Bonds | Portfolio Manager
MACRO INSIGHT
John Pattullo CFA, Portfolio Manager
Read the full article for more trend analysis on secured loans
For higher-income-seeking investors, European secured loans have much to offer at this juncture, according to Tim Elliot and David Huang
With 2023 more than half over, it seems an appropriate time to take stock and look at the secured loan market performance year-to-date and expectations for the remainder of the year (1). The mood around loans heading into 2023 was somewhat pessimistic given expectations for a material slowdown in economic activity. This was expected to impact lower rated companies more severely, combined with concerns that rising interest rates would materially impacted loan borrowers’ ability to service their floating rate debt. Our view was cautious but not negative, as highlighted in the piece we wrote in January 2023 entitled: ”Loans look-through: a year for income?”. We felt the key driver of return for loans would be the high coupons resulting from the increase in underlying cash rates. This has indeed been the case and with investors across credit markets becoming less concerned about a hard landing for the global economy, we have seen some modest spread tightening since the start of the year (figure 1).
David Huang Associate Portfolio Manager
Figure 1: Floating rate instruments have held up well amid broader volatility Year-to-date total and excess returns across broad fixed income markets
Whilst investor concerns have abated somewhat, inflation has continued to prove quite sticky and, as a result, central banks have been forced to continue to tighten monetary policy and push up short-term rates (figure 2). Loans as a floating rate asset class have continued to benefit from this.
Euro IG corporate
Sterling IG corporate
US IG corporate
Euro IG ABS
US IG ABS
EM credit
Euro HY corporate
US HY corporate
Euro secured loans
US secured loans
Source: Janus Henderson, ICE BofA, Credit Suisse, Barclays, as at 31 August 2023. Note: Returns in euros. For illustrative purposes and not indicative of any actual investment.
Figure 2: Surging short-term rates have benefited floating rate assets
Source: Janus Henderson, Bloomberg and ICE, as at 31 August 2023. Note: Data is based on 1-month LIBOR up to 31 December 2020, then SONIA, ESTR and SOFR 1-month rates. Forward rates are based on OIS curves as at 31 August 2023.
The current yield on the Credit Suisse Western European Leveraged Loan Index (WELLI) rose above 8% at the end of June (figure 3) and, as at 31 August 2023 now sits at 8.4%, a 15-year high (2). This yield offers a considerable buffer should the economic outlook decline. It could be argued that with an average loan price of 95.90, the European market is already pricing in some weakness. Excluding the periods covering Covid and the opening of the war in the Ukraine, loans are trading at levels not seen since 2016.
Attractive yields offer buffer against economic uncertainty
Figure 3: Cash interest receipts rising in European secured loans High yield versus loans (average coupon)
Source: Bloomberg, ICE BAML, Credit Suisse, as at 31 August 2023.
Figure 4: Valuations attractive relative to history and other fixed income asset classes Spread ranges – percentile rank (current versus 20-year history)
Source: Janus Henderson Investors, Bloomberg, Credit Suisse, JP Morgan, Citi as at 31 August 2023. Note: Data points represent percentile spread rankings as at 31 August 2023, relative to history. Data for CLOs and UK RMBS from 2006 to date (31 August 2023). All other data is over a 20-year time period (31 August 2003 to 31 August 2023). Indices used as asset class proxies: Credit Suisse Western European Leveraged Loan Index, Credit Suisse Leveraged Loan Index, JP Morgan UK RMBS AAA 5y GBP, ICE BofAML US High Yield Index, ICE BofAML European Currency Non-Financial High Yield 2% Constrained, ICE BofAML US Emerging Markets Liquid Corporate Plus Index, ICE BofAML Sterling Corporate Index, ICE BofAML US Corporate Index, ICE BofAML Euro Corporate Index. CLOs based on Citi Velocity European 1.0 AAA CLOs up to March 2013 then European 2.0 AAA CLOs thereafter. Index data is for illustrative purposes and not indicative of any actual investment.
Lower
Higher
(1) Source: Year-to-date is as at 31 August 2023.
(2) Source: The Credit Suisse Western European Leveraged Loan Index (WELLI) is designed to mirror the investable universe of the Western European leveraged loan market. Loans denominated in US$ or Western European currencies are eligible for inclusion in the index, which is rebalanced monthly on the last business day of the month.
The world is replete with examples of how combining things can create something special. The same can be true in finance – here, we explore the potential benefits of a fixed maturity bond portfolio
Look around you and so many things are the result of a combination. Where would we be if oxygen and hydrogen weren’t combined to make water? Who wants to return to a world where heavy luggage had no wheels? In the financial world, sometimes putting together different structures can provide investors with an appealing investment. Often this might involve a solution that mixes asset classes to offer a different risk/return profile, but sometimes it is also about the structure of the vehicle itself.
FIXED INCOME
Figure 1: Comparison of features of a single bond, a traditional open ended fund and a fixed maturity bond fund.
Source: Janus Henderson investors, 31 August 2023. For illustrative purposes only.
This is where a fixed maturity bond fund comes in. It combines the core features of a single bond (regular predictable coupon and fixed maturity date) with the key benefits offered by a fund (diversification across many bonds, together with security selection and monitoring from investment professionals).
Potential benefits of a fixed maturity bond fund
Many investors crave predictability. It is partly why the bond market exists. In buying a bond, an investor essentially lends money for a set period and – providing the bond does not default – receives a specific income over the term of the bond and their principal back when the term ends (the maturity date). Investors value the predictability of steady income and the return of capital at a defined maturity date that a single bond offers. But this comes with a high degree of concentration risk – what if the bond defaults? Of course, an investor could turn to a bond fund, which would reduce single issuer risk by diversifying across a portfolio of bonds and comes with the comfort that the portfolio is being managed by professionals. However, these tend to be open-ended so the yield on the fund can vary over time and the capital value when the investor comes to divest is less certain.
Seeking predictability
A fixed maturity bond fund has a finite life (typically in the three to five-year time frame), so investors know when to expect a return of capital. Moreover, with investments mostly made during the initial investment period, this helps to lock in yields, offering protection against potential falls in interest rates. This helps provide visibility around the fund’s potential return and means duration risk (interest rate sensitivity) is low and declines as the fund approaches maturity. Fixed maturity products are designed to be held to maturity and investors should be prepared to remain invested for the term of the fund. Normally, to help protect remaining investors in the portfolio, there is a fee applied to any investor who redeems before the maturity date.
Single Bond
"Traditional" open-ended Fixed Income Fund
Fixed Maturity Bond Fund
Total return visibility
High
Low
Regular coupon
Defined maturity
Concentration risk
Security selection and monitoring
Interest rate/spread/price sensitivity over time
Decreasing
Relatively constant
“A fixed maturity bond fund combines the core features of a single bond with the key benefits offered by a fund”
Read the full article for more on the key considerations
Read the full report for more on the cycle indicators and issuer fundamentals that inform our outlook
Red lights are flashing as indicators suggest a deteriorating credit cycle, says Jim Cielinski
Credit quality in aggregate has mostly held up due to the impact of high nominal growth and Covid-era consumer savings on corporate revenues, with default rates yet to show a meaningful rise this side of the debt maturity wall. Nonetheless, traditional indicators of a deteriorating credit cycle – an inverted yield curve, tighter lending standards, and elevated debt levels – remain in evidence. Notable in the third quarter was the sharp rise in real rates, which alongside a fresh tightening in financial conditions is likely to weigh on credit.
NOVEMBER 2023
Debt servicing costs have risen with higher yields and may remain elevated given the looming maturity wall and prospect of higher -for-longer policy rates.
Stronger, larger companies can access capital, but at a higher price. Smaller companies reliant on bank lending are finding it tougher.
The earnings rebound post COVID is now (with some exceptions) being challenged by weaker nominal growth and the incremental rise in financing costs.
Longer term predictors still flashing red
EXOGENOUS SHOCK TO CASH Key metrics: earnings, earnings revisions Prognosis: earnings growth weakening
Read the full article for more on the factors driving up yields
With real yields sharply higher, Jim Cielinski dissects what is behind the recent move
The yield on the US 10-year Treasury reached 4.8% in the first week of October, the highest level since 2007. The pain in bond markets has been contagious, as equities fell and credit spreads widened in response to spiralling interest rates. For fixed income investors, the prospect that longer-dated US Treasuries could be set to deliver a third year of negative returns – something that has never happened in history – became uncomfortably real.
‘Real’ is the operative word here. For much of the past two years, inflation has been the factor that has driven fixed income markets. But core inflation peaked in the US a year ago and in Europe earlier this year. Headline consumer price inflation has tumbled and core inflation is gradually heading down, moving closer to the US Federal Reserve’s (Fed) target, although the mixed data in the US CPI release covering September demonstrated that the path lower may be uneven. Inflation expectations are under control as Figure 1 indicates. What has jumped is real yields.
What’s in a word?
Figure 1: Real yields are driving yields higher
Source: Bloomberg, US Treasury 10-year nominal yield, US Treasury 10-year Inflation Protected Securities (TIPS) yield (real yield). The 10-year breakeven rate is a measure of expected inflation, implying what market participants expect inflation to be in the next 10 years, on average. It is derived from subtracting the yield on TIPS from nominal bond yields of the same maturity. 31 October 2003 to 6 October 2023.
We can think of real yields as the annualised return a fixed income investor can expect to earn after inflation. They are important as they often provide an insight into expectations of future economic growth and monetary policy. Real yields turned negative when investors were worried about the economy and monetary policy was extremely loose. They have since turned positive as the economy heals.
What are real yields?
Longer-dated yields are driven by a combination of:
The forward path of policy rates. This is why the market pays close attention to central bank guidance for a steer on where policy rates are likely to be headed. The market’s recent expectation for impending rate cuts has shifted to a “higher for longer” mantra. A similar re-evaluation of the equilibrium, or neutral, policy rate has also been moving higher. The term premium. This is essentially the extra compensation that a bondholder wants paying for the risk of lending for longer periods. This is a function of inflation, uncertainty and supply/demand dynamics. This term premium is not directly observable but models that estimate it such as one developed by New York Fed economists known as the ACM model suggests term premium has been rising recently (1).
There are a number of factors that seem to have driven real yields higher. First, there has been a fresh focus on bond supply. It was not so long ago that proponents of Modern Monetary Theory were suggesting that governments could print money and spend with abandon, as inflation could easily be controlled. The recent inflationary episode appears to have consigned that theory to the trash. To be fair, fiscal policy was critical in helping the world to recover quickly from the pandemic. Questions are, however, rightly being raised as to why governments are still so heavily in the red. The US government is on course to borrow more in 2023 than it did in 2022. The latest projection is for the 2023 US deficit to reach 5.8% of GDP (7% if we exclude the reduction in outlays associated with student loan forgiveness reversal). For a full employment economy, this is reckless fiscal spending and is contributing to the rise in supply of Treasuries. But the US is far from alone, as Figure 2 demonstrates.
What has driven real yields higher?
Figure 2: Government budget deficits are much larger than pre-Global Financial Crisis
Source: Bloomberg, Government budget deficit as % of gross domestic product (GDP). 2023F figures represent forecasts representing composite of private contributors on Bloomberg. Latest available figures as at 30 September 2023.
(1) Source: Current and former New York Fed economists Tobias Adrian, Richard K. Crump and Emanuel Moench developed a statistical model to describe the joint evolution of Treasury yields and term premia across time and maturities, known as the ACM model.
“Questions are rightly being raised as to why governments are still so heavily in the red”
Read the full article for more on the prospects for EM debt
The instability of the past few years has led to a high level of dispersion between sovereigns, making diversification more valuable than in the past, says Thomas Haugaard
Today, developing countries are still working through the effects of the unprecedented economic shocks of the past three years. Covid, as well as contributing to inflation, created dislocations globally. The Ukraine-Russia conflict, fuelling higher commodity and food prices, disproportionally hit commodity importers and poorer countries in the EM universe (1). Meanwhile, the second order effects of aggressive US monetary tightening aimed at taming inflation (including US dollar strength; higher US Treasury yields), continue to feature in the financial stresses dogging various weaker EM countries servicing hard currency denominated sovereign debt or seeking access to capital markets (2).
A notable aspect of these shocks is that their impact country-to-country has been anything but uniform. This is due to factors such as demographic differences, the different health policy responses to Covid, different fiscal and financial policies (some countries reacted with significant fiscal stimulus measures; others did not), different adaptive capabilities and the asymmetrical impact of these shocks on poorer developing economies. We now have a high level of dispersion or dislocation across the global economy. A good example of this is China. Back in 2022, China cut key interest rates – and then again 2023 – against a backdrop of disruptions to trade, manufacturing and consumer spending, following its harsh zero-Covid policy (3). In 2023, despite China’s much heralded reopening, we saw China slashing its growth target to a multi-decade low of “around 5%” for 2023, and even that target may not be achieved, according to several economists (4). This historically high dispersion is also evident within the EM universe when you look at credit risk ratings and credit spreads among EM countries. A big gap exists between the Investment Grade (IG) countries – financially strong countries like some higher income Middle Eastern countries that have benefited from rising commodity prices in recent years – and a group of countries (bigger than in the past) in the high yield sovereign bucket that are distressed or facing significant funding issues. As at 31 August 2023, spreads on IG sovereigns are well below their long-term averages, partly influenced by index composition changes in recent years, while spreads on high yield sovereigns – despite significant spread compression in the CCC rating band since March 2023 – remain above historical averages (5). From an investment perspective, as investors in EM hard currency debt, we believe the prudent response to this current high level of desynchronisation is to be diversified across different types of economic structures and economic policy responses as economies transition to something that is hopefully a bit more stable. Diversification, at least from our perspective, seems even more valuable than in the past.
High dispersion and desynchronisation
The rise in debt levels and tougher external financing conditions have increased pressure on many EM countries and inevitably brought scrutiny to their primary balances. Most emerging markets continue to have fiscal deficits wider than their pre-Covid trends and thus some fiscal consolidation is needed to get back to where things were before Covid (6). Notably, debt-related issues have impacted countries like Zambia, Sri Lanka, Ghana, Pakistan, Tunisia, Egypt, El Salvador, Kenya and Lebanon. The risk of broader contagion from the group of distressed countries to the overall EM debt asset class is, in our view, limited. Sentiment has been lifted by constructive news on a debt restructuring agreement between official creditors and Zambia – cheered as a success for the G20 Common Framework for Debt Treatments initiative set up during the pandemic to help streamline debt restructurings; approval of an International Monetary Fund (IMF) programme for Pakistan; and progress on local debt restructurings in Ghana and Sri Lanka. While there is still a long road ahead to regain market access, recent progress bodes well for future restructuring processes.
Fiscal consolidation is needed, but progress is evident
(1) By and large, developing countries are vulnerable to rising food, fuel and medicine prices. More than half of the countries classed as developing are commodity importers.
“We now have a high level of dispersion or dislocation across the global economy”
(2) A strengthening US dollar means countries that have issued debt denominated in US dollars see their debt repayments increase relative to the size of their respective economies.
(3) In August 2023, the People’s Bank of China slashed its 1-year loan prime rate (LPR) by 10 basis points to a record low of 3.45%. Source: Trading Economics, Y Charts. (4) Data released in Q3 of 2023 suggests a fading rebound in China from the reopening of its economy at end-2022. Nomura Holdings Inc., for example, has lowered its 2023 growth forecast for China to 4.6%. Source: Bloomberg, 18 August 2023. In a similar vein, Morgan Stanley economists have revised their China growth forecast down to 4.7% for 2023 and 4.2% for 2024. Source: Morgan Stanley, 15 September 2023.
(5) Index composition here refers to the composition of the JP Morgan EMBIG Diversified Index. The Emerging Market Bond Index Global Diversified (EMBIGD) is a widely followed and uniquely weighted (country weights capped at 10%) USD-denominated emerging markets sovereign index. CCCs refer to bonds rated CCC by a credit rating agency. Credit ratings refer to the assessment by a credit rating agency as to the creditworthiness of the entity issuing the bond – in other words, the ability of the issuing entity to meet its financial obligations, including its bond payments. Bonds rated CCC are considered speculative, or non-investment grade.
(6) Fiscal consolidation describes government policy intended to reduce deficits and the accumulation of debt. Fiscal consolidation is often a balancing act involving tough choices. On the one hand, high debt leaves countries exposed to interest rate shocks, limits their capacity to respond to future shocks and reduces long-term growth potential. On the other hand, reducing deficits by cutting spending or raising revenues can, and usually does, hamper growth.
(1) By and large, developing countries are vulnerable to rising food, fuel and medicine prices. More than half of the countries classed as developing are commodity importers. (2) A strengthening US dollar means countries that have issued debt denominated in US dollars see their debt repayments increase relative to the size of their respective economies. (3) In August 2023, the People’s Bank of China slashed its 1-year loan prime rate (LPR) by 10 basis points to a record low of 3.45%. Source: Trading Economics, Y Charts. (4) Data released in Q3 of 2023 suggests a fading rebound in China from the reopening of its economy at end-2022. Nomura Holdings Inc., for example, has lowered its 2023 growth forecast for China to 4.6%. Source: Bloomberg, 18 August 2023. In a similar vein, Morgan Stanley economists have revised their China growth forecast down to 4.7% for 2023 and 4.2% for 2024. Source: Morgan Stanley, 15 September 2023. (5) Index composition here refers to the composition of the JP Morgan EMBIG Diversified Index. The Emerging Market Bond Index Global Diversified (EMBIGD) is a widely followed and uniquely weighted (country weights capped at 10%) USD-denominated emerging markets sovereign index. CCCs refer to bonds rated CCC by a credit rating agency. Credit ratings refer to the assessment by a credit rating agency as to the creditworthiness of the entity issuing the bond – in other words, the ability of the issuing entity to meet its financial obligations, including its bond payments. Bonds rated CCC are considered speculative, or non-investment grade. (6) Fiscal consolidation describes government policy intended to reduce deficits and the accumulation of debt. Fiscal consolidation is often a balancing act involving tough choices. On the one hand, high debt leaves countries exposed to interest rate shocks, limits their capacity to respond to future shocks and reduces long-term growth potential. On the other hand, reducing deficits by cutting spending or raising revenues can, and usually does, hamper growth.
Read the full article for what this means in relation to the bond yield peak
Janus Henderson’s Global Bonds Team compare the recent steepening to historical precedents and consider what it might mean for bond yields
We are three years into a bond bear market driven by a severe inflation shock and a ratcheting up of short rates. Just as we approach terminal rates in many countries and core inflation begins to surprise to the downside, we get hit with a rare bear steepener. Is this the beginning of a whole new bond bear market or the death throes of the existing one? In the financial world, a bond bear steepening of the magnitude we have seen in recent weeks is rare. In fact, we will demonstrate that it has occurred only 15 times (before the current episode) in the last 60 years. And when yield curves have been inverted – as they are now – it has typically led to a fall from peak yields and coincided with the onset of a recession.
Figure 1: Bear steepener illustration
Source: Janus Henderson Investors. For illustrative purposes only.
Jenna Barnard, CFA Co-Head of Global Bonds | Portfolio Manager
What is a bond bear steepener?
This term is used to define a situation in which yields on longer term bonds rise more than the rise in yield on shorter dated bonds. It is called a steepener because the yield curve that plots yields of bonds of the same quality but different time to maturity is normally upward sloping from bottom-left to top-right. So, if yields on longer dated bonds rise faster than on shorter dated bonds, this would cause the yield curve to steepen.
Dillan Shah, CFA Associate Portfolio Manager
“This term is used to define a situation in which yields on longer term bonds rise more than the rise in yield on shorter dated bonds”
Bloomberg bond curve data only goes back to 1976, so we used a dataset from Macrobond (sourced from the Federal Reserve Bank of New York) to show a longer history of bear steepening moves back to 1960. This additional historical data uses the 1-year and 3-year bonds which existed pre-1976 and interpolates a 2-year yield (pre-1976 there was no 2-year yield). Below is a table (in chronological order) of all the bear steepening examples looking at the data back to 1960. The methodology we used to identify instances of bear steepening was that the 2s10s steepening needed to be greater than 10 basis points (bp) and last for a minimum of a week. The move in the 2-year yield is anything greater than 0 bp. This is not an onerous definition, but it only finds 15 examples in 63 years, plus the current one. We bucketed them into three categories, based on the initial shape of the yield curve at the time:
A rare occurrence
One of the most widely followed measures is the difference between the yield on the 10-year US government bond and the yield on the 2-year US government bond. This difference is known as the 2s10s. Normally, the difference is positive (10-year bonds typically yield more than 2-year bonds) but when it turns negative, the yield curve is described as inverted.
ORANGE: A bear steepener off inverted curves (like we have today) BLUE: A bear steepener off a relatively flat curve, with the 2s10s curve ranging between 7-56 bps. GREEN: A bear steepener off a very steep curve.
By grouping these instances into the aforementioned three categories we can look back on what subsequently happened to rates and whether they signalled a recession was around the corner.
Source: Macrobond, Janus Henderson Investors, January 1960 to September 2023. Data reflects intraday highs. Current bear steepening reflects 13 July 2023 to 4 October 2023. Basis point (bp) equals 1/100 of a percentage point. 1 bp = 0.01%, 100 bps = 1%. Past performance does not predict future returns.
Figure 2: Bear steepening episodes
The following graphs show how these moves relate to the peak in bond yields for the cycle. We focus on the orange examples as this condition is the most similar to what we are seeing today (a bear steepening from a deeply inverted yield curve). It generally corresponds with the peak in 2-year yields while for 10-year yields it is close to the peak (with a notable difference being the 1969 episode).
Figure 3: US 2-year Treasury yield
Source: Macrobond, Janus Henderson Investors, 2 January 1960 to 4 October 2023.
Figure 4: US 10-year Treasury yield
In all but one of these four examples when we bear steepened off an inverted curve we were in recession or going into recession soon. In 1969, we had to wait two months before the recession started in December 1969. In 1981, we were already in a recession for two months when the bear steepening completed in September. In 2007, the recession started in December 2007, six months after the bear steepening. The exception was 1966 (the bear steepening actually began on 29 December 1965 and continued through the first two months of 1966) where there was no recession but there was a period of relatively slow economic growth for the subsequent 18 months. Therefore, looking at the examples above, there is no precision in timing of when a recession will occur, however the likelihood of one occurring is high.
Relation to the economy
Later
Earlier
The bear steepening move we are currently experiencing is unusual, in combining both a high magnitude and the starting point of a deeply inverted 2s10s curve. The closest direct comparison is the bear steepening in August-September 1969, when the curve bear steepened 53 bps over 6 weeks off a deeply inverted curve. The current move has superseded that example given it bear steepened 55 bps from 13 July to 4 October 2023.
Bear steepenings off inverted curves (1966, 1969, 1981, 2007 & today)
Read the full report for more debate on the prospects for fixed income
The latest meeting of Janus Henderson’s Fixed Income Investment Strategy Group centred on the shifting narrative in the market. What should we read from recent economic data and were arguments around a changed natural rate of interest justified?
Recent months have seen a spurt higher in yields, with various conjectures put forward for the moves. Economists have rowed back on recession fears in the US while fresh emphasis has been put on bond supply. Could more structural factors be behind the rise in yields?
Figure 1: Real yields at a post-Global Financial Crisis high
For fixed income investors, the shifting narrative poses a particular dilemma. A stronger economy is potentially good for credit fundamentals but upward pressure on yields is an offsetting factor. Real rates have risen, reflecting a higher term premium and expectations for a “higher for longer” rates regime. Should we be reassessing our view that we are near peak yields?
Source: Bloomberg, US Treasury 10-year nominal yield, US Treasury 10-year Inflation Protected Securities (TIPS) yield (real yield). The 10-year breakeven rate is a measure of expected inflation, implying what market participants expect inflation to be in the next 10 years on average. It is derived from subtracting the yield on TIPS from nominal bonds yields of the same maturity. 31 October 2003 to 31 October 2023.
