- Fixed Income Portfolio Manager
United States, Institutional
Change
The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.
In my full-year Outlook for 2023, I advocated for a defensive credit market risk posture, given my forecast for the global economy to enter a recession this year. While that remains my base case, I continue to see several attractive investment opportunities across fixed income sectors and expect there to be better entry points for allocators to take on additional credit risk in the second half of the year.
Global recession risks remain elevated
The leading economic and financial market indicators I monitor are continuing to signal a high probability of substantial weakening in the global economy in the coming quarters. I believe more restrictive central bank monetary policy over the past year or so, particularly in the US, likely contributed to recent banking-sector stresses and could be the transmission mechanism that eventually leads to lower corporate earnings and an increase in corporate defaults.
While the end of interest-rate-hiking cycles in the US and elsewhere may be near, engineering a soft economic landing will prove quite challenging, in my view, and I don’t think global central banks will be able to pivot to accommodative monetary policy anytime soon amid persistent inflationary pressures. Broadly speaking, financial conditions had already been tightening prior to the March deposit run that plagued the US banking system, which will likely make matters worse via tougher bank lending standards.
Despite these known perils and headwinds, credit spreads across many fixed income sectors have recently compressed to within their historical median levels, which may not adequately compensate investors return-wise for the much-anticipated economic slowdown — hence, my overall defensive stance on credit market risk at this time.
Banking sector stresses could devolve into a crisis
Concerns around potential contagion across the US banking sector are still lingering, although I believe the worst of the liquidity issues have been addressed through the swift, decisive actions taken by the Federal Deposit Insurance Corporation (FDIC) and the US Federal Reserve (Fed). Nonetheless, policymakers may have not yet done quite enough to stem the risk of further bank-deposit outflows (e.g., guarantee uninsured deposits). Accordingly, consumer and investor confidence in the system remain somewhat shaky.
However, not every US bank faces the same liquidity problems, nor is every bank's depositor base equally concentrated in narrow, interest-rate-sensitive sectors. I therefore expect significant performance dispersion across US banks through the rest of 2023. In my view, large, systemically important banks are likely to fare better in this environment. Their businesses and deposit bases are generally more diverse and subject to stricter capital requirements than those of smaller banks. In contrast, banks with a large share of uninsured deposits, high geographic or customer concentration, and sizable unrealized losses in their securities portfolios are at greater risk going forward, in my judgment.
Market volatility to spawn relative-value sector opportunities
Credit spreads across most fixed income sectors have widened only modestly since the banking crisis unfolded, and with high-yield spreads now around median levels relative to history, I believe it is still too early to add much in the way of credit risk. However, despite my cautious outlook on the economic and credit cycles, there may be opportunities on the horizon for discerning investors to potentially improve portfolios through sector rotation and duration management (Figure 1). For example:
- European financials continue to be among my higher-conviction investment ideas, even though Additional Tier 1 (AT1) contingent capital securities suffered following the write-down to zero of Credit Suisse’s AT1 debt as part of its acquisition by UBS. Despite the greater uncertainty surrounding the future of the AT1 market, I see value across the capital stack in some “national champion” banks that are highly regulated and profitable and appear to be well capitalized.
- Non-agency residential mortgage-backed securities (RMBS) have been pressured by higher mortgage rates and declining affordability, but I expect home prices to be supported by a favorable technical backdrop. Not only is US housing supply relative to the population near historic lows, but I don’t see a near-term catalyst to push inventory substantially higher. This, combined with record homeowners’ equity, conservative underwriting standards, and a dearth of “affordable” mortgage products, form the basis of my constructive view on housing prices.
- Valuations for bank loan issuers look attractive to me, while interest coverage remains strong despite upward moves in rates. I suspect credit fundamentals may deteriorate from here as the impact of tighter monetary policy continues to work its way through the system. In particular, issuers with unhedged floating-rate capital structures may experience free-cash-flow strains. Wary of these risks, I favor sectors and credits that have some pricing power and are less vulnerable to rising input costs over those that may be more susceptible to negative supply chain surprises.
- For many fixed income investors, as global central banks (and markets) begin to shift their primary focus from fighting inflation to promoting economic growth, I think duration exposure can act as a more effective stabilizer of portfolio returns for the balance of this year than it did last year.
Figure 1
Maintain slightly below-average risk profile with above-average liquidity
I still believe ongoing credit market volatility and today’s more challenging liquidity conditions could create some attractive entry points for fixed income investors in the period ahead. With that in mind, I suggest being ready to act quickly to potentially take advantage of credit market inefficiencies or dislocations that could arise suddenly with unforeseen market events and turmoil.
So, bottom line for the second half of 2023: I advocate for many investors having a below-average credit risk posture, with significant exposure to liquid developed market government bonds and cash, along with an above-average duration profile.
