A team of our senior investors recently completed the GFICC Investment Quarterly (IQ) meeting and released our views on the global fixed income markets for the next three to six months. We invite investors to read the IQ letter from Bob Michele, our Global CIO, which summarizes our thoughts on unconstrained investing.

Views from this quarter’s IQ:

• In the face of elevated geopolitical risks in Eastern Europe, our base case remains above-trend global growth, with U.S. and emerging market economies providing an offset to sharply slowing European growth.

• The continued shift in consumption from goods to services could provide a positive growth impulse given the potential to catch up to pre-pandemic levels.

• Inflation should remain high, further supported by commodity price shocks and renewed supply chain bottlenecks from the geopolitical crisis.

• Despite growing growth risks, the Federal Reserve (Fed) is undeterred in embarking on its normalization process, hiking rates every meeting toward 2.00% on the federal funds rate (FFR) by the end of 2022.

• High inflation, central bank rate hikes and above-trend growth push interest rates higher, with the 10-year U.S. Treasury rate rising to the 2.00-2.50% range by year-end 2022.

• Potential risks include:

  • Russian retaliation or self-imposed European sanctions result in a large curtailment of Russian natural gas supply, exacerbating commodity prices enough to send the eurozone into a recession.

  • Accelerating inflation from sustained higher commodity prices and supply chain disruptions cause a slowdown in consumption. Central banks tighten policy aggressively to rein in inflation expectations. Tighter financial conditions result in a continued deleveraging, destabilizing financial markets.

  • Russia and Ukraine military tensions escalate, spurring wider military conflict.

1Q22 recap

There was no shortage of obstacles for market participants over the quarter. Persistent inflation, a rapid hawkish tilt from global central banks and a commodity-led geopolitical flare-up sent interest rates higher and curves flatter. Core inflation pressures accelerated further, driven by a continued rise in shelter prices coupled with lingering momentum in goods categories like household furnishings and apparel. The COVID-19 crisis seemed to have faded to a secondary risk as the Omicron variant – the most contagious variant of the virus we have seen – proved mild for vaccinated individuals, limiting its impact on lockdown policies in most of the developed and emerging world. From a public health crisis to full-fledged war, market attention turned toward the Russian invasion of Ukraine. Spreads swiftly widened across almost all asset classes as investors parsed through immediate and future implications of the direct conflict and the impact of sanctions on the landscape of global trade. The freeze on foreign reserves for the Central Bank of Russia sent the ruble tumbling, while the Society for Worldwide Interbank Financial Telecommunication (SWIFT) lockout brought into question the ability and willingness for trade partners to transact with Russia on its sizeable share of global commodity exports (crude oil, natural gas, base and precious metals, wheat and fertilizer, to name a few) and for Russian borrowers to service its debt. When analyzing economic sensitivity to the situation across regions, it became clear that the degree of energy independence would play a key role in forecasting local impacts to growth. For example, the outsized reliance of Europe on Russian natural gas has left the region with limited recourse to impose (or withstand) further curtailment of trade without increased risk of recession.

Taken together, global central banks are faced with a fundamental question: seek price stability at the expense of growth? So far, the answer has been a resounding “yes.” The European Central Bank (ECB) shrugged off elevated growth risk by announcing an expedited end to its quantitative easing (QE) program along with an expectation to lift policy rates from zero later this year. While the Fed didn’t hike the FFR by the previously expected 50 basis points (bps) at its March meeting, Chair Jerome Powell was as hawkish as ever, messaging an intention to hike rates at every meeting for the remainder of 2022 and commencing balance sheet runoff later this year. Further, the revision of its Summary of Economic Projections (SEP) dots revealed the expectation to hike rates above its stated neutral rate, showing its willingness to enter restrictive territory in order to combat inflation.

Investment-grade (IG) corporate credit posted one of the worst starts to a year in history, punished both by the rapid rise in interest rates and a gap wider in credit spreads. For the first time in multiple quarters, the BBB-rated cohort underperformed the index, with higher beta and more liquid sectors, like transportation, autos and banks, underperforming. U.S. energy stands out as the outperformer, given producers’ financial discipline and cash flow windfall from the meteoric rise in energy prices. Overall, corporate fundamentals are still positive, but progress on further improvement has slowed. For the median IG industrial company, both gross and net leverage are 0.2x and 0.4x, respectively, below pre-COVID-19 levels, with operating margins stalling out near 20-year highs. We cite elevated margins in the U.S. as a key defense mechanism against moderation in global growth, as companies have been able to pass along rising input costs to consumers thus far. It is clear that more of the IG market has transitioned into the “expansion” phase of the credit lifecycle, intentionally allowing debt levels to rise in favor of shareholder returns. Consistent with last quarter, sectors that were most affected by the COVID-19 crisis that have not yet achieved their leverage targets, like airlines, energy and autos, remain prudent. Corporate bond technicals, which have been a backstop to spreads in prior quarters, have turned decidedly negative. After a short hiatus amid the geopolitical volatility, cumulative year-to-date (YTD) new issue supply has climbed back to levels consistent with YTD 2020/21 issuance. Meanwhile, negative total returns in the asset class have led to net retail outflows from high-grade funds for the first year since 2010. The positive correlation between asset class total returns and net retail flows continues to hold true into 2022.

The 2Q22 IQ meeting was the first 100% in-person edition since the onset of COVID-19. With this format came an upbeat feeling of a return to normalcy, and it fostered a lively debate on the outlook for the global markets. While views were anything but unanimous, there was a uniform acknowledgement of the growing risks facing markets, including further escalation in Ukraine leading to increased sanctions or broader military conflict, an acceleration in inflation that crowds out consumption and the possibility of central banks tightening financial conditions into restrictive territory faster than expected. Despite the growing risks, our base case remains for risk assets to remain resilient given the exceedingly strong starting point of the U.S. economy, as well as consumer and corporate fundamentals. We expect a continued handoff from goods to services consumption to be a positive offset to rising commodity prices. In Europe, where recession risk is elevated, we expect fiscal initiatives in the form of subsidies for rising commodity prices, increased defense spending or support for the energy transition to cushion the blow. Commitment to our investment process is more important than ever in this environment.

Pairing frequent evaluation of the macroeconomic landscape together with rigorous bottom-up, security-level analysis will be paramount in navigating the increasingly challenging environment for fixed income investors.

U.S. life insurers

Higher interest rates and wider credit spreads were a welcome development for U.S. life insurers over the quarter. For the first time since the COVID-19 crisis, the industry was able to take advantage of poor market technicals and risk-off sentiment to add incremental yield to portfolios without sacrificing quality or liquidity. While our expectation is for longer-term interest rates to be rangebound at current levels, we view current spreads across investment grade to be pricing in excessive recession risk versus our economic outlook and are biased to add exposure.

Within the IG corporate credit market, we favor sectors where companies have maintained financial discipline and have pricing power, like utilities and selectively within basic industrials and energy. Value has also been created within banks, where U.S. money center spreads have been dragged wider due to a front-loaded funding schedule amidst technical selling pressure to access liquidity and meet money manager outflows. We also maintain conviction in Yankee banks, given their limited direct exposure to Russian counterparties and elevated capital buffers versus previous crises. The new issue market is our preferred venue to add exposure given the elevated concessions caused by recent market indigestion. New issuance has pulled secondary spreads wider, while newly issued bonds have performed well off the break. Where we have flexibility, we prefer to invest in intermediate maturities to maximize book yield per unit of duration given the flatness of Treasury and spread curves.

Securitized assets are still a diversification and yield enhancement tool for life portfolios; however, the recent backup in spreads has made the relative value decision between corporate and securitized credit more nuanced. For example, IG collateralized loan obligations (CLOs) have been an attractive tool for life insurers to fill shorter liability buckets and protect against rising rates. We still view the sector as fundamentally strong, but the lag in spread widening of the sector leads us to favor corporates for short-end needs. Additionally, the rapid rise in short-end rates is now more fully pricing the trajectory of the Fed. Our increased selectivity also extends to asset-backed securities (ABS), where we have been active given our positive outlook for the U.S. consumer. In subprime auto deals, low delinquency rates and high auto prices have decreased cumulative net losses since the COVID-19 crisis. At this point, we prefer to add seasoned deals in the secondary market that have already built credit enhancement and were underwritten at lower auto valuations. Consumer fundamentals remain a key tenet of our positive outlook for growth, but we note a moderation from extremely strong levels. Consumer deposit balances are elevated at 2x pre-COVID-19 levels, yet down from 3x in mid-2021. At the same time, we’ve observed delinquency rates across prime and sub-prime borrowers rise toward normal levels. We remain highly selective within commercial mortgage-backed securities (CMBS) given the continued uneven recovery and prefer deals with higher-quality collateral and exposure to defensive and secular growth exposed sectors like multi-family and industrial properties. For portfolios that can participate, our extended sector pick is high yield corporates, as we also expect the lower-quality corporate world to absorb inflationary pressures from elevated margins.

U.S. P&C insurers

For P&C insurers living in the belly of the curve, the flattening of rate curves has forced intermediate spread curves to steepen. Selling has been most destructive in the front-end, which has made it tough for those seeking liquidity. However, it has reversed the trend of front-end bonds trading through make-whole calls, providing an opportunity for shorter-duration buyers. The supply bolstered within the financial sector has pushed spreads in that cohort wider relative to industrials, especially in Yankee banks, allowing for more attractive entry points for a sector where we have been constructive. Operating margins are flat QoQ, but near 20-year highs as firms have been able to pass along higher prices to date. That could change if inflation does not start to abate. We anticipate that sectors with pricing power or COVID-19 tailwinds are best positioned to maintain it in the current environment (energy and health care). Single-A bonds currently look more attractive, as BBB bonds have more room to widen in this risk-off environment, but we will continue to be active across IG. With heightened volatility and lean dealer inventories, it will be important to be opportunistic when it comes to repositioning corporate exposures.

Securitized sectors also re-priced wider to begin the year amid a more hawkish than expected Fed, negative fund flows and elevated interest rate volatility. Despite their high-quality nature, agency mortgages widened in tandem with other spread sectors, as the technical tailwinds buoying the sector for the better part of two years unwound with the end of QE4 and the expectation of balance sheet runoff in the coming months. Fundamentals, however, have improved with the backup in rates, as some of the negative convexity risks in the market have softened. A significant number of borrowers took advantage of historically low mortgage rates in 2020 and 2021, and only a small portion of the mortgage universe (<10%) is now “in the money” (at least a 50bps incentive to refinance). As a result, prepayments recently slowed to an annualized rate of around 10% (from 35%). Insurance portfolios can finally start to find comfort in agency mortgages, as the market has widened to near historical long-run averages (+50bps off the lows of 2021 to a nominal current coupon spread of +110bps). Option-adjusted spreads are now firmly into positive territory, and we think it makes sense for core insurance portfolios looking for cash flow stability and predictability to begin legging into better-convex products, such as specified pools and agency multifamily, that have cheapened in recent weeks.

Fundamentals elsewhere within securitized credit remain largely constructive despite increasing headwinds. We think that consumer balance sheet health will continue normalizing from its post-COVID-19 peak. The consumer is battling several expense pressures that will persist for the foreseeable future (rising rents, auto payments, gas prices and food inflation), but we think robust employment and elevated savings balances across income cohorts will provide support to help offset these challenges. The median Chase consumer deposit account still points to near two times the balance versus pre-COVID-19, suggesting consumers still have some room to run. Specifically, we favor targeting consumer-backed ABS in seasoned vintages (2020 and early 2021) that have experienced de-leveraging and were underwritten during a time in which rating agencies were requiring additional levels of credit enhancement. The commercial real estate market continues to heal, but at an uneven pace. We are selective with the type of underlying asset, structure and credit risk we are adding to portfolios. For example, we are comfortable adding to subsectors such as single-family rentals, post-COVID-19 originated conduit and high-quality CRE CLOs with strong sponsors. P&C insurers that have the luxury to be liquidity providers during these bouts of elevated asset volatility should take advantage of these wider credit spreads and higher all-in yields.

UK & European insurers

The humanitarian crisis taking place in Ukraine has spurred inflation further, as well as raised growth concerns in the region. This has led to an increase in the probabilities of recessionary and stagflationary scenarios making central bank policies less certain. Despite these new factors, the ECB continued to indicate its current focus on tackling inflation, which has risen toward 6% in Europe. With the Pandemic Emergency Purchase Programme (PEPP) ending in March 2022, the ECB announced its taper of the Asset Purchase Programme (APP) at an accelerated pace from €40 billion in April, to €30 billion in May, then to €20 billion in June, with rate rises to follow “some time after” APP ends, meaning liftoff is likely before the end of the year. The removal of bond purchases is creating some technical concern for the market; however, we expect foreign demand to return as yields rise into positive territory, especially on the shorter end. On the other hand, local demand is sustaining current valuations. Principal-guarantee policies are pushing insurers to take advantage of now-positive Bund yields to fund their liabilities and lock in a low, yet safe, yield. Notwithstanding the ECB stance, flows have also proven surprisingly resilient in peripheral sovereign spaces (Italy, Spain), as the European Union (EU) Next Generation funds should be a game changer in the region’s medium-term debt sustainability.

Meanwhile, the UK’s proximity to the war and relative dependence on Russia is also challenging the Bank of England (BoE). Having started the hiking cycle in December 2021, the BoE was facing increased pressure to introduce 50bps hikes to counter record inflation. While the Ukraine crisis has dampened these expectations, 5 further hikes are priced in from now until the end of the year, as well as the sale of £10 billion of corporate bonds by the end of 2023. On the back of this aggressive monetary shift and less conducive risk sentiment, some UK insurers are re-calibrating their strategic asset allocation (SAA), moving away from strategies rich in credit risk premium (e.g., high yield) in favor of illiquidity premia of different sorts. We continue to field inquiries around portfolio sensitivities to stagflationary stress environments as realized inflation and growth expectations have diverged.

EU IG spreads have underperformed in recent weeks and are beginning to offer attractive entry points. However, the ongoing uncertainty has led European investors toward higher yields outside of their home market, including U.S. municipals and emerging market debt. The longer the war rages and weighs on European growth, the increased likelihood we may see some divergence in central bank policies between Europe and the U.S. While COVID-19 and the pandemic seem to have disappeared from European minds, the boost from the re-opening should help sustain economic growth. Insurance companies continue to lead the efforts in terms of ESG and carbon transition portfolios, and the importance has become even clearer, with the crisis accelerating the need for alternative energy sources.

Asian insurers

Yield maximization remains a paramount objective for Asian insurers amid a rapidly growing and competitive insurance marketplace. U.S. dollar (USD) assets continue to present a yield advantage for Asian insurers, especially to back USD liabilities. Even when accounting for hedging costs back to local currencies, U.S. rates still provide a pick up relative to the opportunity set. We anticipate that a period of stability in interest rates should renew inflows back into U.S. markets.

Outside of direct investment strategy, we have noticed Asian insurance clients making internal strategy shifts to prepare for upcoming capital and accounting rule changes. This includes better matching of asset and liability cash flows to reduce accounting volatility and solvency risk capital, as well as economic risks. For example, we’ve seen use of the matching adjustment under Hong Kong and Singapore’s new capital regime. For non-matched portfolios, clients have reduced interest rate risks by outright reducing duration and allocating toward floating rate assets, while also giving their asset managers more leeway to actively manage duration. In preparation for the IFRS 9 accounting change, we’ve seen clients formulate firmwide plans to reclassify accounting treatments to reduce volatility, including solely payments of principal and interest (SPPI) tests for bond investments and consolidation of some bond funds to avoid mark-to-market treatment under the new regime.

While we believe the risk of adverse credit events is muted, we are acutely aware of the importance of credit risk management for Asian insurance clients. We remain grounded in the tenants of our investment process: rigorous, bottom-up security selection and stress testing as the market environment becomes more challenging.

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