Mid-Year Outlook: Sailing through Uncharted Waters

Macroeconomic Outlook

Sailing through Uncharted Waters

Paul Mielczarski »

Head of Global Macro Strategy

The macroeconomic backdrop is becoming increasingly favorable for G10 bond markets after a difficult start to the year. Hot U.S. inflation prints in the first quarter raised doubts about the Federal Reserve’s (Fed’s) ability to cut rates in 2024. However, more recent data shows a resumption of the disinflationary trend. Meanwhile, U.S. growth has slowed to a trend-like rate, and further weakness may be in store as the economy adjusts to high interest rates and reduced fiscal support. Overall, we expect slower nominal gross domestic product (GDP) growth across G10 economies. In turn, this slowdown will enable central banks to lower policy rates from restrictive levels, supporting bond market returns. However, while it feels as if the macroeconomic ship is now sailing smoothly toward something resembling normal, it is important to remember that this is all still uncharted waters. And farther out, the economy is headed toward perhaps even greater uncertainties. One uncertainty is the lack of any historical precedent for the current economic cycle and ongoing post-pandemic rebalancing. But another complicating factor for investors is the upcoming U.S. election, which has the potential to generate significant volatility across a wide range of asset markets.

Something Closer to Normal

During the past two years, we have already made significant progress in reducing inflation (see Exhibit 1). The upside surprises in U.S. inflation during the first quarter were concentrated in service sectors, in which the lags with economic activity are particularly long. In essence, high inflation in these sectors is the result of shocks from two to three years ago, rather than current economic conditions. Goods price inflation, which responds faster to current demand/supply imbalances, is already back to its pre-pandemic run rate. The unit labor cost growth rate is slowing, reflecting labor market rebalancing and faster productivity growth. Meanwhile, shelter inflation should continue to decelerate in the months ahead due to more benign market rent trends.

Growth Drivers Rebalancing

We expect some additional moderation in U.S. economic growth going forward as well as a rebalancing of its relative drivers. Government spending and service consumption have contributed disproportionately to GDP in recent years. We should see lower growth contributions from these sectors in the future. Monetary policy is restrictive and a headwind to economic growth. This tightness is reflected in very soft private sector credit growth, stress across commercial real estate markets, rising credit card delinquencies, and weak small business confidence surveys.

It appears that recession risks are relatively low at this point, particularly if the Fed cuts rates this year. However, we recognize that the current economic cycle is unique and without obvious historical comparisons. In light of this lack of past parallels, we remain openminded about recession risks and are closely monitoring economic data. It is possible that a large slowdown in service spending together with less fiscal support could potentially lead to a deeper retrenchment in labor demand and a higher unemployment rate. The labor market has shown very mixed signs recently, with strong headline employment growth contrasted by a rising unemployment rate, soft survey indicators of employment, and falling temporary help employment. It is noteworthy that the Fed expects the unemployment rate to finish the year at 4%. Since we are already at this level, any further softening in labor markets could trigger a more aggressive easing cycle.

Eurozone economic growth has improved in recent months as falling inflation boosted real consumer incomes and allowed the European Central Bank (ECB) to cut rates. However, the upcoming French elections have introduced a large element of political uncertainty going into the second half of 2024. In the event of a divided government, the broader economic impact on the eurozone is likely to be relatively short-lived. However, if the National Rally (RN) party wins an outright majority, that could lead to a sustained increase in sovereign risk premiums across the eurozone, undermining recent economic growth improvements.

With inflation moderating across developed market economies, central banks in the eurozone, Canada, Sweden, and Switzerland have already cut policy rates. The Fed is priced for 160 basis points (bps) of rate cuts over the next 3 years. If our inflation view is right—that is, inflation should continue to moderate as lagging service components catch up to goods price disinflation—the Fed should be able to deliver what is priced into the money market curve, starting with two 25bps cuts later this year. It is very unlikely that the Fed will need to hike rates again in this monetary cycle. But we could see a number of scenarios in which policy rates are cut more aggressively than what is priced in. In the event of a deeper slowdown in growth or a large sell-off in risky assets, bonds offer an attractive asymmetry and portfolio protection.

Electing a Cautious Approach

Recent elections in Mexico, South Africa, India, and the European Union caused large bouts of market volatility. And November could bring even bigger disruptions. The U.S. elections in November could have major implications for fiscal policy, trade policy, and international relations. For example, looking at the massive scope of potential trade implications, if all of Donald Trump's trade policy proposals are implemented, U.S. tariffs would reach their highest levels since the 1930s. Granted, it is hard to know how much is campaign rhetoric or what the timing of any proposed trade restrictions might be. However, even if half of the current proposals are implemented, 70 years of U.S. trade liberalization will be reversed. It is very difficult to estimate the impact of such a large policy shift on financial markets. So, while moderating inflation and growth may feel constructive now, in the second half of the year markets will shift their focus from the timing of the Fed's first cut to election polling. At some point, a more conservative approach to position sizing will be warranted because of the possibility of large market shocks in the fourth quarter.

Developed Markets Fixed Income Outlook

Year of the Coupon Continues

Jack P. McIntyre, CFA »

Portfolio Manager

Global bonds have mean-reverted to a more historically normal environment (see Exhibit 1). The quick take is that income in fixed income is back to being a driver of performance.

Keeping the story simple in an increasingly complicated world, developed market bonds offer both income and value. However, it is U.S. Treasuries that have our attention as we believe they will provide leadership going forward.

During the second half of 2024, the time will be right to move out of cash and to position farther out on the Treasury curve, in our view. Since the next move by the Federal Reserve (Fed) will be to cut rates, some of that over $6 trillion in money market funds will become a source of funding for U.S. Treasuries (see Exhibit 2). Those funds likely are not going into equities given stretched valuations. The “unknowns” are the timing of Fed rate cuts and their magnitude. For now, the Fed thinks it will take a nuanced approach and nudge rates lower, more so in 2025 than 2024. History shows this is not the norm. Typically, there is a “crisis” in which something is breaking, and that becomes the reason for the Fed to cut more aggressively.

We like the return potential of longer-dated U.S. Treasuries. In line with our call that 2024 will be another year of the coupon in fixed income, Treasuries pay an attractive coupon, and unlike cash, time is on your side. Additionally, longer-dated Treasuries have a “kicker” of potential price appreciation when the Fed is forced to cut more aggressively.

So, what will drive the Fed to act more forcefully? If it comes down to only one economic data point, initial/continuing jobless claims in the U.S. would be the series that warrants watching. Recent claims data point to an acceleration in labor market deterioration, which confirms the increase in the unemployment rate that has been unfolding for months. The Fed has emphasized the labor market’s importance, even more than inflation, and remains sensitive to shifts in the jobs data.

One way to think of longer maturity bonds, i.e., 10- to 30-year, is as a low-cost insurance policy on something going wrong with the economy. In two out of three scenarios—the Fed on hold or the Fed cutting rates—U.S. Treasuries will offer positive returns. The one scenario in which they will not work is the fat-tail event, meaning an event that is not expected and seen as highly unlikely, of a strong rebound in economic growth and a recovery in inflation. That is the scenario where the next move by the Fed is to hike rates, but it is not our base case. It also would be painful for bonds. Another risk that would be painful for the bond market would be a sweep by either party in the upcoming U.S. election. Depending on the party, a sweep likely means either more spending or more tax cuts, which would not be good for developed market bonds and U.S. Treasuries in particular.

In the U.S., there are two high-level factors we must monitor in analyzing our bullish Treasury bond thesis.

1. The first factor is the more straightforward one. We will be monitoring the overall economic backdrop for developments in growth and inflation dynamics as well as market environment factors. These are some of the more important ones:
• Demand for U.S. Treasuries: This dynamic has clearly shifted. Recent auctions of longer-maturity Treasuries have been met with stellar demand, marking a major shift in sentiment around the Treasury complex. It is not that supply is shrinking, but demand influenced by weaker economic fundamentals has a stronger influence than never-ending Treasury supply. Furthermore, there should be less competition from corporate bonds as supply is expected to slow in the second half of the year.
• Peak immigration in the U.S.: Immigration declines under both a Biden or Trump administration will have a labor impact and may detract from growth in a meaningful way.
• Falling inflation: Inflation continues to grind lower, evidenced by May CPI and PPI, and the sources of lower inflation are increasing (see Exhibit 3). The last major source of lower inflation will come from housing, which is a lagging indicator, but we will probably need weakness in the labor market as the catalyst. Lower oil and commodity prices also help, including by unwinding the frothy long positions from the speculative hedge fund community. Remember, inflation has come down sharply without a significant economic slowdown—yet. What happens if we get a slowdown? Inflation will melt lower. For now, the direction of inflation is more important than the level of inflation. Inflation expectations are still well anchored.

• Bifurcated economy: Lower income, non-asset owning consumers are feeling more stress relative to higher income, asset owners. The same is true in the corporate sector. Large companies versus small businesses exhibit the same bifurcation in performance in this economy. This divergence is not sustainable.
• Equity market warning signals: Underlying dynamics in the equity market are cautionary—a potential negative wealth impact. The underperformance of cyclical stocks could be a barometer for global economic growth. Be on the lookout for a divergence in stocks and bonds, which may signal a shift in the expected soft landing turning into a harder landing. Remember, on a number of levels bonds are undervalued relative to equities.
• Fiscal policy: Relative to 2023, the U.S. has likely reached the peak of fiscal accommodation. The U.S. federal government cannot stay on its current fiscal path without risking political instability. Interest costs will continue to crowd out necessary spending, e.g., defense.
2. The second factor is harder to quantity. It relates to election volatility and the “shades of gray influences” we could see in economic data and markets in the second half of 2024. Economic data might not give its normal signal to markets as it may be influenced by the election cycle. This certainly could be the case in the U.S., and it may have already started. The chart below highlights the rare instance when current conditions in the University of Michigan survey are below the expected consumer confidence reading (see Exhibit 4). Our take on this development is that this year’s election cycle, whether warranted or not, is already having an impact on the U.S. consumer and, by default, the corporate sector.

There have been enough election surprises globally so far that 2024 could be dubbed “The year of the election.” Market volatility has increased as a result, but elections like those in France and Mexico may be just a precursor of the potential election-induced volatility that is yet to unfold. As we head into the second half of the year, the “Granddaddy” of 2024 elections—the U.S. election—will capture the markets’ attention.

In the case of France, if political developments do not lead to a “Frexit,” a hypothetical withdrawal of France from the EU, we expect a reconvergence of normality in the OAT market. In Mexico, President-elect Claudia Sheinbaum has sent positive messages around continuing outgoing President Andrés Manuel López Obrador’s path of fiscal responsibility.

In the U.S., we expect election-induced market volatility to start earlier this year than typical. Our base case is that we get a divided government no matter who wins the White House. That would be the best-case scenario for markets. A divided government curtails new major spending programs and tax cuts. There is not a clear-cut hedge against election volatility other than taking smaller positions than normal to better withstand the price moves. Polls have not been accurate in the past elections, and there is no reason to expect this one will be different.

There are several other developments to monitor in the developed markets bond space in second half of 2024. However, one theme that will persist is that data will continue to be more important than central bank rhetoric.

Japan: The Bank of Japan (BOJ) needs a definitive plan to address inflation concerns, rather than a “plan to have a plan.” Markets hate the uncertainty. We would avoid Japanese government bonds as their natural buyer, the BOJ, is in retrench mode.

Eurozone: The eurozone cannot get out of its own way. Recent developments in France remind the markets it is not really a unified currency bloc but 20 individual countries, which in turn are a subset of the 27 that make up the EU. European bonds generally trade expensive to U.S. Treasuries. The bigger change in information in the second half will be relative to the slowdown in the U.S. economy and whether the Fed follows and then leads the European Central Bank (ECB) in rate cuts. If so, Treasuries should outperform their European counterparts.

UK: The UK might have moved into the lead of stable countries, on a relative basis. Gilts should outperform core eurozone bonds in the second half. Spreads versus German debt look attractive.

China: We still view China as a source of global deflation that is trying to export its way out of economic malaise. A structural issue of too much leverage and not enough growth to support it points toward further deflation.

I still believe the rest of 2024 will continue to be the year of the coupon. Developed market bonds have value because the coupon is now meaningful. One caveat, investors should expect to endure an uptick in volatility in the second half, as markets focus more on the political landscape than on the economic one.

Global Currencies Outlook

Lower Dollar Likely but Election a Risk

Anujeet Sareen, CFA »

Portfolio Manager

The first half of 2024 was marked by U.S. inflation persistence, driving U.S. interest rates higher in absolute and relative terms, which, in turn, supported broad dollar performance. Stepping back, in the big picture, most developed market currencies have been rangebound for the past 18 months, since the beginning of 2023. While U.S. economic growth outperformed throughout 2023, the U.S. dollar has been unable to move higher, limited by currency overvaluation and the greenback’s particular risk characteristics.

We remain of the view that U.S. ‘exceptionalism’ over the past few years was largely a function of fiscal ‘exceptionalism,’ i.e., the U.S. government spent more money to support its economy than any other major economy. From 2021 through 2023, the U.S. dollar benefited from a ‘tight money/easy fiscal’ combination. Although the overall U.S. fiscal deficit remains significant, it is the change in this deficit—the ‘fiscal impulse’—that matters most for economic growth. We anticipate the fiscal impulse will move from a significant source of support in 2023 to a mild drag on economic growth in 2024. Without fiscal support, the restrictiveness of U.S. monetary policy is likely to become more apparent as the year progresses. Notably, U.S. real gross domestic product (GDP) slowed to 2% in the first half of this year, nearly half the pace recorded in the second half of 2023. The lack of fiscal stimulus appears to be having a meaningful impact on the growth rate of overall output. Real GDP growth of 2% is not weak, but along with a further moderation of employment growth and inflation, we expect the slowing of nominal output in 2024 to prompt the Federal Reserve to ease monetary policy over the coming year. In turn, we expect this shift in policy will weaken the dollar.

Emerging market currencies generally performed well in 2023 and the first quarter of 2024, as their higher policy rates and stronger economic fundamentals attracted capital into their markets. However, in the second quarter, a number of these currencies experienced corrections, partly because valuations changed, interest rate spreads narrowed, and/or political risks rose. We reduced exposure to emerging market currencies in the first half of 2024. Going forward, we expect further upside in emerging market currency performance is likely limited to more select opportunities.

Lastly, the outcome of the U.S. election may impact currency performance. Current polling is too close to integrate a base scenario outcome, but in general, the key risk is a Republican sweep that allows Trump to pursue further anti-trade policies and/or pro-growth fiscal policies. While a true mercantilist framework ultimately requires a weaker dollar, the president has more direct control of tariffs than monetary policy. Hence, the risk is that protectionist policies initially serve to drive the dollar higher.

Emerging Markets Outlook

Forward Real Yields Point to Select Opportunities

Carol Lye »

Portfolio Manager & Senior Research Analyst

Michael Arno, CFA »

Portfolio Manager & Senior Research Analyst

U.S. inflation persistence early in the year resulted in higher U.S. rates, a stronger dollar, and volatility in Federal Reserve (Fed) pricing, which has weighed on local emerging market (EM) rates and currencies so far this year. The JP Morgan GBI-EM Diversified Index has been fairly correlated with markets’ pricing of Fed policy over the past year (see Exhibit 1). We saw a sharp rally starting at the end of October 2023 through the end of December 2023, with markets accelerating expectations of Fed rate cuts. However, following several higher-than-expected U.S. inflation prints, those expected cuts were quickly removed, weighing on the local EM asset class. Despite the recent improvement in Fed pricing, we have not seen an improvement in local EM performance, which could be related to apprehensions over U.S. growth, local fiscal concerns, and election outcomes.

In addition to Fed uncertainty, we have recently seen a deterioration in performance, particularly across Latin America. This quick deterioration in the performance of local markets in Latin America came on the back of questions around fiscal policy. For example, Colombia recently presented its medium-term fiscal framework, showing a worse-than-expected fiscal deficit for 2024 and 2025. There are concerns with fiscal policy in Brazil in addition to the future composition of the central bank toward the end of the year when President Luiz Inácio Lula da Silva, or Lula, appoints three new board members. With the recent election in Mexico, we will see how the government will adjust fiscal policy in 2025 from elevated levels in 2024. In addition to potential changes in fiscal policy, markets also had to digest the overwhelming victory by the ruling party, Morena. President-elect Claudia Sheinbaum won by over 30%, and her party achieved a qualified majority in the Chamber of Deputies and a close qualified majority in the Senate. This outcome gives outgoing President Andrés Manuel López Obrador, or AMLO, the chance to push through constitutional changes with the new Congress in September before Sheinbaum assumes office in October. Latin America continues to offer high nominal and real yields relative to history, but we must continue to pay close attention to fiscal policy and domestic politics.

Central and Eastern European countries (CEE) comprise one region with positive real policy rates above 2% (see Exhibit 2). Disinflation has been a major theme since last year, giving central banks the space to cut rates up through the first half of this year. Given the macroeconomic conditions for the rest of the year, CEE central banks, however, are likely to be more cautious in their rate-cutting cycle, preferring to reduce the pace of cuts. First, domestic demand has been picking up over the past quarters following still resilient wage growth and fiscal spending. Second, CEE as a region could benefit from a manufacturing rebound as core Europe recovers. Last, countries such as Hungary and Czech Republic, which have seen weaker currencies in the first half of the year, are now more cautious about imported inflation. This concern may lead to a slower central bank rate cut path for the rest to the year.

In contrast, Asian bond yields offer low carry and are less attractive compared to Latin America and CEE. This unattractiveness is driven partly by Chinese government bonds, which have been rallying in the wake of disinflation (see Exhibit 3). While Chinese policymakers have been supporting the beleaguered property market, and the latest policy rescue package involving the purchase of unsold inventories has been encouraging, consumer confidence remains weak. This weakness has been accompanied by continued deleveraging and downward price pressures. We believe China needs to do more to bring confidence back to the property market.

Nominal yields are no longer as extreme across EM local markets, compared to the highs of 2023 (see Exhibit 4). Furthermore, spreads relative to U.S. Treasuries are at the tighter end of their historical range. However, forward real yields remain quite elevated (see Exhibit 5), and we think there are attractive opportunities that still exist in select local EM.

Over the coming months, we will be watching the Consumer Price Index (CPI) and labor market data in the U.S. Can the Fed achieve a soft landing or not? We are seeing some deterioration in U.S. labor market data that will support further declines in wage pressure but could weigh on the growth outlook should unemployment accelerate higher. A recession in the U.S. would likely be a bad outcome for emerging markets. We have already seen a number of surprising election outcomes so far this year, with the U.S. election still ahead in the coming months. Polls currently show a tie between the two candidates; however, polls have not been a good barometer for actual election outcomes. We also will be monitoring developments in China, given the significant impact on the commodities complex and growth in other EM. In July, the Chinese government will hold its third plenum. This meeting typically coincides with some policy announcements, so we are waiting to see if any new policy updates follow.

Investment Grade Credit Outlook

Strong Fundamentals and Attractive Yields

Brian L. Kloss, JD, CPA »

Portfolio Manager

As investors, we tend to look back—and then forward—at performance at certain times on the calendar. Mid-year happens to be one of those times to assess where markets have been and to contemplate what path lies ahead for investors. Much of the return for investment grade credit can be explained by the impact of global treasury markets. Persistent strength of various global economies pushed the anticipated rate-cutting cycle further into the future, sending yields for many benchmark sovereign bonds higher while compressing credit spreads.

Notwithstanding a slight deterioration in price during the first half of the year, the macroeconomic environment remains supportive of risk assets, like corporate credit. Furthermore, we believe the individual fundamentals remain attractive for investment grade investors to bear certain risks in their portfolios. The starting point of today’s yield is at attractive levels. With rate cuts on the horizon, some investors may find shorter-duration investment grade credits a compelling alternative to cash and cash equivalents. Many issuers have reasonable leverage profiles, and their interest burdens generally remain manageable. These strong fundamentals should allow for any interested investors to take exposure. We would caveat this view with certain parameters given the world is still an uncertain place with geopolitical risks, many potentially disruptive global elections, and fiscal policies in some countries, like the U.S., that appear to remain unchecked.

Our focus would be on exposure in the front end of a capital structure of those credits that have what we would deem to be strong balance sheets. This positioning is based on a view that spreads will continue to compress, and the credit curve should steepen, supported by continued demand from investors looking past spreads to capture all-in yields that are at multi-year highs. We would also favor those that are lower in the rating spectrum, such as BBBs, as opposed to those that are higher rated given the latter are generally trading at spread levels that would appear to be tight at this point in time. Our bias continues to be focused on energy, commodities, and financials.

High Yield Credit Outlook

Positive Factors Outweigh Tight Spreads

Bill Zox, CFA »

Portfolio Manager

John McClain, CFA »

Portfolio Manager

Both the U.S. and global high yield markets continue to benefit from an attractive yield around 8%, low average dollar prices, strong fundamentals, and favorable supply-demand dynamics. The one metric that warrants caution, a spread over Treasuries that is near the tight end of the historic range, must be managed but is not, in our view, enough to offset the many positive factors. In the U.S. market, defaults have stabilized at well below average levels since late last year. Interest coverage has stabilized at well above average levels while leverage ratios remain modest (see Exhibit 1).

The management teams of high yield issuers have had over two years to prepare for higher interest rates and a possible recession. And, except for the 10-15% lowest credit quality issuers, they have had ample access to capital, not just in the high yield market but in loans, private credit, asset-backed securities, and public and private equity. High yield issuers with publicly traded equities potentially can access the convertible bond market at nearly the same low interest rates as in 2020 and 2021 if they are willing to give up some of the upside on their stock, which may well be at a high valuation given the current elevated state of equity markets.

Since 2022, most of the new issuance in high yield has been used for refinancing. We have not seen much of the risky bond structures or financing of bad businesses that precipitated major sell-offs in prior high yield cycles. In the U.S. market, a limited net new supply (see Exhibit 2) is generally being met with strong global demand for high yield bonds from allocators who understand these positive factors and the long history of compelling risk-adjusted returns that the asset class has delivered.

For the second half of the year, we expect the attractive yield and dollar price, strong fundamentals, and favorable supply-demand dynamics to continue to lead to reasonable returns in the U.S. and global high yield markets. Any spread widening may be the result of lower government bond yields rather than lower prices for high yield bonds.

Structured Credit Outlook

Three Musketeers of Carry, Convexity, and Volatility

Tracy Chen, CFA, CAIA »

Portfolio Manager

Supported by the “high for longer” interest rate environment, solid housing fundamentals, healthy household balance sheets, and benign credit fundamentals, high-yielding floating-rate sectors like credit risk transfers (CRT) and collateralized loan obligations (CLO) have outperformed most credit sectors year to date in 2024. Commercial mortgage-backed securities (CMBS) BBB tranches shone as well due to distressed valuations and more certainty in the Federal Reserve’s interest rate path (see Exhibit 1).

Looking forward to the second half of the year, we believe the underlying factors described above continue to hold. We see recession unlikely this year with peak interest rates looming. Credit spreads within the structured credit market generally still have room to tighten despite the rally so far. We see attractive opportunities in the following sectors, which we believe offer good relative value with high all-in yields (see Exhibit 2), backed by solid credit fundamentals and a favorable market technical. They are further supported by the tailwinds of good carry, positive convexity, and lower rate volatility.

1. High-yielding floaters, like CRT and CLO, provide good carry with high all-in yields. They also are a great hedge against rate volatility, in our view:
• Government-sponsored enterprises (GSE), like Fannie Mae and Freddie Mac, have been and will continue tendering outstanding CRT bonds with premiums above market prices. When investors need to reinvest those proceeds, it should create a favorable market technical. The lack of issuance of non-investment grade (IG) tranches and continuous rating upgrades also creates scarcity value for non-IG mezzanine tranches in the secondary market. Underlying performance should stay solid given the tight job market, significant home equity accumulation, and decent housing price appreciation.
• CLO BBB and BB mezzanine tranches provide good value with high all-in yield and still benign credit performance. The increasing creation of CLO exchange-traded funds (ETFs) boosts demand and liquidity for CLOs. The credit support of bonds with BBB or BB quality ratings should withstand moderate credit stresses. Spread levels on CLO remain elevated compared to corporate credit counterparts, providing room for convergence.
2. Agency mortgage-backed securities (MBS) offer attractive valuations, a great convexity profile, and potential bank and insurance buying in the future. Due to the lock-in effect, convexity on agency MBS should stay in positive territory, unprecedented in history. The spread of current coupon agency MBS relative to 7- to 10-year Treasuries is hovering above 140 basis points, representing one standard deviations of cheapness in its 10-year history. The spread between IG corporate and MBS option-adjusted spread (OAS) is at historical tights, indicating the latter is cheap. We believe the MBS spread to Treasuries should tighten due to declining interest rate volatility and improving demand from money managers, banks, and insurance companies. We prefer production coupon agency MBS as they offer the cheapest spread with moderate duration.
3. CMBS new issue versus the secondary market represents a tale of two worlds. The underwriting standards for the new issue market have tightened significantly, offering less exposure to the troubled office sector, lower leverage, and shorter duration. Spreads on BBB tranches have tightened significantly since the beginning of the year. On the other hand, a lot of bad news in the office sector is being gradually priced into secondary market deals, providing upside opportunities with the right credit selection. There are plenty of other property types that are doing well and provide value, too. GSE multi-family CRT is an example of a sector that we like.
4. Asset-backed securities (ABS) on the consumer side, such as subprime auto ABS with sufficient credit protection, are still attractive given the short duration and fast delevering structure (see Exhibit 3). On the corporate ABS side, we see interesting opportunities in whole business securitization, data center, and fiber ABS from established issuers. Several offer cheaper valuations, growing business prospects, great scalability of size, and solid duration opportunity with IG ratings.

Looking into the second half of the year, we see the following trends impacting fundamentals within the structured credit market.

Housing fundamentals still solid

Mortgage rates in the U.S. increased to the low-to-mid-7% range in the first half of 2024. Listings for both new home sales and existing home sales increased. However, supply remains relatively low with housing shortages supporting housing prices. We believe home price appreciation will stay in the low-to-mid single digits in 2024.

Healthy household balance sheets

Credit fundamentals are returning to pre-COVID levels as consumers spend their increased savings, built up from the generous stimulus packages and large wealth effects due to rising asset prices. Consumer wellbeing is a bifurcated story of net asset owners versus net debt borrowers. The former are mostly baby boomers who benefited from asset price inflation, higher interest income, and less debt. The latter, who are mostly younger or lower-income cohorts, are feeling the squeeze of higher consumer debt with higher rates. However, the job market is still decent and baby boomers still dominate the macro consumer story for now.

Commercial real estate market woes

The reckoning of the office sector will be a long, drawn-out process that may last multiple years. Market sentiment should gradually bottom with interest rates peaking. The wide CMBS spread pickup relative to corporate bonds provides spread compression potential. We believe the recent incident of a AAA-rated CMBS deal taking losses is not an isolated event. Consequently, we expect to see more capitulation and price discovery, which is a part of the bottoming process.

Higher CLO tail risks

The recent high-profile Altice credit rating downgrade highlighted the increasing tail risks in the leveraged loan space. However, the CLO market has been resilient due to robust deal structures and other factors. In addition, the floating rate nature of CLO assets should continue to provide hedges against duration risks.

Favorable market technical

Reduced net new issuance and still-high demand across many sectors are buoying the market technical.

Summary

Generous carry, positive convexity, and lower rate volatility along with good value relative to corporate credit sectors are tailwinds for structured credit markets. We believe high yield floaters, like CRT and CLO BBB/BBs, production coupon agency MBS, and certain pockets of CMBS and ABS, offer great value in in the second half of 2024.

Global Equities Outlook

Opportunities and Catalysts across the Global Investment Landscape

James J. Clarke »

Portfolio Manager & Director of Fundamental Research

Sorin Roibu, CFA »

Portfolio Manager & Research Analyst

In our relentless pursuit of investment opportunities across the global canvas, several compelling themes have captured our attention.

1. The premium valuation of U.S. stocks compared to other markets worldwide is strikingly apparent (see Exhibit 1).

   

2. A global monetary easing cycle has commenced, led by emerging markets (see Exhibit 2). Latin America has already begun cutting interest rates, while Canada and Europe have recently followed suit. We expect others to follow shortly, with the U.S. now likely to lag. These regions offer catalyst-rich environments poised to benefit from a reversal in central bank policy. Latin American commercial real estate and UK housing are two sectors that appear highly attractive to us as clear beneficiaries of falling interest rates.

   
3. The U.S. tech and internet sector continues to dominate the global benchmark, though some of the largest players are experiencing setbacks this year. We have owned some of these names before when valuations were favorable, but currently our macroeconomic research, coupled with a value-oriented mindset, suggests that there are far more compelling opportunities worldwide than simply investing in what everyone else already owns.
4. Occasionally, we identify industry catalysts with global implications. Our current favorite example is the global shortage of commercial aircraft resulting from Boeing's five years of production issues. Owners of this increasingly scarce asset, whether they are airlines in any region of the world or the largest aircraft lessors, trade at single-digit price-to-earnings (P/E) ratios. Basic supply and demand economics suggests that pricing is likely to be quite favorable moving forward.

As global investors, we have access to the broadest possible equity opportunity set, enabling us to achieve significant diversification while targeting catalysts, whether they are macro or industry-specific. An effectively executed global strategy should always have multiple ways to win, in our view. Given the many geopolitical uncertainties and risks in the second half of the year, including a U.S. election with the potential to generate excessive volatility in financial markets, our broad mandate gives us the flexibility to potentially sidestep certain obstacles while capitalizing on opportunities created by diverging global monetary policy and economic cycles.

U.S. Equities Outlook

Value Will Have Its Day

Patrick S. Kaser, CFA »

Managing Director & Portfolio Manager

Celia R. Hoopes, CFA »

Portfolio Manager & Research Analyst

For most of the first half, the U.S. economy has been surprisingly strong. Meanwhile, inflation has been more stubborn, staying above 3%, than markets seemed to expect. As a result, expectations for Federal Reserve rate cuts have come down dramatically. Up to this point, the Fundamental Equity team has been in the “higher for longer” camp on both inflation and interest rates. However, as of mid-year, our view is starting to evolve as signs of economic slowing finally may be picking up with initial unemployment claims up 20% from levels early in the year. While this development does not necessarily signal an imminent recession quite yet, we believe the pendulum may start to swing back toward the market expecting more short-term rate cuts. As we have emphasized repeatedly, historical indicators suggest an inevitable recession, even if the timing has been tricky.

One mystery has been that the broad market indexes, driven by the large weights of the “Magnificent Seven”—or Three or Four, depending on the day—have largely shrugged off most concerns as AI-driven excitement spreads to other parts of the technology chain. We still see risks to market valuations and have leaned into a relatively defensive exposure compared to our history. The current scenario is not quite the never-happening Waiting for Godot, and we are sticking to our value framework despite the challenges the style has experienced. We believe that between a slowing economy, an uncertain election backdrop, and the challenge in maintaining tech hype forever, value will have its day.