If a recession were to occur sooner and prove severe, the timing of rate cuts would accelerate, but given the stickiness of US core inflation at present, our premise is that a recession would need to be evident for the Fed to pivot. While leading growth indicators such as PMIs have declined along with manufacturing, services have been stronger than anticipated. Services have propelled both growth and inflation, especially in the US, and led growth in the large core blocks — in the Eurozone and the US, and in the early stages of China’s reopening — surprising to the upside relative to our expectations. We expect the downside risks to increase as the year progresses and our base case continues to be for a recession in the US given the lagged effects of tighter monetary policy. Central banks continue to prefer to react to data, increasing the likelihood of a policy mistake.
It is noteworthy that many small and midsize companies in the US, the backbone of the US economy, are serviced by regional banks. If these banks curtail lending, this will impact services growth and potentially shift the employment paradigm.
Investment implications
As our base case is for a US-centric recession, if not a global recession, we will need to see how Europe and China fare in the next several months. Given that we have seen peak inflation in the US and some deceleration in the markets based on core inflation numbers, we are now likely to have left the “taper tantrum” regime we lived in for much of last year. In the next six to 12 months, we expect to be in a “Goldilocks,” or risk-off, regime.
Both regimes would advocate adding duration. We are starting to look for opportunities to do so in our global multisector fixed income strategies. Not all duration is created equal, and in general what we have been looking to do is to start by neutralizing our position in the US. We have been looking for opportunities in rate-sensitive markets like Canada, Sweden and some of the local emerging markets such as Mexico. At this point, we prefer local EM bonds issued by some of the Latin economies, which have been ahead of the curve with regards to the tightening cycle and what is priced into the market.
On the FX side, we are neutral the US dollar. Over the last several months, we have been adding euro and yen to offset an underweight position in the dollar; and looking for EM FX elsewhere to add FX risk. We are looking for pair trades based on a fundamental approach to valuations.
Regarding securitized and structured debt, mortgages are now more attractive considering the spread widening, though they are not as interesting as they were in the fourth quarter of 2022. We remain focused on idiosyncratic opportunities and dislocations within some of the CMBS parts of the portfolio. We are adding ABS securities that are not consumer-driven and have proper asset backing in the form of equipment collateral. In general, we remain relatively neutral in ABS and continue to be underweight traditional mortgages.
In credit, we have been adding exposure to investment-grade credit with a bias to markets that have become more dislocated. In EM, while we are still overweight EM hard currency, this overweight has been reduced; we have been selling some of our EM investment-grade bonds and finding value in other parts of the investment grade or corporate market versus emerging markets. In high yield, we are not seeing many defaults priced in as we mentioned earlier, and spreads have come in. Many investors are looking at the front end of the HY yield curve to provide additional spread and yields. In our case, while we still have exposure to HY bonds, it is driven by a bottom-up process based on our research platform. We are not necessarily looking to add high-yield risk at these spread levels.
Conclusion
While storm clouds continue to hover over the markets, this is an interesting time for investors in fixed income. We have not seen yields at these levels in years, nor this level of inflation in years either. We continue to favor an active approach and diversification in fixed income considering the many uncertainties. A research platform able to identify idiosyncratic opportunities amid the turbulence, along with a longer investment time horizon, is key in our view.
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The views expressed are those of the author(s) and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice. No forecasts can be guaranteed.