by Adam Smears, Russell Investments
In this latest survey, 59 leading bond and currency managers considered valuations, expectations and outlooks for the coming months.
- This survey was conducted at the beginning of June, before the most recent Federal Reserve (Fed) hike, which surprised the market by coming in at 75 basis points (bps). While participants on average expected more rate hikes than market pricing at the time of the survey, they underestimated the market reaction to higher-than-expected inflation data.
- Investors see further Fed rate rises, but believe they will start moderating in size after September. This comes as U.S. inflation expectations remain firmly above the Fed’s traditional 2.0% target rate. Additionally, the majority of investors expect a rate hike lift-off by the European Central Bank (ECB) during the third quarter this year.
- Investors continue to see some risks to credit markets, with views that fundamentals will deteriorate and spreads will generally widen somewhat. There is some improvement from the last survey, likely reflecting the weakness in corporate credit since the beginning of the year. That being said, more investors see default rates not rising significantly.
- Survey participants opined that the British pound will be the worst performing currency within the G10 (Group of Ten) currencies, followed by the Japanese yen. Investors were very optimistic about the U.S. dollar and the Australian dollar. In developing currencies, the Turkish lira and Russian rouble were the least-liked currencies. Broadly emerging market managers were positive on their currencies relative to the dollar.
- There is uncertainty around when a U.S. recession could occur, however, investors are more concerned about the effects of stagflation overall. Related concerns are inflation globally and its effects on growth, as well as the pace of interest rate increases.
The hawks won’t turn back now
Views from interest rate managers
- On the back of stubbornly high core and non-core inflation in the U.S., survey participants updated their inflation expectations for the next 12 months. Now, more than two-thirds of investors expect inflation to stand between 3.0% and 4.5%. None of the participants expect inflation to fall below 2.0%.
- At the time of the survey close on June 8, market pricing expected the Fed to raise rates to 2.2% by the end of the year. Over 75% of our survey participants expected rates to be between 2.5% and 3.0%, thus expecting the Fed to hike more aggressively. Managers were directionally correct but underestimated the impact of the latest inflation data. The Fed has subsequently increased the magnitude of interest rate hikes from 50 bps to 75 bps. Bond yields have reacted to this by pricing interest rates to reach 3.5% by the end of the year, higher than even the bearish estimates of managers.
- Before the Fed surprised markets with a 75-bps-hike at the last meeting, almost half of investors saw the Fed moderating its 50-bps-rate-hike pace at the meeting in September. After this meeting, 44% of investors expect the central bank to only conduct two 25-bps rate hikes in 2023. In the end, the majority of investors expect the U.S. funds rate to stand between 2.75% and 3.00%.
- In regard to yields, half of the respondents expect the U.S. 10-year Treasury yield to trade no lower than 3.0%. Moreover, 75% of respondents believe that the 10-year Treasury will peak at a level between 3.0% and 3.5%.
- Meanwhile, most investors (53%) expect the supply-demand balance of U.S. Treasuries to become less favorable due to the Fed’s tapering. They do not expect an increase in U.S. Treasuries to further destabilize the U.S. Treasuries supply-demand balance. Notwithstanding, 57% of managers expected fiscal stimulus to continue supporting the economic recovery, and partially offsetting negative impacts from restrictive monetary policies.
- There is considerable disagreement about when a putative recession starts. 31% of investors expect it to start next year, while 27% and 28% expect it to start in either 2024 or later, respectively. It is important to mention that participants’ main concern (58%) is stagflation.
- Regarding Europe, the majority of investors expect the European Central Bank (ECB) to raise rates at a pace of 25 bps, three consecutive times, this year (starting in Q3). 38% expect the ECB to increase rates in the second half of the year to total on an aggregate rise of 50 bps. As a result, 63% believe that the 10-year German Bund spot rate will stand above 1.26% in 12 months.
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Views from IG credit managers: Sentiment changing
- Are managers still concerned about valuations? Yes. 39% of respondents are expecting a moderate widening in spreads in the next 12 months, although this is down from 54% in the previous survey. Meanwhile, the share of managers that expect a moderate tightening increased from zero in the beginning of the year to 21%.
- Interestingly, despite a better view on valuations, the share of managers with a more negative short-term view increased to 17%.
- Meanwhile, participants believe that the deleveraging trend that was observed in 2021 has ended, as the majority of respondents affirmed that they expect the leverage of U.S. BBB-rated companies to increase. Moreover, the share of managers that consider caution around fundamentals is warranted, almost doubling to 40%. This is surpassing the share of managers that considered that spreads compensated, to some degree, the deterioration in fundamentals.
- The main concern among global investment grade (IG) credit investors is higher interest rates. This is followed by recession risk in Europe and geopolitical risks (Ukraine-Russia). Interestingly, concerns regarding ESG factors took more of a backseat.
Global leveraged credit
- Survey participants are concerned about the global leveraged credit space, with the majority of participants expecting at least a moderate widening in spreads. Over 52% expect spreads to widen moderately, although only 5% expect spreads to widen significantly from here.
- Within this market segment, more investors (37%) favor the multi credit sector, while the share of investors that favored U.S. high yield bonds decreased to 21%.
- Investors significantly increased their return expectation (from above 6%), from zero to 35%. This comes mainly at the expense of a decrease in expectations of returns lower than 4%.
- Managers, on balance, think corporate fundamentals will remain the same (50%), but a sizeable minority (40%) believe there will be at least a moderate deterioration.
- This deterioration in corporate fundamentals has been accompanied by a modest increase in concern about default rates. In our last survey, 85% of investors believed defaults would remain below 3%. This number has fallen to 70%.
- Confidence in fallen angels remains considerably positive, as 37% of the survey respondents classified them as rising stars, while 63% classified them as potentially attractive opportunities.
- Investors’ attention remains focused on inflation (35% of respondents) and its impact on global economic growth (40%). Consequently, concerns regarding elevated geopolitical risks and COVID-19 remain relatively subdued.
Risk across the globe
Emerging markets (EM)
- Managers remain constructive in regard to the performance of EM currencies, with almost 55% expecting a positive performance of EM currencies in the next 12 months and 80% expecting this over the next three years.
- 62% of respondents, down from the previous 70%, indicated that they favor local currency emerging market debt (LC EMD) over hard currency emerging market debt (HC EMD) for the next 12 months.
- Within LC EMD, managers expect total return for the GBI-EM GD index to be at 4.6% over the next 12 months, after reaching a low of 3.3% in the third quarter of 2021 and a recovery to 3.3% in the first quarter of 2022. However, current total return expectations remain considerably below the 5.6% registered one year ago.
- On a regional basis, most investors continue favoring Latin America (72%). The Turkish lira and the Russian rouble remain out of love.
- Within the hard currency emerging market debt (HC EMD) space, 57% of managers expect spreads in the HC EMD index to tighten in the next 12 months vs. 38% in the previous survey. Meanwhile, 11% of managers expect spreads to widen.
- Managers again expressed their preference for Argentina, Indonesia and Egypt (as the countries with the highest expected return over the next 12 months). China, the Philippines and Turkey remain the top underweight countries.
Developed market currencies
- The majority of survey participants expect the U.S. dollar to trade on the upper side of parity, between 1.01EUR/USD and 1.05EUR/USD. However, they consider this to be a floor, whilst they expect the top to stand at 1.15EUR/USD.
- 43% of investors expect the British pound to post the worst performance among G10 currencies, with no respondents considering it a top performer. Meanwhile, investors are positive about the U.S. dollar and Australian dollar, with the Japanese yen being the second-least favored currency.
- There are less conservative views in the securitized segment: 35% of managers expressed they will be adding risks in the return-oriented securitized portfolios in the next 12 months. The same number of managers indicated that they will maintain current positions, while 29% announced that they will decrease exposure to risk.
- When asked about taking a meaningful beta position, 47% of managers expressed already having a short bias in their portfolios, up from the 9% in our first-quarter survey. On the other hand, only 20% already have a long position, down from the 73% registered in the previous survey.
- Meanwhile, the number of investors indicating that they expect non-agency spreads to tighten increased from 14% in January 2022 to 30% in June. The percentage of managers that indicated that they expect spreads to remain range-bound decreased from 43% to 24% and the number of managers that indicated that they expect spreads to widen increased from 43% to 47%.
- Managers expressed balanced views regarding concerns/risks for the CLO market, with 47% mentioning broad risk-off sentiment as main risk, followed by underlying loan collateral credit deterioration.
While inflation has been on the market’s mind this year, the latest data and subsequent 75 bps hike in interest rates clearly took managers by surprise.
Directionally, our managers had expected more rate hikes than the market, but not to the magnitude seen. This survey indicates that concerns on inflation have been driving policy to be tighter, but this was only leading to expectations of a moderate deterioration in credit fundamentals.
The key question outstanding is whether managers, following the surprise hike and selloff in interest rates, will increase their concerns around economic growth and its impact on the various credit sectors. Will the weakness we have seen in corporate bonds in the weeks after the survey closed cause investors to see value or will the change cause greater concerns around corporate profitability and fundamentals?
This survey, more than ever, showed how quickly markets are moving and how sensitive they are are to any major event. We are only halfway through the year, so let’s strap in for an interesting ride.
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