Morgan Stanley IM: The More Things Change, the More they Stay the Same

Here you can find the complete article.

In fact they reached their year high on March 31 with the 10-year U.S. Treasury yield closing the quarter out at 1.75%, up 34 basis points (bps) on the month. However, outside of Canada, whose government bond yields are closely linked to their U.S. brethren, somewhat remarkably not much happened in other developed markets. Indeed, yields fell across Europe as the region saw an uptick in coronavirus cases with a potential for additional lockdowns, coupled with the slower than expected rollout of vaccines. U.S. exceptionalism once again.

Credit markets were somewhat bifurcated with investment grade spreads essentially unchanged on the month while U.S. high yield spreads compressed although yields rose on the back of Treasuries. Emerging market external debt also outperformed as yields did not rise as fast as U.S. Treasury yields did. The real outlier for March was emerging market local debt. Disappointment with rate hikes in Russia, abrupt central bank leadership changes in Turkey, a worsening pandemic in Brazil and India -- along with rising U.S. Treasury yields-- undermined local markets. While Polish government bond yields only rose 1 bp, Turkish yields rose over 400 bps!

What really changed in March was market expectations of Fed policy. The Fed has said over and over it has no intention of raising rates until there is overwhelming objective evidence (not forecasts) that the economy is fully recovered, on a sustainable, acceptable growth trajectory with an “inclusive” drop in the unemployment rate back to pre-pandemic levels. On their reckoning, this means the Fed was unlikely to raise rates until late 2023/early 2024, with tapering of QE happening sometime before. The market disagrees. It views the Fed as being too optimistic about how low inflation will stay and under appreciating how fast labor markets will normalize. Therefore, based on those assumptions, it has brought forward the first hike and accelerated the path of hikes to get to a terminal rate of around 2.5% much faster than previously. By bringing forward and accelerating the forecasted path of short rates, longer term yields repriced higher. Is this reasonable?

On one hand, this is perfectly reasonable. Real yields are still negative, albeit less so; growth is fantastically strong; jobs are being created at almost a one million per month pace; and financial conditions (e.g., credit spreads, equity market, etc.) remain historically easy. And, to top it off, what is the likely risk distribution of rate hikes versus rate cuts? The probability of additional easing by the Fed is essentially zero, and while the Fed is unlikely to raise rates this year or even next, the writing is on the wall. The market wants a risk premium in case the Fed acts sooner than it currently says it will.

On the other hand, the Fed has been steadfast in its commitment to FAIT (flexible average inflation target). Comments by the Chairman and other members of the Board of Governors have reiterated this over and over again. The Fed has emphasized their outcome based approach which implies they think growth will not be strong enough, inflation high enough and unemployment low enough by end 2022 to start raising rates. Who is right? Unfortunately, no one knows. We do know that the market does have a tendency to over predict changes to monetary policy rates. And there is a reasonable risk premium in the yield curve when there was none at the beginning of the year.

What does this mean? Betting on higher yields is going to be less remunerative going forward unless there is a material upturn in inflation. But, yields are still likely to go higher medium term on the back of exceptionally strong growth and policy support. Interest rate/duration risk will continue to be a headwind for bond market performance. Stronger growth is good for corporate bottom lines and likely their balance sheets as well. We remain positioned to benefit from credit-sensitive assets outperforming government bonds and continue to believe duration will be a headwind (though less so than year to date) to performance over the remainder of 2021.

Display 1: Asset Performance Year-to-Date

^{Note: USD-based performance. Source: Bloomberg. Data as of March 31, 2021. The indexes are provided for illustrative purposes only and are not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See below for index definitions.}

Display 2: Currency Monthly Changes Versus U.S. Dollar

^{Note: Positive change means appreciation of the currency against the USD. Source: Bloomberg. Data as of March 31, 2021.}

Display 3: Major Monthly Changes in 10-Year Yields and Spreads

^{Source: Bloomberg, JPMorgan. Data as of March 31, 2021.}

Fixed Income Outlook

“It’s all about the economy,” is what we said last month. It is. But it is also about the pandemic and the U.S. seems to be winning the vaccination race, although the rise in new variants is slowing the pace of gains. Therein this month’s title, “The More Things Change, the More They Stay the Same.” The vaccination numbers are far better than anyone may have anticipated, but, given market pricing and expectations, the strategy implications essentially remain unchanged.

U.S. nominal and real yields rose swiftly and uncomfortably in March. But markets survived. Volatility rose, undermining risky assets, rocking the equity boat a bit, but markets survived, if not thrived as high yield external emerging market spreads compressed. With the U.S. economy performing stronger than expected (economic surprise indexes continue to show data surpassing forecasts), it is logical for riskier, more cyclical, less interest rate sensitive assets to outperform. We do not view what has happened to U.S. rates as a “tantrum” but more a mark-to-market to reality: better than expected growth all around. Indeed, it is really only the U.S., Canada and emerging markets which suffered big yield increases in March. All of these were based on objective, reasonable interpretations of events.

It must be emphasized that this is primarily a U.S. phenomenon. Yields in most developed markets have not risen as much as in the U.S.. And in many countries, yields fell in March. Just because data and events in many countries outside of North America have not been conducive to higher yields, does not mean it will not happen over Q2/Q3 as vaccines roll out faster and lockdowns end. Of course, the absence of yield or income in most countries does create a more asymmetric risk profile, meaning these markets are not necessarily less risky than U.S. Treasuries where a risk premium exists. Being underweight interest rate risk in Europe and/or Japan is in many ways less risky than in the U.S.

With the market now pricing in earlier and faster rate hikes in the U.S., do we have too much of a good thing? Is policy too easy necessitating an earlier than expected end of zero rates?Central banks say no. Markets say yes, at least in terms of when it expects the Fed to raise rates. Basically the market believes the Fed will relent and tighten policy sooner than they are saying. But, according to the Fed and the ECB (and most other central banks), economies are far from achieving the inflation/labor market/growth targets necessary to tighten policy. Only more data will resolve this debate and, given the Fed’s desire to see a “string” of strong data, it might be a while before there is more clarity on who is winning. That said, given the data and information flow, we would not be surprised to see the market price in faster rate hikes.

Thus, given the continuation of strongly pro-cyclical policies in 2021 and beyond, high savings rates, mass vaccinations, the synchronized nature of the global business cycle and the relatively low level of nominal and real yields, we believe fixed income asset allocation should continue to be oriented towards cyclical assets and away from high quality/high interest rate sensitive bonds. That said, there are levels at which government bonds are a buy. It’s just that we do not know where that is, yet. As always, it is conditional on the state of the economy and the central bank’s view as to its appropriateness. However, discrimination remains key given valuation levels. Both IG and HY spreads are near their historical lows. A lot of good news has been discounted but with no real “bad” news on the horizon, adding extra yield (carry) and protecting against higher yields is the right strategy.

This means we continue to hold lower than average credit quality; overweight external emerging markets and look to own a reasonable level of risk premium where it seems appropriate. However, we remain wary of “land mines” as the outperformance, of for example, CCC rate corporate bonds have significantly outpaced BB rated bonds. On the other hand, fallen angels still look to have upside in a fast growing economy. An idiosyncratic, bottom-up strategy seems appropriate given market pricing.

Developed Market (DM) Rate/Foreign Currency (FX)

Monthly Review

During March, government bond yields were bifurcated across the developed markets, with yields climbing higher in the U.S. as vaccines were rolled out faster than expected and economic data continued to improve. Conversely, yields fell marginally over the month in the Eurozone as the region saw an uptick in coronavirus cases with a potential for additional lockdowns, coupled with the slower than expected rollout of vaccines and a dovish ECB.

Outlook

Recent data and information flow continue to imply 2021 economic growth will be very strong. Falling infection rates, vaccine rollouts, strong efficacy results, massive U.S. fiscal stimulus, high savings rates, economic re-openings and dovish central banks are buttressing a very positive outlook for economies. With the $1.9 trillion support/stimulus package being implemented, U.S. fiscal policy is on a trajectory to significantly improve 2021/2022 growth globally, not just in the U.S.

While we do not expect a dramatic sell-off in government bond markets, we think the risk is skewed to yields rising, as valuations are still rich relative to history and there is potential for additional term premia to be priced in across the yield curve. Central banks in general have not expressed significant concern about the rise in yields, presumably because it has not yet led to an unwarranted tightening of financial conditions. We expect significantly higher inflation in 2021, but for it to be transitory, and for central banks not to respond to it.

Emerging Market (EM) Rate/FX

Monthly Review

EM debt posted negative returns in March across the board, i.e., in both local and hard currency bonds. From a sector perspective, companies in the Consumer, Infrastructure, Real Estate and Financial segments led the market, while those in the Transport, Oil & Gas, and Metals & Mining sectors underperformed.

Outlook

Despite a challenging year for EM debt so far, we still hold a constructive view on the asset class for the rest of 2021. A global backdrop of steady monetary policy accommodation, further progress on vaccine rollouts in the developed world (and increasingly, in parts of EM), and expectations of looser fiscal policy in the U.S. should be supportive for the emerging market asset class. Potential disappointments of optimistic expectations about Biden policies vis-à-vis growth and trade could negatively impact the performance of growth-sensitive assets. Finally, reemergence of geopolitical risks (as evidenced by recent escalation in U.S.-Russia and U.S.-China tensions) could also disrupt our relatively benign outlook for EM.

Credit

Monthly Review

Credit spreads finished the month a touch wider in both Euro and U.S. IG. Higher U.S. yields reflected the increased concerns that inflation was a risk and not “transitory” as communicated by central banks. March also saw increased cases of coronavirus in Europe causing a third wave of lockdowns impacting the timing of the expected economic rebound.

Market Outlook

We see credit being supported by expectations of an economic rebound in 2021 as well as continued positive support from monetary and fiscal policy as rates stay accommodative and QE strong. We expect continued strength with a potential price overshoot in the first half of the year, with a correction in the second half as M&A increases, questions are asked over the level of QE in 2022, and as fear of missing out buying activity turns to fear of owning valuations that look historically expensive.

Securitized Products

Monthly Review

After a weak performance in February, agency mortgage-backed securities (MBS) bounced back in March. U.S. Non-agency RMBS spreads were essentially unchanged in March, although new Non-agency RMBS securitizations increased and was met with healthy demand. U.S. ABS, U.S. CMBS, and European RMBS spreads were also largely unchanged. CMBS issuance remained slow in March, unlike most securitized sectors.

Outlook

We continue to have a positive outlook on residential and consumer credit sectors and a more cautious view on CMBS. We have moved to a negative stance on agency MBS, due to tighter valuations and concerns that the Fed may begin to taper its agency MBS purchases in the coming months. U.S. non-agency RMBS still offer reasonably attractive relative value. U.S. ABS continues to have mixed outlook for 2021, with traditional consumer ABS (credit cards and auto loans) looking relatively expensive while the more COVID challenged ABS sectors continue to offer much greater recovery potential. CMBS valuations have also increased over the past few months, but this sector remains very idiosyncratic, with some attractive value opportunities and some potential credit problems as well. European markets are experiencing similar sector-specific performance dynamics.

Risk Considerations

Diversification neither assures a profit nor guarantees against loss in a declining market.

There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in a portfolio. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Certain U.S. government securities purchased by the strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. High-yield securities (junk bonds) are lower-rated securities that may have a higher degree of credit and liquidity risk. Sovereign debt securities are subject to default risk. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default, and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. The currency market is highly volatile. Prices in these markets are influenced by, among other things, changing supply and demand for a particular currency; trade; fiscal, money and domestic or foreign exchange control programs and policies; and changes in domestic and foreign interest rates. Investments in foreign markets entail special risks such as currency, political, economic and market risks. The risks of investing in emerging market countries are greater than the risks generally associated with foreign investments. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, and correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). Due to the possibility that prepayments will alter the cash flows on collateralized mortgage obligations (CMOs), it is not possible to determine in advance their final maturity date or average life. In addition, if the collateral securing the CMOs or any third-party guarantees are insufficient to make payments, the portfolio could sustain a loss.