Inflation battle continues, but no recession this year
As the Fed starts raising rates to fight inflation and the uncertainty of war continues, investors wonder how to position fixed income portfolios. In an environment of measured hikes with continued economic growth, we think spread sectors should continue providing competitive returns on a relative basis. We continue to favor credit sectors, especially senior loans, preferreds and high yield corporates.
- The higher yields of credit sectors may help offset the negative price effects of rising rates.
- Given the positive near-term growth outlook, we continue to favor spread sectors and credit risk in asset allocation.
- Rising rates should benefit floating-rate investments, like senior loans, and shorter-duration markets like high yield credit and some emerging markets.
The Fed starts hiking
The U.S. Federal Reserve delivered its first 25 basis point (bps) rate hike since December 2018. Rates continued to rise across the yield curve, with the 10-year U.S. Treasury yield increasing by 0.8%. While rates marched upward throughout the quarter, the sharpest moves occurred following the 16 March hike.
The rise in inflation and the war in Ukraine, along with the resulting energy price shock, make policy decisions less certain from here. The Fed must gauge the economic impact of sharply higher energy prices – without knowing how long they will last – as it calibrates the proper path forward for interest rate hikes.
The market continues to predict a steady series of rate hikes this year. However, geopolitical concerns certainly cloud the outlooks for both growth and inflation. We expect the 10-year Treasury yield to end the year between 2.50% and 2.75%.
All bond sectors experienced negative returns
Because the price of bonds mathematically declines as interest rates rise, the sharp increase in Treasury yields negatively impacted all sectors. The shortest duration senior loans and asset-backed securities fared best, and U.S. TIPS benefited from increasing inflation. Emerging markets debt suffered most due to its longer duration profile and exposure to some of the regions hardest hit by the war.
Inflation outlook is less certain, but no stagflation
Certain factors previously driving inflation have moderated, like used car prices, but the labor market continues to tighten and oil prices are soaring. Just how high inflation goes depends on the war’s resolution and how quickly inflation fades over the summer. We believe year-over-year inflation is peaking now, near 9%, and will moderate over the coming months and quarters.
However, the Russia/Ukraine conflict makes the growth outlook less certain. Three main channels of contagion have emerged:
- Higher oil prices act as a tax and will reduce consumer spending. However, energy costs account for less wallet share than during the 1970s crisis.
- Geopolitical uncertainty weighs on business investment, which is more nebulous.
- Financial stress, including as a result of sanctions.
Overall, we anticipate European economic growth to decline two percentage points and U.S. GDP to fall one percentage point as a result, though these estimates remain highly uncertain. Healthy growth is still expected this year, rather than the stagflation of the 1970s. We do not expect geopolitical events to derail the underlying dynamics. But the Fed will carefully monitor both inflation and growth data and balance the two in its policy decisions.
Higher income credit sectors should best weather the storm
The higher yields of credit sectors may help offset the negative price effects of rising rates. While corporate earnings may grow less than we previously expected, defaults will likely remain low.
For these reasons, we continue to emphasize credit sectors across our portfolios. We especially like leveraged loans, which benefit from their floating rates in a rising rate environment, and preferreds, which have weakened more than warranted so far this year.
As an active manager, we leverage our deep research capabilities to find bonds we feel offer the best relative value, adjust duration and yield curve positioning and emphasize sectors with less sensitivity to rising rates. Investors may consider these types of portfolios:
To help preserve principal:
Short-term bond funds. The lower duration profile reduces the impact of rate changes on portfolio returns while still benefiting from a wide array of sectors. These funds typically combine higher-quality, short-duration sectors – like U.S Treasuries, asset-backed securities and mortgage-backed securities – with smaller amounts of higher-yielding sectors, such as high yield corporates and emerging markets debt.
Senior loan funds. Floating-rate coupons can increase as rates rise, adding income and total return. We think single-B corporate credits across both high yield bonds and senior loans represent a sweet spot for the risk/reward trade-off, as they appear attractively valued with decent yields and are less exposed to higher rates than other areas of the market.
To provide income and return potential:
Multisector bond funds. The additional yield potential can help offset price declines due to rising rates. These funds augment a base of diversified higher-quality sectors with larger allocations (typically up to 50%) to below-investment-grade securities. They offer higher yield potential than core plus, in return for greater potential volatility.
Core plus bond funds. The ability to actively adjust allocations to lower-quality segments may increase yield while balancing overall risk. These funds combine a larger portion of higher-quality sectors – like U.S. Treasuries, mortgage-backed securities and investment grade corporates – with smaller (typically up to 30%) allocations to lower-quality sectors, such as high yield corporates, senior loans and emerging markets debt.
Preferred securities. These portfolios may offer compelling yields from issuers with strong balance sheets. A large portion of the universe has non-fixed-rate coupons that increase periodically as rates rise, reducing their sensitivity to rate changes. In addition, the bank and insurance industries that make up much of the preferred universe may benefit from periods of rising rates.
Expect continued economic expansion
We expect further robust growth in the U.S. and global economy this year. Although the geopolitical shock from the Russia/Ukraine conflict has sent oil prices higher, we still anticipate above-trend growth in the U.S. Europe will likely face a tougher near-term outlook, but expansion should continue. Supply chain issues have begun easing somewhat, though overall disruption remains high. We continue to expect inflation to moderate later in 2022, but from a higher peak than previously expected. We forecast headline inflation of around 4% at year-end.
On the Fed front, we now expect two 50 bps rate hikes, one each at its May and June meetings, followed by another four 25 bps hikes over the remainder of the year. The European Central Bank is likely to hike rates later this year as well, but by a smaller amount and from a much lower base. Policymakers in China will likely pivot further toward economic support later this year.
Given the positive near-term growth outlook, we continue to favor spread sectors and credit risk in asset allocation. We still see potential upside to long-end yields, with the 10-year Treasury yield ending 2022 between 2.50% and 2.75%. Higher rates should benefit floating-rate products like loans, as well as shorter-duration markets like high yield credit and some emerging markets.
Inflation: U.S. Bureau of Labor Statistics Consumer Price Index for All Consumers. Employment: Bloomberg, L.P., Bureau of Labor Statistics, Nuveen. Global debt and yields: Bloomberg L.P
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Investing involves risk; principal loss is possible. Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, derivatives risk, dollar roll transaction risk, and income risk. As interest rates rise, bond prices fall. Foreign investments involve additional risks, including currency fluctuation, political and economic instability, lack of liquidity, and differing legal and accounting standards. These risks are magnified in emerging markets. Preferred securities are subordinate to bonds and other debt instruments in a company’s capital structure and therefore are subject to greater credit risk. Certain types of preferred, hybrid or debt securities with special loss absorption provisions, such as contingent capital securities (CoCos), may be or become so subordinated that they present risks equivalent to, or in some cases even greater than, the same company’s common stock. Asset-backed and mortgage-backed securities are subject to additional risks such as prepayment risk, liquidity risk, default risk and adverse economic developments. Non-investment-grade and unrated bonds with long maturities and durations carry heightened credit risk, liquidity risk, and potential for default.
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