Fixed Income Monthly - March 2023

The FIXED INCOME MONTHLY provides a forward-looking summary of the medium-term views from the Fidelity Fixed Income team. Our investment approach is multi-strategy, with portfolio managers given clear accountability and fiduciary responsibility for all investment decisions in a portfolio. Given this portfolio manager discretion, there may at times be differences between strategies applied within a fund and the views shared below. We believe in managing portfolios with a mix of active investment strategies, including top-down and bottom-up, such that no single strategy dominates risk in a fund.

Outlook

The Fed raised interest rates by 25 basis points last month, bringing the Fed funds rate to a range between 4.50% and 4.75%. The decision to switch to smaller hikes would allow policymakers to calibrate more closely with the incoming data, according to the minutes from the most recent Federal Open Market Committee (FOMC) meeting. Participants noted that until inflation is clearly on a path to 2%, interest rates would need to move higher and remain elevated and that upside risks to the inflation outlook continue to play a significant role in determining the monetary policy outlook. The next FOMC meeting is scheduled for 21-22 March.

In recent weeks, markets have priced in additional rate hikes and priced out rate cuts for the rest of the year because of sticky consumer inflation and strong labour market data. A sign that price pressures are still pervasive in the US economy is the personal consumption expenditures (PCE) price index, which was up 0.6% in January, after gaining 0.2% in December. US CPI was up to 6.4% y/y in January, well below the most recent peak of 9.1% in June but still significantly higher than the Bank’s 2% inflation target.

Fed implied rate path - market is pricing in further hikes

The U.S. economy is increasingly experiencing a shift in inflationary pressures from goods to services. The decline in goods inflation has been largely offset by rising price pressures in the services sector, especially from rent inflation. The latter will likely to remain above pre-pandemic levels so long as the labour market remains tight, amid job gains and wage growth. At the start of 2023, hiring in the US surged. The US Department of Labor reported that non-farm payrolls increased by 517,000 in January after being seasonally adjusted.

Meanwhile, the ECB has already stated that it will increase interest rates by an additional 50 basis points at its meeting on 16 March. New data indicates that persistent cost pressures are continuing unabated, raising expectations of further rate hikes in the upcoming months. Eurozone inflation stood at 8.5% y/y in February, with a big fall in energy costs offset a price surge in nearly all other areas, but still above market expectations. Though significantly lower than the most recent peak of 10.6% in October, inflation is still higher than the ECB's target rate of 2%. Investors are also pausing for thought because of hotter-than-expected inflation numbers from France, Germany and Spain.

ECB implied rate path - further hikes amid hot inflation

It may take some time before the headline inflation rate reaches the ECB's 2% target, amid the persistence of price growth and its upward trend. The services sector, which accounts for the largest share of core inflation, posted an acceleration in price growth to 4.8% from 4.4%, which is extremely concerning given that the sector is particularly susceptible to wage growth. All signs point to a tight jobs market that could drive nominal wage growth to above 5% this year, despite unemployment holding steady at 6.7% last month, just above a record low.

Finally, the Bank of England raised interest rates by 50bps to 4% in February. The next rate decision is on 23 March. At a closed-doors event organised by public relations firm Brunswick Group, Governor Andrew Bailey said, "Some further increase in Bank Rate may turn out to be appropriate, but nothing is decided. The incoming data will add to the overall picture of the economy and the outlook for inflation, and that will inform our policy decisions.”

Outlook

The month started with global central banks hiking rates, setting the tone for a more-familiar, risk-off February. Real yields climbed closer to recent highs, with US 10-year real yields reaching 1.5%, up 28 bps during the month. Similar trends were noted in the inflation-linked Gilt market, with 10-year real yields climbing out of negative territory by 15 bps to 0.2%, despite indications of easing monetary policy from the Bank of England at the beginning of February. German inflation-linked bonds bucked the trend, with 10-year Bund yields flat m/m.

We continue to see value in both US and UK real yields from here and retain small, long real duration positions in both regions, though have remained active in this positioning during the month. We took profit from our long UK real yield positioning at the beginning of the month, as US payrolls and China lending data caused real yields to change course. However, this long positioning was readded following the back up in real Gilt yields during the month. We simultaneously removed our small, long in European real duration at the beginning of the month, again due to stronger than expected data prints.

Ten-year breakevens rose in all regions during February on the back of stronger than expected economic data. US 10-year breakevens increased 9 bps m/m to 2.4% and the UK posted a similar small increase of 5bps m/m to 3.6%. Europe saw a much larger increase of 22 bps m/m, bringing 10-year inflation expectations to 2.5%. We continue to operate small, long positions in both 10-year US and UK breakevens, in addition to a cross market long US, short European 30-year breakeven trade.

US headline CPI rose 0.5% m/m in January, reaching 6.4% y/y. The shelter basket component was the largest contributor to this increase, accounting for almost half of the overall m/m increase. Subsequently, core inflation rose 0.4% m/m in January, reaching 5.6% y/y. Core US CPI is now at its lowest level since December 2021, driven by goods deflation, particularly in second-hand cars. Though the shelter component of the basket is likely to continue to drive core inflation, decelerating in goods price increases should help to offset these rises. 

US core inflation continued its decline in January

European headline flash HICP estimates for February came in stronger than consensus, prompting a fresh sell off in nominal yields as ECB terminal rate expectations were revised. Headline inflation came in at 8.5% y/y in February, with consensus estimating a rise of 8.3% y/y. Stronger than expected services inflation drove the surprise, at 4.8% y/y verses 4.4% y/y in January.

Regionally, French headline CPI estimates came in at 6.2% y/y, higher than consensus of 6.1% y/y and January’s 6.0% y/y. The increase was driven by a strong services component, as well as increases in food. Energy inflation continued to decline significantly. Similarly, Spanish flash headline CPI estimates were higher than consensus of 5.7% y/y, coming in at 6.1% y/y. The upside surprise was again driven by sticky core inflation, which reached an all-time high of 7.7% y/y. German flash CPI estimates also surprised to the upside, with headline inflation reaching 8.7% y/y, verses a consensus of 8.5%. It was due to increasing core inflation offsetting declines in energy inflation.

European CPI estimates surprised to the upside

In the UK, both headline and core inflation surprised to the downside in January, coming in at 10.1% y/y (consensus: 10.3% y/y) and 5.8% y/y (consensus: 6.2% y/y). The decrease in core and services inflation was primarily due to a fall in air fares and hospitality costs, compounded by an increase in basket weight of these components. These declines were partially offset by rises in alcoholic beverages and tobacco. 

Currently, the energy price cap in the UK is set at £2,500. It is scheduled to rise to £3,000 in April before falling again in July to approximately £2,600. Given the recent announcement of a UK fiscal surplus, there is a possibility that the April cap increase could be cancelled, which is not priced into forward RPI expectations for 2023.

In Japan, the governments energy price subsidies are set to cool inflation. Headline CPI came in at 4.3% y/y in January, well below that of other G10 nations but at historic highs for the country.

Outlook

IG corporates returned -2.3% in February, retracing most of January’s strong rally in credit and rate markets. Global corporate spreads ended the month roughly unchanged, highlighting the dominance of rates volatility in the total return picture. Though corporate spreads remained resilient, financials were more volatile, with some names ending the month 30-50 bps wider than their tightest levels. US corporate spreads are now unchanged on the year, with a small outperformance from the consumer discretionary and materials sectors and a small underperformance from larger telecoms capital structures. So far this year, Euro and Sterling credit spreads have outperformed their US counterparts, erasing some of last year’s underperformance. 

YTD total returns for global IG corporates now stand at 0.8%, with 0.6% of this return due to income, demonstrating the support that higher corporate bond yields now provide. There was still a large amount of issuance, though among these issues the spreads were predominantly flat or wider than launch pricing spreads across all sectors. While January posted record supply from emerging market issuers, February posted very little despite strong performance in prior weeks. We remain constructive on global IG from here. Corporate spreads in most regions are well-priced for a macroeconomic slowdown, and recent rises in yields have left government bonds looking attractively valued, which should provide support to total returns in months to come should yields come down from current highs.

Higher bond yields are providing support to YTD returns

US IG corporates returned -2.9% in February, with spreads widening by 5bps. There was a monthly record issuance of $150bn, surpassing February 2021’s numbers. Amgen dominated the supply picture for the month, making it the single largest issuer in the healthcare sector and the sixth largest global corporate issuer overall, behind Apple, Oracle, Verizon, AT&T and Comcast. While financials supply is still high, it remains well flagged and may eventually undershoot expectations. On the other hand, the equity market rebound means there could be more M&A activity, such as the recent $30bn Pfizer acquisition, resulting in further supply in the pharma and healthcare space. 

There is limited intra-sector dispersion across US IG corporate sectors today, which would typically pick up as growth slows. Bottom-up investors will be the beneficiary of an increase in dispersion if it should happen. We retain our neutral outlook on US IG, as its valuations remain less attractive on a spread-basis to those in the UK and Europe. However, US IG credit remains a safe haven for global investors.

There is only significant dispersion in two US IG corporate sectors at present: leisure and autos

European IG corporates returned -1.4% in February, with spreads tightening by 4bps. Europe continues to outperform other regions, regaining some of its underperformance in 2022. Higher beta BBB credit spreads continued to outperform higher quality credit spreads. On a sector basis, the real estate sector continued its outperformance, tightening by 27bps in February as real estate markets continued to operate with low vacancy rates and no over-supply. 

Following the recent increase in government bond yields, we are moving to a very positive outlook in European IG. Our view remains that the European economy will struggle with rates at or above 3% for a sustained period, which should provide a tailwind to the asset class. European credit spreads still stand out as relatively attractive on both a regional and historic basis, and we continue to believe that European IG corporates are fundamentally strong enough to weather a higher rate environment.

Sterling IG corporates returned -2.5% in February, with spreads widening by 3bps. The sterling market is back to ‘business as usual’ following the LDI crisis late last year, as well as following global trends, rather than being at the epicentre of global volatility. We are moving to a neutral outlook in Sterling IG, as although risk markets remain attractive on a yield basis, valuations are less attractive on a spread basis than they have been in recent months.

Asia IG corporate spreads tightened a further 9bps in February, with the asset class returning -1.4% in total. The macroeconomic backdrop remains supportive in China, with covid cases having peaked, easing monetary policy from the People’s Bank of China (PBOC) and increasing fiscal support. Though PMI data remains weak, it looks on track to recover some ground in the coming months. Whilst there are macroeconomic tailwinds, the valuation picture is less attractive. Asia IG spreads ended the month at 141 bps, just ~20bps from lows reached in the last few years. On balance, we retain our neutral outlook on Asia IG.

Outlook

Global high yield bonds returned -1.2% in February in local currency terms, with spreads tightening by 6bps. Risky assets posted a strong start to the year, as prospects of an early to mid-2023 recession in the US and European economies were dismissed, whilst China’s reopening remained on track. However, stubbornly tight labour markets and recent CPI data indicated that inflation is not falling rapidly. Elevated costs of capital are likely to negatively affect firms’ investment and hiring plans in the quarters to come. Margins are expected to be squeezed and earnings forecasts will likely move lower. In terms of sectors, energy should fare well if economic growth stagnates. The key focus remains on healthy coupons, as well as on choosing idiosyncratic exposures carefully. However, we maintain a positive stance on the overall asset class as returns appear better than equities from current levels.

Turning to regional markets, US high yield bonds returned -1.3% in local currency terms and spreads tightened by 8bps over the month. Headline index yields are now just above 8.4%, less generous than a month ago, with equally less appealing spread cushions. US high yield balance sheets and debt coverage metrics are in good condition at the aggregate level, with leverage at cyclical lows and robust interest coverage metrics (see below). However, these will be eroded as EBITDA weakens and higher refinancing costs come into the picture. Lack of issuance from both BB rated bonds and leveraged buyouts has boosted covenant scores, given the typical lack of strong protection. Dispersion within the rating buckets remains elevated across the broader market, with compression in the BB bucket lagging. We maintain a neutral stance as risk and rewards are skewed to the downside, considering of a recessionary environment, but also acknowledge the attractive yield profile of the asset class. 

US HY Interest coverage ratio

European high yield bonds returned -0.2% in euro hedged terms, and spreads tightened by 23bps over the month amid the recent volatility. Despite the relative gloom, we have been able to build a good cushion to shield us from excessive drawdowns with resilient fundamentals. The technical picture looks supportive as supply remains weak, with expectations of a thin pipeline in the first quarter. The maturity wall still looks benign as most issuers are not eager to come to the market. We continue to prefer lower rated bonds with healthy coupons. So far this year, high-risk segments within the market have been outperforming, with the CCCs rated bucket delivering ~7% total return on a year-to-date basis (see below). The key focus is still on credit selection and tactical timing opportunities. In terms of valuation, expect a low default rate environment for the time being. The recession in Europe was well publicised last year and today’s uncertainty around the possibility of a recession this year is being deemed a positive surprise. Thus, we maintain a positive stance on European high yield bonds amid a healthy combination of fundamentals, technicals and valuations.

European HY CCCs total returns on YTD basis

Asian high yield bonds returned -2.5% in February, in local currency terms, while spreads widened by 50bps in response to the US Treasury yield curve movement. We moved back to a positive stance from an overweight position as spreads have come in quite aggressively. However, the asset class is still supported by an attractive convexity profile, while corporate fundamentals among most issuers in the space remain benign and investor sentiment towards the universe is improving gradually. As such, yields are still above average, coupled with decent coupons. Technicals are supportive, fundamentals look resilient, and the valuation picture is still strong. The return of credit differentiation and the avoidance of idiosyncratic events continues to be the source of alpha. 

Outlook

Emerging market debt underperformed during February with all three sub-asset classes posting negative returns. Hard currency corporates (-1.6%) outperformed hard currency sovereigns (-2.2%) and local currency bonds (-3.2%). A rise in US treasury yields weighed on hard currency bond returns, off the back of stronger-than-expected US economic data, which caused an upward shift in terminal rate expectations and volatility in rates, alongside rising geopolitical risks. Local currency bonds also weighed lower on negative FX returns and rising local yields.

For EM external debt, we remain overweight for now. Along with upward revisions to US growth forecasts, global growth targets for Q2/Q3 were also boosted by the performance of European economies due to falling natural gas prices and a Chinese economy now running at full tilt and being fiscally stimulated. However, these upward growth revisions are yet to trickle through to EM economies. With commodity prices remaining robust, we think there could be upside growth and fiscal surprises for some EM economies, where refinancing is not a pressing issue (for the BBs and better). It should provide some support to growth sensitive parts of EMD credit if the global economy remains buoyant. However, we are still wary of names, especially in the EM HY credit universe, who still do not have access to primary debt markets and could be at a higher risk of default. 

We have been reducing our weighting in distressed names and holding our portfolio overweights in the BBB/BB rating buckets in CEE and Latin America. The valuation bounce in all of EM regardless of ratings category may not continue further and the distressed credits which rallied in January are now getting differentiated. We are looking at selling names that have tightened credit spreads at levels posted back in early 2022 or even mid-2021 and using the new issue market to add IG exposure. 

Upward growth in developed nations, but not yet in EM

We have a neutral outlook on EM FX. Many EM currencies now offer quite attractive nominal yields following the behaviour of central banks over the last 18 months, which have hiked interest rates to help control elevated inflation expectations. At the same time however, recent US data has surprised to the upside, prompting a shift higher in US nominal yields, bringing near term strength in the US dollar. 

The market’s positioning skew in EM FX has also shifted considerably from very underweight three months ago to much more neutral now. Similarly, valuations are not as compelling as they were late last year. The EM currency universe has also benefitted over the last three months from improving expectations of Chinese and European economic growth this year. However, at this juncture most of the good news on this theme has now been priced in. Thus, our focus is to stay as nimble as possible, with a focus on relative value opportunities, whilst continuing to reduce frontier FX exposure where possible. 

Most EM currencies weakened vs US dollar in February

On EM rates, we maintain a curve flattening bias in our EM local duration exposure - avoiding front-end rates in many countries makes sense from a tactical perspective. In our opinion, a policy shift among EM central banks towards monetary easing may come later this year. However, given recent hawkish Fed rhetoric it is probably unlikely to materialise in the very near-term. While we have rotated some of the exposure out of places where there have been large rallies, we still retain an overweight duration position in aggregate. The potential for a combination of falling growth prompting central banks to cut interest rates and inflation dropping quickly, combined with high real rates compared to central bank targets creates a supportive backdrop for this sub-asset class over the coming months.