From the ashes emerge compelling opportunities

2022 was a year most investors would be glad to forget. Fixed income had some of the worst returns on record and aside from a handful of commodities, most asset classes posted firmly negative returns (Figure 1), despite some recovery in the fourth quarter. Sky-high inflation, hawkish central banks, China’s lockdown and the war in Ukraine stirred up a poisonous cocktail for financial assets.

Figure 1: Performance of global financial assets in Q4’2022 and full-year 2022

Source: Bloomberg, Deutsche Bank. Past performance is not a guide to future results.

Tailwinds for fixed income, headwinds for risk taking

So where should investors turn next? Will investors delight in the kind of return to soaring assets markets that characterized the post-Global Financial Crisis (GFC) era? While some of the headwinds are definitely fading, as we may have survived the worst of inflation and while most investors expect central banks to moderate their hawkishness, we believe this will be a year when the market pivots from concerns about inflation to concerns about growth. In our view this means much more favorable returns, particularly for higher quality fixed income assets like Treasuries and mortgages. We also anticipate more significant downside risk in cyclical sectors and riskier assets such as investment grade corporate debt, high yield corporates and equities. We have built considerable liquidity in portfolios to take advantage of what we believe will be continued volatility, cheaper valuations within spread sectors and attractive opportunities this year.

Global financial assets in aggregate fared worse than during the GFC

While fixed income returns were mostly negative, the asset class enjoyed good company. Elon Musk earned a remarkable distinction when he became the first person to lose $200 billion dollars in a matter of weeks. Even more staggering is the $2 trillion loss in the crypto market. As we look closer at the performance of fixed income markets in 2022, the still unpalatable negative absolute returns linger for investors. The -15.76% return of the US investment grade corporate bond market marked the worst year by a very wide margin (the next worst year posted a return of -5.85% in 1974), dating back to the index inception in 1973.

Yet there is an upside to a year like 2022 as it means that given the prevailing elevated yield levels, fixed income offers the best absolute and relative return opportunities that we have witnessed in a number of years. Treasuries, in particular, which suffered the most significant repricing are now offering yields near the highest level in two decades. Despite attractive all-in yields in the corporate sector, spreads over Treasuries remain around the 10-year median. Given our expectation for continued volatility in riskier assets, we foresee an abundance of opportunities to generate alpha for value-driven managers as the year unfolds and as a result, are more conservatively positioned within corporates. Current yields for high quality assets offer more opportunities with compelling positive real yields for the first time since the GFC and even 3-month T-bills offer 4.6% yields as of January 17th. The positive 3.63% total return of the US investment grade corporate sector in Q4 is just a small taste of what the markets have to offer for those with the patience to ride out the volatility.

Monetary policy – Less restrictive but still a headwind

At the forefront of every investor’s mind is the Federal Reserve (Fed) and its battle to tame inflation. It is hard to know whether the markets are correctly reading the obscure tea leaves auguring the Fed’s future course. Perhaps there is some skepticism on the heels of the Fed’s pivot from the “inflation is transitory” mantra of 2021 to the most aggressive hiking cycle since the 1980s. This massive tug of war between the markets and the Fed is playing out in a variety of ways. Fed funds futures contracts (Figure 2, left side) persist stubbornly below 5% throughout 2023 despite the messaging from a number of Fed governors who are sticking to their bulletin du jour by indicating that rates will remain higher for longer.

Figure 2: Implied number of rate hikes/cuts and implied Fed funds futures rate (left side) / Fed dot plot – projections for the Fed funds rate as of December 14, 2022 FOMC meeting (right side)

Source: Left chart: Bloomberg as of January 18, 2023. Right chart: Federalreserve.gov as of December 14, 2022 FOMC meeting. Forecast may not be realized.

St. Louis Fed President Jim Bullard went so far as to map out where the Fed funds rates should land based on the Taylor rule, a rule that establishes a link between what the Fed funds rate needs to be compared to inflation and economic growth. According to Bullard, that range is anywhere from 5% to 7%, well above the current 4.5% target Fed funds rate. Support for this view across the Federal Open Market Committee (FOMC) is apparent in the consensus of the Fed’s19 policymakers as noted in the December dot plot (Figure 2 above, right side) or summary of the FOMC’s outlook for the Fed funds rate; 17 out of 19 participants said they expect the rate to reach 5.125% or more at the end of 2023.

Macroeconomic backdrop

There are a plethora of data points to support either camp, the Fed versus the markets, in their battle. We will not cover every data point here but we will highlight a few that our team tracks closely. The first anomaly is unemployment. We have all read the headlines regarding big job cuts across the tech space, yet The Job Openings and Labor Turnover Survey (JOLTS) continues to show well over 10 million unfilled positions. How can this be? The Wall Street Journal published a timely article titled “Get Ready for the Richcession” that touched on this very topic. As we dig a little deeper into the employment numbers, we find that those most impacted by the recent cut in jobs are in the higher paying six-figure range at large corporations. At Mark Zuckerberg’s Meta Platform the median salary for 2021 was $295,785 and $232,626 at Twitter. Both are companies that announced layoffs in the thousands. To put this in context, if every software developer in the US became redundant, the unemployment rate would only increase by 0.1%.

The unfilled positions we either read about in the press or see firsthand in “Help Wanted” signs when we walk along main street America are for small businesses, which account for 78% of the total openings. There are currently 3 million more job openings in the small business sector than prior to the pandemic. In the leisure and hospitality sector alone there have been 980,000 fewer jobs filled since the start of the pandemic. This is one of the driving forces behind the escalation in wages that we are seeing in the services component of core CPI (Figure 3) or the Fed’s favorite inflation metric the core PCE.

Figure 3: US CPI yoy – Top line contributions and core CPI (%)

Source: Bureau of Labor Statistics as of January 12, 2023.

Some may argue that housing, which is embedded in the services segment of CPI, is a significant factor in that higher component of the inflation metrics. That may be true today, however, there is a material lag of about 12 months before inflation metrics reflect housing data. Household prices peaked in June of 2022; therefore we expect to see a decline in the housing data to impact the CPI data by mid-year. If we look at the services component without housing, we see the effect that wages are having on services, with the core PCE number hovering around 4%.

Given stickier wage inflation, demonstrated by the service component of the CPI data, the Fed’s aggressive “higher for longer” stance may have more merit than what those Fed fund futures contracts are pricing in for 2023. This begs the question: how does the Fed tackle this portion of inflation if supply chain bottlenecks are resolving and housing is trending downward? While inflation remains a concern, its elevated levels are likely to fall during the year as the Fed slows the pace of rate hikes. Then the market could shift its focus from inflation to growth.

Another big debate among investors is the trajectory of the economy. Are we headed to a soft landing or hard drop? Can the Fed descend smoothly as Captain Sully famously did on the Hudson? The Bloomberg weighted average forecast among 71 economists calls for growth to amount to 0.4% for calendar year 2023, which we interpret optimistically. We are in uncharted waters in terms of the size of the stimulus leaving the global economy. The Fed’s balance sheet more than doubled to $8.9 trillion versus pre-pandemic levels. Expectations are for the Fed to reduce its balance sheet by roughly $79 billion per month, well short of the $95 billion cap, leaving it at a still lofty $7.6 trillion. Despite the likelihood that the Fed may slow and likely stop hiking rates this year, the growth impact from previous tightening may not recede.

While some indicators such as the yield curve suggest a recession, other metrics, such as credit spreads, are forecasting far more benign territory. The inverted yield curve, as defined by the 2-10-year Treasury slope (Figure 4) indicates a recession is pricing into the markets with an average gap between inversion and recession of about 19 months. The curve first inverted in early April, then again in early July and has remained inverted in the interim.

Another curve that the Fed prefers is the spread between the yield on 3-month Treasury bills and the expected yield on those bills in 18 months' time (referred to as the near-term forward spread), which recently inverted in November and remains inverted today. These prominent signs of tight Fed policy are a strong signal that the markets are anticipating a slower economy - the depth of which is up for debate. Credit assets, on the other hand, are not pricing in a recession as a simple regression of high yield spreads indicates that valuations are extrapolating a growth rate of around 2% in 2023. We believe this to be far too optimistic.

Figure 4: Inverted curves, spread between the 2-10-year Treasury yields and the near-term forward spread

Source: Bloomberg as of January 11, 2023. Economic indicators and related historical trends may not be accurate measures of market activity and should not be relied upon to predict future results.

In our view, the market will grapple with three headwinds this year: 1) the Fed continuing its quantitative tightening program, 2) the economy continuing to slow, and 3) funding costs for companies that are considerably higher today than they were 12 months ago that will pressure earnings. Given this context, the resilience of US corporate bond spreads last year was notable. Of the -15.76% return in calendar year 2022 only -1.25% was due to widening credit spreads with the rise in Treasury yields contributing 92% of the total negative returns. This seismic shift in 10-year Treasuries created the worst annual returns for the asset class since 1788. While we believe Treasury yields will move lower throughout 2023, we believe corporate spreads are likely to come under pressure.

Portfolio positioning – Ample liquidity to the rescue

We are positioned conservatively across the platform, allocated to high quality sectors and issuers that we believe should do well in both a soft or hard landing scenario. We possess a history of capitalizing on market dislocations and have been building liquidity across all of our strategies over the last several months. US investment grade corporate spreads have tightened from 165 bps in October to 130 bps at year-end (Figure 5, left side). These levels are around their median from both shorter and longer term perspectives, which is why we trimmed some of our corporate credit risk during the fourth quarter. We were not receiving adequate compensation for risk given our view that the full force of the Fed’s actions have yet to affect the broader economy. We are not advocating for investors to run for the hills, which is why we still maintain some risk in the portfolios. While spreads are close to the 10-year median level, yields are not. From an absolute yield perspective, US investment grade corporate bonds still offer some of the most attractive yields we have seen over the last 10 years at 5.42% as of December 31, 2022 (Figure 5, right side). This is especially attractive when compared to the S&P 500’s dividend yield.

Figure 5: US investment grade corporate spreads (bps) and yields over the last decade

Source: Bloomberg as of December 31, 2022. Current market trends may not continue or lead to favorable investment opportunities.

US investment grade corporate spreads are more attractive than they were a year ago but they are not close to recessionary levels. As a result, investors will be well served to focus on the least risky pocket of the corporate market. Short maturity investment grade bonds in particular now offer yields north of 5%. With credit curves flat, there is little need to buy longer maturity corporates with high degrees of spread sensitivity, especially given that it is likely that credit spreads will widen as the US economic outlook deteriorates. Short-dated bonds will, however, survive such moves, given their low sensitivity to price changes and the high degree of income they generate.

As we face the impending economic slowdown, keep in mind that the US corporate bond market is coming from a position of incredible strength. We have seen stable debt levels coupled with growing revenue and EBITDA growth. Leverage is down to 2.9x from the peak of 3.4x in 3Q 2020. More importantly, the ability to manage the debt in terms of interest coverage is up 1.8x year over year at 12.8x, well above pre-Covid levels of 9.8x. As we move into 2023 and the Fed’s goal of reducing employment to stall wage inflation materializes we should have a better sense of the resiliency of corporate balance sheets.

The high yield corporate sector is also benefiting from some of the fundamental strengths inherent in the investment grade space. Spreads between BB-rated and BBB-rated bonds have compressed to a short and longer term median of 105 bps, which is well below the 2022 high of 216 bps (Figure 6). Defaults in high yield are extraordinarily low at 2.7%, with the view that they will increase to 5.7% in 2023. We are beginning to see the wave in historic upgrades abate. Expectations are for $75 billion of rising stars (high yields bonds that are upgraded to investment grade) in 2023 but this estimate is subject to the severity of the expected recession. If in fact we are moving towards a slower economic environment, our more judicious approach to allocating to high yield bonds will leave us with more flexibility to add risk to this segment of the market where possible.

Figure 6: Spread between BB-rated and BBB-rated corporate bonds

Source: Bloomberg as of January 11, 2023. Current market trends may not continue or lead to favorable investment opportunities.

Our exposure to high quality municipals, both taxable and tax-exempt, is deliberate as we view them as a sector that is not only attractively priced relative to corporate bonds but one that will also perform well in a hard landing environment. Our long duration mandates are invested in long tenor top tier university taxable municipal bonds. Historically we have seen spreads for these institutions remain rather strong during periods of serious corporate bond spread widening.

For our tax-sensitive strategies we have taken a similar stance and have had plenty of opportunities to buy long, deeply discounted AAA-rated school general obligation bonds at tax-exempt yields well above 4%. We believe high quality tax-exempt municipals are a quasi-Treasury security that tends to follow the movements of the Treasury market with a lag. We have said before and we will say it again, the retail market’s fear of rising rates primarily drives municipal relative valuations. In a recessionary scenario with rates moving lower, high quality tax-exempt municipals should perform well. More importantly, we are profiting handsomely while we wait.

Agency mortgage-backed securities (MBS) comprise a sector where we see value and a sector to which we have been adding back exposure since mid-2022. This sector was a conspicuous underperformer during 2022, maimed by the Fed drawing down its holdings and significant interest rate volatility. We believe both the technical and valuation backdrop now suggests much more favorable returns in the coming months. The Fed still owns $2.6 trillion of agency MBS, the vast majority of which is low coupons. As we get more granular in the sector, the lower the coupon, the worse the excess returns were. Lower coupon MBS bonds have fully extended and there is now no incentive for those borrowers to refinance, which has led to less sensitivity to rates volatility, as reflected by the lower option-adjusted spread (OAS). Key considerations for our portfolios that do not contain agency MBS in their benchmark are the Fed’s monstrous portfolio of low coupon bonds and how the Fed intends to wind down these positions. Current production coupons, on the other hand, are sensitive to rate volatility as reflected in the higher OAS. However, there are some dynamics that are likely to reduce their sensitivity to rates. The decline in home prices is likely to lead to a diminished ability to refinance should rates fall. One critical impact that agency MBS is sure to have is it sets a floor on how low risk spreads can go because as credit spreads tighten, MBS becomes a high quality alternative for investors.

Emerging market (EM) assets have faced a challenging macroeconomic environment in 2022 as well – one characterized by slowing global growth, geopolitical disruptions, persistent inflationary pressures and a sharp tightening of global liquidity. In spite of these headwinds, EM debt ended the year with good momentum, posting positive returns in both November and December. Total returns in the fourth quarter were supported by a weaker US dollar, -7.7%, as measured by the Bloomberg Dollar Spot Index (DXY), while commodity prices were modestly higher at 2.2%, as measured by the Bloomberg Commodity Index. Other headwinds facing EMs in 2022 also showed signs of ameliorating in the fourth quarter. Notably, China’s shift away from zero-Covid protocol towards a re-opening is expected to accelerate growth in Asia and in EM countries more broadly. While we expect the re-opening to be gradual, the current trajectory is certainly positive. Despite some deterioration in EM sovereign credit metrics during the height of the Covid pandemic and recurrent flareups in political tensions, influential EM countries such as Mexico, Brazil, Indonesia and South Africa still exhibit relatively robust macroeconomic fundamentals thanks to strong balances of payments, manageable financing needs, cheap real effective exchange rates and credible monetary policy frameworks.

Conclusion

Last year was among the worst on record for fixed income investors. This year, given the multi-year high in yields and softening inflation and growth, suggests returns will become much more favorable. Last year the Fed’s aggressive policy and the return of inflation led to a different market than the one we experienced over the past decade. Tightening cycles usually provoke fractures, sometimes idiosyncratic and sometimes systemic. While central banks and markets can usually manage idiosyncratic risks, there is concern about how markets will price a systemic rupture and how policymakers will respond. Managing these risks will be more difficult in an environment where governments do not have access to their traditional policy levers due to already high debt burdens and still-too-high inflation. The recent experience of the UK is testament to how sensitive markets are to increasing debt burdens in a period of evaporating liquidity.

We believe the market environment over the next year will feature less central bank intervention, which will lead to more volatility than the prior decade. Increased volatility will cause more disruptions and dislocations and therefore more opportunities for a dynamic multi-sector manager to add value. Our value-driven philosophy combined with our opportunistic, high conviction approach lend themselves to shift allocations towards pockets of promise. We are unbiased as to where those openings arise, whether they be in agency MBS, municipals or corporate bonds. As the market morphs, we are ready to adjust our allocations. We accept short-term volatility and instead focus on longer term value propositions, which our attractive performance over time clearly reflects.

Currently patience is the name of the game. Valuations have not yet justified a bullish stance across broad credit markets but we have positioned the portfolio with ample amounts of liquidity in the form of US Treasuries and agency MBS. We will be looking for opportunities to present themselves as the tide of liquidity continues to subside. The good news is that high quality, liquid fixed income now offers attractive yields that allow investors to sit and wait.