Positioning for a New Economic Landscape – Mid Year Outlook
T.Rowe Price recently released its mid year market outlook. In this article we republish parts we feel are relevant for fixed income investors. Chief Investment Officer, Fixed Income, Mark Vaselkiv, based in London, provides the fixed income commentary.
The pandemic recovery is generating opportunities, especially in markets outside of the U.S., but risks have risen after period of strong returns and there is potential for a structural move to higher inflation in months ahead.
Post-pandemic demand shifts create winners and losers, giving active managers wider scope to pursue benchmark-beating performance.
Broad Fixed Income observations – Creativity in an era of rising yields
- Yields on U.S. Treasuries and investment-grade corporate bonds remain surprisingly low given the strength of the economic recovery. Negligible or negative sovereign yields in some major markets, including Germany and Japan, have fuelled demand for U.S. Treasuries from yield-hungry, risk-averse institutional investors.
- Fixed income investors seeking attractive opportunities in the second half of 2021 may need to get creative and look to riskier credit sectors, such as U.S. and global high yield, bank loans, and corporate bonds issued by companies in emerging markets.
- Credit spreads – the difference between yields on bonds exposed to default risk and those on U.S. Treasuries of comparable maturity – are extremely tight by historical standards, reflecting a benign credit outlook. Corporate defaults have plummeted, companies have repaired their balance sheets, with almost USD 2.8 trillion of U.S. corporate credit issuance in 2020 and another USD 1.4 trillion in the first five months of 2021.
- Credit rating upgrades rose above credit rating downgrades in the first half of 2021, all constructive trends for credit investing moving forward.
- On currencies, investors should allow for the possibility of a moderately weaker U.S. dollar, owing to huge U.S. fiscal and trade deficits and continued Federal Reserve stimulus. But risk assets have performed well historically during periods of gradual U.S. dollar decline. A weaker dollar could also boost returns for U.S. companies that derive a large portion of their earnings from overseas operations and strengthen the creditworthiness of emerging markets firms that borrow in dollars.
Opportunities – quotes from Mark Vaselkiv’s, CIO Fixed Income:
- Floating rate bank loans currently offer a particularly attractive combination of relatively high yields and very short duration (an average of 90 days). This could provide benefits all the way through the next Fed tightening cycle, he argues.
- At a time when short‑term rates in many developed countries hover near zero, China’s credit markets offer attractive current income potential. “With a 10‑year Chinese government bond yield sitting at around 3%, plus an appropriate credit spread above that, there clearly are opportunities for credit pickers”. But active management, backed by locally based research, could be critical to success.
Although efforts by Chinese regulators to slow credit growth and several recent high‑profile defaults have raised concerns about financial stability— particularly in China’s real estate sector—stricter market discipline is a long‑term positive. “That’s how credit markets mature over time,” he says.
Risks In Coming Months
- The coronavirus. While vaccine campaigns have gathered speed in some developed countries, progress remains slower elsewhere. New variants of the virus remain a threat.
- U.S. fiscal policy. Although the Biden administration is seeking to raise the U.S. corporate tax rate, the increase is likely to be modest. This would be neutral for U.S. equity markets, but proposed increases in capital gains and dividend taxes, if enacted, would be negative for after-tax returns on most asset classes.
- Valuations. Price/earnings multiples in some sectors and for some stocks imply demanding earnings expectations. Even relatively strong second-half results might fail to meet those expectations, potentially generating increased market volatility.
- Political instability. Latin America, Eastern Europe, and the Middle East all contain possible flash points that could disrupt the global economic recovery
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Founded in 1937, Baltimore-based T. Rowe Price Group, Inc., is a global investment management organization with US$1.59 trillion in assets under management as of May 31, 2021. The organisation provides a broad array of mutual funds, subadvisory services, and separate account management for individual and institutional investors, retirement plans, and financial intermediaries. The organisation also offers a variety of sophisticated investment planning and guidance tools. T. Rowe Price’s disciplined, risk-aware investment approach focuses on diversification, style consistency, and fundamental research.