Inflation

Inflation always matters for the bond market, but we believe it could matter even more now. There are a few things about the inflation picture that stand out to us. 

For starters, we haven’t seen inflation this high in decades, and it’s caught the attention of the American public—and politicians. The Fed maintains its independence of course, but political pressure can’t be ignored.

Then we have the COVID-led supply chain bottlenecks.  We’re reasonably confident they’re temporarily and artificially boosting prices in certain areas—for example, we don’t think used car prices can rise at 25% every year. We think those prices will come down to earth once the bottlenecks ease. 

However, there are longer-lasting inflationary forces out there. One is housing.  Home prices have been red hot over the past year, and while prices will likely moderate, we believe they have room to run.  Housing prices feed through to inflation measures with a lag, meaning we could see upward pressure even after gains in housing prices peak.

Another is labor costs. Labor supply is falling short of demand because millions of people haven’t returned to the labor force. We see many reasons for this. One is because many individuals have significant precautionary savings aided by massive government support programs. We think this group will eventually return to the job market as their savings erode, and we’re already seeing a meaningful drop in the savings rate.  But we believe some of the other factors depressing labor supply—fear of COVID, lack of childcare, accelerating retirements—may be longer lasting and could keep wages and salaries high for the foreseeable future. 

Ultimately, where inflation goes and how the Fed reacts will likely set the tone for the market as we enter the new year.

Monetary Policy

We believe monetary policy will be a key theme next year. In our view, it’s becoming increasingly likely that the Federal Reserve will pivot its attention toward fighting inflation.

Recent statements from Fed Chairman Powell indicate a potentially faster pace of bond purchase tapering as we begin 2022. In addition, recent statements from Treasury Secretary Yellen suggest continued concern about the global supply chain and its effect on the prices of goods and services. One possible conclusion from these statements is that the Fed may adjust monetary policy much sooner than anticipated.

A faster pace of tapering, along with the potential for Fed Funds rate increases sooner than the market previously expected, would alter the shape of the US yield curve, likely driving short rates higher. Real interest rates remain significantly negative. We believe that the end of tapering and the potential for multiple rate hikes over the next year could begin to move real rates higher as well as the long end of the nominal yield curve in the US. We remain cautious on higher-quality, interest-rate-sensitive sectors and are focused on identifying securities with positive convexity. We anticipate remaining neutral to underweight duration across all strategies as 2022 unfolds.

Higher Rates (and Fear of Rates)  

Looking ahead, we think the fear of rising rates and actual rising rates will be key themes.

We like to remind people that leveraged loans can be a good option for yield potential, but we know many investors think of loans primarily for protection from rising interest rates.

Some investors will come back to the loan market early, because they fear rising rates, and some investors will be late movers, when rates actually start rising after over a decade of central bank suppression.

We believe high demand for loans from across our investor base of CLOs, mutual funds and institutional accounts, should hold loan prices close to par if rate fears, and eventually reality, are driving other fixed income prices down.

Looking at our portfolios, we see a lot of companies that reduced costs permanently in the pandemic, and that are showing pricing power on the top line. That combination should help bolster results against cost inflation into 2022.

After a record-breaking year in the loan market for the syndication of loans backed by mergers and acquisitions, we think the credit environment is very favorable for loans and default forecasts are at industry lows.

We believe strong corporate fundamentals, robust demand and slowly rising rates should all combine for a positive outlook for leveraged loans.

Higher Volatility

We’re positioned for higher volatility in 2022. In our view, extremely accommodative fiscal and monetary policy have driven credit valuations above fair value. We think the probability of technically-driven spread widening has risen, given some of the themes already discussed here, such as inflation data and our belief that the Fed may normalize policy faster than the market thinks. If the Fed does in fact become more hawkish than the market expects, we believe risk assets such as equities and corporate credit could come under pressure.

Although credit quality is fundamentally sound and default expectations are quite low, we have reduced our credit exposure to help provide us with dry powder to deploy if and when credit spreads offer more attractive valuations.

We do believe however that pockets of opportunity still exist in credit. In our view, potential rising stars in the energy, finance and healthcare sectors offer decent upside, as well as specific issuers in sectors that are likely to benefit from economic reopening, such as airlines, toll roads, aerospace & defense, and lodging.

A Shift in Growth Dynamics in Asia

When talking about the prospects for EM Asia, the conversation usually starts with China growth, as China has been the bedrock for Asia growth for years. China should end 2021 with around 8% YOY GDP growth, well above the estimated growth rate for emerging Asia ex China.  Looking ahead to next year, the story for Asia will likely change.  China’s policy efforts are causing growth headwinds in certain sectors of the economy, most importantly in the real estate sector – a large driver of economic growth. This step down in growth could lead to lower but still respectable China growth for 2022 at about 5%.  But, we are expecting more robust growth out of other major Asian countries that could bring Asia ex-China growth to around 6%. Broadly speaking, we believe growth in Asia will be supported by India, Indonesia, Malaysia, the Philippines, Vietnam, and Bangladesh. We see a broad set of drivers across the region - exports are benefiting from a strong global recovery. Capex is on the upswing.  Consumption looks to be recovering with good vaccine numbers across many countries. We believe the re-balancing of growth within Asia creates interesting opportunities outside of the Chinese opportunity set. Within the Asia x China landscape, we maintain a preference for corporates exposed to digitalization such as tech and telecom, renewable energy, the consumer space as well as some industrial themes.