Morgan Stanley IM: Dazed and Confused

Morgan Stanley IM: Dazed and Confused
Fixed Income

Bond markets were a bit more orderly in October than the mayhem experienced in September.

25.11.2022 | 06:36 Uhr

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That said, markets were still mixed, and investors could be excused for feeling a bit dazed and confused with regards to volatility, dispersion of returns, illiquidity, central bank policies and deciphering how to determine value. Nominal U.S. Treasury and investment grade U.S. dollar bond yields moved substantially higher as strong inflation and labor market data continued, to the disappointment of the Fed and other central banks. However, just to confuse things more, real yields on 10-year U.S. TIPs fell approximately 14 basis points (bps),1 substantially outperforming nominal bonds, despite continued hawkish rhetoric coming from the central banking community. Does this mean real yields are high enough to sufficiently slow economic growth to bring down inflation to acceptable levels?

On the other hand, advanced economy bond markets outside of the U.S. generally performed well, boosted by continued fallout from the UK liability-driven investment (LDI) maelstrom in September, and a pivot by several central banks (Australia and Canada) to downshift their tightening pace. Other central banks like those in Sweden and Norway are also expected to shift to a slower pace of tightening. Other than this news, data or policy pronouncements did not particularly justify this move in and of itself, but German government 10-year yields had risen over 50 bps in September and a correction was understandable.2 Emerging market local yields did not have a great month, with most countries experiencing yet again higher yields as inflation pressures fail to abate.

Despite the gyrations in government bond yields, credit markets performed well. Under constant threat of weaker economic data (this is what central banks are striving for) and higher U.S. and Euro yields, credit markets performed well, particularly high yield. In fact, after widening 68 bps in September during the British LDI meltdown, U.S. High Yield spreads tightened 88 bps in October!3 A truly impressive performance given the sideways performance of equities. This great performance was also helped by record low issuance, continued good news on default rates, good third quarter results so far for S&P companies (tech stock woes notwithstanding), and locked in term financing. Investment grade spreads also held their own: impressive.

DISPLAY 1: Asset Performance Year-to-Date

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Note: USD-based performance. Source: Bloomberg. Data as of October 31, 2022. The indexes are provided for illustrative purposes only and are not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See pages 6-7 for index definitions.

The one continuing negative (outside of U.S. rates) has been the performance of the mortgage/securitized credit markets. U.S. agency spreads continued to widen as investor sponsorship remains sparse and the withdrawal of buying by the Fed, other official institutions, and banks weigh on the market despite the paucity of new supply.

Another interesting development in October was the mixed performance of the U.S. dollar. It was not a one-way bet. For the first time in a while, the U.S. dollar fell against almost half of the currencies we follow. In particular, EM currencies led the pack, with the Brazilian real, Hungarian forint, and Polish zloty leading the way.

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1 Source: Bloomberg, October 31, 2022.
2 Source: Bloomberg, October 31, 2022.
3 Source: Bloomberg, October 31, 2022.
4 Source: Bloomberg. Data as of October 31, 2022.
5 Source: Bloomberg. Data as of October 31, 2022. EM corporates represented by The JP Morgan CEMBI Broad Diversified Index.
6 Source: Bloomberg Indices: U.S. Corporate Index and the European Aggregate Corporate Index. Data as of October 31, 2022.
7 Source: J.P. Morgan and Bloomberg US Corporate High Yield Index. Data as of October 31, 2022.
8 Source: Refinitiv Global Convertibles Focus Index. Data as of October 31, 2022.
9 Source: Bloomberg, as of October 31, 2022.

Risk Considerations

Diversification neither assures a profit nor guarantees against loss in a declining market.

There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in a portfolio. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Certain U.S. government securities purchased by the strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. High-yield securities (junk bonds) are lower-rated securities that may have a higher degree of credit and liquidity risk. Sovereign debt securities are subject to default risk. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default, and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. The currency market is highly volatile. Prices in these markets are influenced by, among other things, changing supply and demand for a particular currency; trade; fiscal, money and domestic or foreign exchange control programs and policies; and changes in domestic and foreign interest rates. Investments in foreign markets entail special risks such as currency, political, economic and market risks. The risks of investing in emerging market countries are greater than the risks generally associated with foreign investments. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, and correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). Due to the possibility that prepayments will alter the cash flows on collateralized mortgage obligations (CMOs), it is not possible to determine in advance their final maturity date or average life. In addition, if the collateral securing the CMOs or any third-party guarantees are insufficient to make payments, the portfolio could sustain a loss.

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