Morgan Stanley IM: Let the Good Times Roll! But for How Long?

Global Fixed Income Bulletin – Februar 17, 2023
Fixed Income

What a difference a few days make. 2022 ended with a bear growl. Bond returns were deep in negative territory for December and for the year, as were U.S. equities.

22.02.2023 | 08:06 Uhr

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Move forward 30 days to the end of January and bonds are generating 4% returns while the S&P 500 index was up over 4.5%, recouping most of December’s losses. Indeed, after yields rose dramatically in December, bond markets made a U-turn and fell dramatically in January. Markets do not simply change direction this abruptly without a reason, and in this case, there were many.

irst and foremost, the absence of central bank meetings gave markets some freedom to examine the state of the global economy and assess where it stood after the aggressive 2022 rate hikes. Additionally, central banks, by and large, did not come out with hawkish actions or comments in January. Surely, the pace and magnitude will slowdown, reasoned the market. And the market was proven right in early February when both the U.S. Federal Reserve (Fed) and the Bank of England (BoE) reduced the size of rate hikes from 50 basis points (bps) to 25 bps. While this outcome was market consensus, it validated the idea that monetary policy will be less of a drag on economies and markets in 2023. As such, volatility fell, supporting the idea that risk premiums could fall and support risk assets. As volatility diminished, the U.S. dollar continued to fall as the need for safe havens diminished and the economic outlook improved outside the U.S., particularly in Europe and in emerging markets.

Second, fundamentals generally went the right way. Inflation came down significantly in the U.S. Goods price inflation was negative. The U.S. housing market continued to weaken. The business outlook, as summarized in the ISM manufacturing and service sectors, pointed to outright recession. And the labor market seemed to be loosening, e.g., deceleration of wage and employment growth, a key factor in reducing service sector inflation. Yields had reached levels that suddenly seemed attractive if fundamentals were likely to continue to improve and generate one of the rarest of beasts, a “soft” economic landing. A big change from 2022 when markets bounced like a pin ball between the walls of fear of recession and inflation.

Third, FOMO—fear of missing out—certainly played a role, especially as fundamentals looked like they had turned the corner. After the dire financial performance of most financial assets in 2022, the danger of missing out on a bull market (bear market correction) must have been on people’s minds. After all, the best performing asset (outside of commodities) was U.S. dollar cash. Not a stretch to surmise that the investment community was likely long this asset coming into 2023. So, technical conditions played a role as markets rallied over the month. Short covering by speculators and the reduction of underweights by institutional and retail investors helped drive markets higher.

In summary, January was a gangbuster month for financial markets. A lot of fear and loathing evident in December disappeared allowing bonds, equities and non-U.S. currencies to rally. The continued decline in volatility was a key factor in allowing bond yields to fall, equities to rally and credit spreads to materially tighten. In fact, we believe the only way to square the circle of these asset returns is to suggest the market was both oversold, under owned, and a “soft” landing was coming, obviating the need for much more central bank tightening.

DISPLAY 1: Asset Performance Year-to-Date

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Note: USD-based performance. Source: Bloomberg. Data as of January 31, 2023. 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 below for index definitions.

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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