Inflation expectations surge among fixed income managers
Russell Investments’ latest quarterly survey of fixed income managers has found that about 70 per cent of respondents expect inflation for the next 12 months to exceed 2 per cent, surging from 38 per cent who expressed that view in the Q1 survey.
The 72 bond and currency managers who responded to the Q2 2021 survey also expressed less confidence that the US Federal Reserve (Fed) will deliver its target inflation rate. About 50 per cent expect the Fed to deliver its inflation promise, declining about 10 percentage points from the previous survey.
“Fixed income managers expect higher inflation to continue a little longer as the transition from lockdowns to full economic recovery accelerates,” says Adam Smears, Head of Fixed Income Research at Russell Investments. “With higher inflation on their radar and the prospect for interest rate hikes moving forward, we expect managers will be digging deeper into asset classes in their hunt for yield.”
The survey found 31 per cent of fixed income managers expect the Fed to start tapering its asset purchase programme as soon as in Q4 2021, though, the consensus expects the most likely timing to be Q1 2022. Respondents also believe interest rates will remain lower for longer. About 80 per cent expect the next Fed hike will not occur before 2023, increasing from 36 per cent in the Q1 2021 survey. After lift-off, 80 per cent of managers expect between two to four interest rate hikes per year.
The survey also revealed less consensus around movement of the U.S. yield curve, with 43 per cent of managers expecting a bear steepening of the yield curve in the next 12 months (versus 71 per cent in the Q1 2021 survey.) In addition, 86 per cent of respondents expect the 10-year US Treasury yield to trade between 2.0 per cent and 3.0 per cent in the next 12 months, including 45 per cent of managers who pin it between 2.5 per cent and 2.75 per cent.
The Q2 survey also assessed sentiment among fixed income managers for investment-grade (IG) credit, leveraged credit, emerging markets, currencies and securitised sectors.
Investment-grade credit: Almost 30 per cent of respondents expect a moderate widening in spreads in the next 12 months (up from just 5 per cent in Q1 2021), versus 60 per cent predicting range-bound spreads. Overall, respondents expect spreads to widen by 5 basis points (bps), revealing a change in sentiment from the Q1 2021 survey when managers expected a spread compression of -6 bps. Meanwhile, 70 per cent of managers remain confident on declining leverage of IG companies whilst almost 30 per cent of managers expect leverage to remain at least stable over the next year. When considering potential material mispricing, managers pointed to the energy and utilities sectors given increasing investor focus on environmental, social and governance (ESG) issues.
Leveraged credit: 83 per cent of managers expect range-bound spreads over the next 12 months versus 50 per cent in the Q1 survey, while only 9 per cent of respondents still expect a moderate tightening. In addition, 70 per cent expect to see a material improvement in corporate fundamentals, an increase of 5 per cent compared to the previous survey. Respondents see U.S. leveraged loans as offering the most compelling market opportunities, followed by CLO Mezzanine. Reflecting on the most concerning potential risks for the global high yield market in the next 12 months, managers selected inflation and rising interest rates. No manager expressed concerns about inflation in our Q1 2021 survey. In addition, almost 80 per cent of managers expect defaults to be between 0-3 per cent in the next 12 months, compared to 50 per cent of respondents in the Q1 survey who saw defaults in the 3-5 per cent range.
Emerging markets (EM): Survey respondents remain very constructive on EM currencies, with almost 86 per cent expecting positive performance from developing currencies in the next 12 months. Roughly 17 per cent of managers expect EM FX to post strong positive returns over the period, dropping from 40 per cent in the Q1 survey, while 11 per cent expect FX to be a detractor. Looking at EM FX opportunities, managers expect the Brazilian real and the Russian ruble to outperform in the next 12 months, while 35 per cent expect Turkish lira to be the worst-performing EM currency, in stark contrast to the previous survey where the Turkish lira was the top overweight trade. Overall, 63 per cent of managers expect positive FX returns in the next 12 months, including 10 per cent who see rates as offering the most positive return potential.
Managers are however less bullish on hard currency emerging market debt (HC EMD). Only 33 per cent expect spreads in the benchmark to tighten in the next 12 months, dropping from 74 per cent in the Q1 survey. They expect a weighted-average return at 3.9 per cent over the next 12 months. From a country preference perspective, managers selected Ukraine and Egypt as offering the highest expected return over the next 12 months. China and the Philippines remain as the top two underweight countries. In addition, managers picked Fed policy, followed by changes in the level of US Treasuries, as the top two most significant risk factors for hard currency EMD performance in the next 12 months.
Currency: Expectations for the Euro are wider, with 80 per cent of managers expecting the Euro to trade in the 1.21-1.30 range. In our previous survey, 61 per cent of managers expected the euro to be in the 1.21-1.25 range. Managers expressed more consensus with a tilt towards appreciation of the British pound with 72 per cent of respondents expecting the British pound to be in the 1.41-1.50 range in the next 12 months. In our Q1 survey, 77 per cent of managers expected the British pound to be in the 1.36-1.50 range. 61 per cent of managers expect EM FX implied volatility to increase in the next 12 months. 65 per cent expect implied volatility in G10 countries to increase.
Securitised sectors: Managers expressed more conservative views in the securitised segment. Only 19 per cent plan to add risks in their return-oriented securitised portfolios in the next 12 months, dropping from 50 per cent in the Q1 survey, while 67 per cent expect to maintain current risk levels. When asked about taking a meaningful beta position, 22 per cent noted that they already have a long basis in their portfolios, down from 64 per cent in the Q1 survey, while 50 per cent expect to add short positions. The survey also found 48 per cent of managers expect non-agency spreads to moderately tighten in the next 12 months, declining from 57 per cent in the Q1 survey, while 29 per cent expect spreads to be range bound. Regarding long/short positions on CMBX.6.BBB-, 47 per cent of managers responded they would take a short position, while 32 per cent responded that they would buy protection. As for the CLO market, managers expressed more balanced views with 57 per cent mentioning broad risk-off market sentiment as the main risk, followed by underlying loan collateral credit deterioration.