The outlook for fixed income in Q2 seems much more stable than compared to the beginning of the year, after a first quarter characterised by a healthy global consumer, accommodative central bank policy, progress on trade negotiations and a return of risk appetite.
At our latest fixed income investment strategy committee quarterly meeting, we reaffirmed our thesis for a soft economic landing, whereby economic growth will slow without triggering a recession. The cycle's extension and durability derive from the strength of the US economy - especially the consumer economy - and the prospect of trade policy stabilisation, which can also help steady other developed and emerging economies.
Policy clarity is improving not just at the Federal Reserve, but also at central banks in Europe, Japan and China. At the same time, growth dynamics in China and emerging markets also point to continued low, but moderate and stable growth. From an investment perspective, this supports a preference for credit markets and an appetite for moderate risk.
However, we suspect the benign environment for central bank policymaking will not last throughout 2019, and we will continue to see pockets of market volatility. Our continued confidence in the global economic cycle will give us conviction to be opportunistic when the market temporarily veers off course and to recognise changes in valuations due primarily to technical factors. Below, we outline our top five allocation calls for Q2:
Opportunity in high yield laggards
Many fixed income securities with higher yields have underperformed broader credit markets so far this year. We are constructive on high yield debt and leveraged loans and see opportunities in BBB-rated debt, where well-known concerns may be overstated over the short to intermediate term.
We also have a positive outlook for European bank credit spreads, especially subordinated bonds. The banks are relatively low risk due to increased capital, as well as supervision by the European Central Bank (ECB) instead of national central banks.
Additionally, non-performing loans (NPLs) have been reduced to very low levels. As significant laggards, collaterised loan obligations (CLOs) could also snap back as new issuance trends slow, due to challenging CLO arbitrage and a meaningful slowdown in refinancing activity.
Affordable housing drives US mortgages
We expect the US economy to maintain growth at about 2%, based on continued strength in the labour market, signs of bottoming in the housing market and a more patient US Federal Reserve.
In addition to this, improvements to affordability metrics and better matching of supply and demand of new homes have bolstered the outlook for securitised mortgage securities and private mortgage lending.
Within this, relative value has largely shifted from the legacy distressed credit market to the Credit Risk Transfer (CRT) market.