Figure 2. Risk assets performed well in Q2
* Excess returns are calculated relative to comparable-maturity U.S. Treasuries for each index. Excess return does not always mean "outperformance."
Source: Bloomberg, as of 6/30/23. Indexes are unmanaged and do not incur expenses. You cannot invest directly in an index. Past performance is not indicative of future results. High-yield bonds are represented by the Bloomberg U.S. Corporate High-Yield Index, which covers the U.S. dollar-denominated, non-investment-grade, fixed-rate, taxable corporate bond market and includes securities with ratings by Moody's, Fitch, and S&P of Ba1/BB+/BB+ or below. EM (emerging market) debt is represented by the Bloomberg EM Hard Currency Aggregate Index, which is a flagship Emerging Markets debt benchmark that includes USD, EUR, and GBP denominated debt from sovereign, quasi-sovereign, and corporate EM issuers. U.S. IG (investment-grade) corporate debt is represented by the Bloomberg U.S. Corporate Index, a broad-based benchmark that measures the U.S. taxable investment-grade corporate bond market. CMBS (commercial mortgage-backed securities) are represented by the Bloomberg U.S. CMBS Investment Grade Index, which measures the market of commercial mortgage-backed securities with a minimum deal size of $500 million. Agency MBS (mortgage-backed securities) are represented by the Bloomberg U.S. MBS Index, which covers agency mortgage-backed pass-through securities (both fixed-rate and hybrid adjustable-rate mortgages) issued by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC).
We have a cautious view on the corporate credit market, although we continue to find pockets of idiosyncratic opportunities. We believe investment-grade and high-yield fundamentals and technicals are strong, while valuations are largely reflective of a non-recessionary economy. In the second quarter, the Bloomberg U.S. Corporate Investment Grade Index returned –0.29%, and the JPMorgan Developed High Yield Index returned 1.86%.
Corporate fundamentals were strong entering 2023 and have been resilient up until now, with margins, leverage, and balance sheet health slightly off their peaks but near decade highs. We do not believe a recession is imminent absent further distress in the financial sector, but we are positioned for slower growth or a mild recession in 2024. We expect market technicals to remain tethered to broader risk appetite in the near term. Valuations are still somewhat attractive, particularly high yields and lower dollar prices. Macro forces of high inflation, central bank tightening, slowing growth, and tighter credit conditions remain considerable headwinds to both fundamentals and market technicals, although we are likely nearing a point where the hiking cycle will start to wind down.
Floating-rate bank loans
We expect the leveraged loan market to generate returns in 2023 that are above their long-term annual average. The leveraged loan market has continued its positive momentum into July, with the Morningstar LSTA US Leveraged Loan Index hitting 94.5 on July 10, which is 160 bps higher than the end-of-May reading when price dispersion had seemingly peaked. We believe the U.S. leveraged loan market may be at, or very close to, a price dispersion inflection point, when loan prices will begin a sustained recovery. Loan price dispersion is likely to remain high, in our view, thereby creating more opportunities for outperformance for an active, credit-driven strategy. Prudent credit selection will be an important driver of alpha. New issuance activity is also a source of attractive investment opportunities, particularly with issuers that must address loan maturities.
Commercial mortgage credit
Commercial real estate is facing meaningful headwinds and increased risks, in our view. We believe the risk of recession remains relevant through 2024, as the Fed continues to combat inflation by raising the cost of capital. Recent bank turmoil will likely result in a tighter lending channel and higher capital costs. We believe property types that can adjust rents (e.g., hotels and apartments) will hold their value better, while property types with longer leases and greater exposure to rising capital costs and/or needs for capital investment will face pressure. We believe many of these risks are priced into the CMBS market, which has experienced significant credit spread widening. The most attractive relative value opportunities require detailed analysis and security selection.
Residential mortgage credit
Residential mortgage credit spreads widened significantly in 2022 and continue to offer attractive risk-adjusted return opportunities despite some tightening in 2023. U.S. homeowner balance sheets are solid, in our view. They are supported by a combination of locked-in, ultra-low mortgage rates and the substantial price appreciation that houses have experienced in recent years. We expect home prices will be flat in 2023, followed by tepid growth in subsequent years, as affordability pressures limit demand while supply gradually increases.
Despite fears that the market would be overwhelmed with supply of agency MBS, the FDIC's liquidations have been met with robust demand. It now appears the systemic risk posed by regional bank failures is behind us. Supply should taper in the near term as new production slows and as the FDIC winds down its portfolio. Demand has been robust in recent weeks; however, the future of bank demand remains uncertain and may hinge upon regulatory changes. Overall, we find value in agency mortgages. Many prepayment-sensitive assets now offer an attractive risk-adjusted return at current price levels, in our view, and significant upside potential if interest rates stabilize and rate volatility declines. Certain subsectors offer the potential for more upside if prepayment speeds slow further.
Municipal credit fundamentals continue to be stable, in our view. Higher employment and increasing wages have bolstered tax receipts in the past few years. We continue to monitor the housing market, including home values, an important factor in property tax revenues.
State and local tax collections fell 4.2% in Q1 2023 compared with Q1 2022. At the same time, total tax revenues are nearly 30% above 2019 levels. Also, state and local governments' rainy-day funds and financial reserves remain elevated at close to 30-year highs. Municipal defaults through June are down nearly 50% versus the average of the past four years and continue to represent a very small percentage of the market. As such, we believe the credit outlook remains favorable, though we continue to actively monitor credit conditions. Security and sector selection remain a cornerstone of our investment process.
Our positioning generally features overweight exposure to both the lower tiers of the investment-grade universe and the highest-rated portions of the high-yield universe. We remain cautious on lower-rated municipal bonds in general, given our view that the Fed's aggressive tightening cycle could result in slower U.S. economic growth later this year. The portfolios are diversified in a wide range of sectors, including charter school, retirement community, private higher education, housing bonds, essential service utilities, and state-backed bonds. We have targeted a modestly long duration position in the portfolios relative to their Lipper peer groups. (Duration is a measure of the funds' interest-rate sensitivity.)
Emerging market credit
We remain cautious on our intermediate outlook in EM, although we are beginning to see recession risks and inflation risks declining for now. China's expected recovery has been disappointing, challenging the idea of a sustained recovery. However, the global growth outlook doesn't appear as fraught as we expected earlier in the year. We do expect some adjustment in monetary policy in the event that a severe slowdown materializes, but central banks will be somewhat constrained as long as inflationary pressures remain. Regardless of the policy path, we continue to believe higher-grade EM names are overvalued given the current environment. At the same time, we see recession risks and inflation risks declining, which should be supportive of EM over the near term. As such, we expect a bit more downside within the next 3–9 months, but timing remains challenged. We prefer for now to stay beta neutral and seek relative value opportunities, remaining very selective on our high-yield risk exposure.
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