All about income

We expect a significant shift by central banks toward monetary easing, as they seek to cushion a global growth slowdown sparked by rising trade tensions. This policy pivot should extend the long expansion, we believe, creating a supportive backdrop for income-generating assets. We see income, or carry, as the key driver of bond market returns in this low-for-long world.

Income wanted
Yield ranges on various fixed income asset classes, 2018-2019

• Themes: The dovish pivot by central banks and a slowing, but growing economy, bode well for income-seeking investors, in our view. Bond yields’ recent plunge has created challenges for investors in an already yield-starved world. With geopolitical crosscurrents and policy at the ready for easing, stability in yields is our base case for global fixed income for the months ahead. We are overall more positive on credit markets, where valuations still look decent. Credit yields have fallen to the bottom of recent ranges, driven by the decline in government bond yields and tightening yield spreads. See the Income wanted chart above. Yet spreads still leave some cushion against the risk of rising rates.
• Central banks: The Federal Reserve now looks ready to trim rates as insurance against any slowdown. Yet with a recession unlikely, we believe markets are counting on too many Fed rate cuts and could be disappointed. We see the Fed likely cutting rates as insurance against escalating trade conflicts, but failing to deliver on the four quarter-point rate cuts through 2020 that markets are currently pricing in. In contrast, we expect the European Central Bank (ECB) to meet — or even exceed — stimulus expectations. ECB President Mario Draghi looks set to commit the central bank to more stimulus in his final months in office before a successor takes the reins in November. We expect ECB measures in the form of both deeper negative interest rates and more quantitative easing as a result. Elsewhere, the Bank of Japan is mulling more stimulus measures on top of its mega asset purchases, as inflation shows no sign of reaching target and the yen has remained strong.
• Growth and inflation: At the same time that we see central banks’ dovish pivot extending the long expansion, we have downgraded our global growth outlook as trade disputes stoke greater macro uncertainty. We expect U.S. growth to cool to around trend-like levels just below a 2% annual rate. The eurozone is steadying after last year’s abrupt slowdown. China’s growth is finding its footing but looks to be at risk of staying sluggish due to the tariff fallout. In the near term, tariffs and the uncertainty around trade policy could deliver a one-off boost to prices, damage business confidence, and discourage capital spending. This comes at a time when our Inflation GPS already points to upside risk in U.S. inflation in coming months.

  The possibility of a snapback in yields leads us to downgrade our tactical view on U.S. Treasuries. But even at today’s yields, we still see an important role for long-term government bonds as key stabilizers against a backdrop of rising macro uncertainty. We now prefer long-term eurozone sovereign bonds over their U.S. counterparts, given what we view as markets’ more realistic expectations for the ECB. And U.S. dollar-based investors can pick up an immediate yield boost after hedging euro-denominated exposures back into their home currency, because of the interest rate differential between the two regions.

• Risks: Global trade and strategic tensions between the U.S. and China could escalate or broaden to the Americas, Europe or other Asian economies. This could hit market sentiment, lead to an extended lull in major economies and weigh on global growth. And even if monetary and fiscal policy support helps extend the life of this cycle, we could still face the prospect of slower growth and higher inflation. Heightened macro uncertainty could also herald a shift to a new regime of more frequent risk asset selloffs and higher financial market volatility. This is why we believe that building portfolio resilience is critical as this cycle continues to age, as detailed in our Midyear 2019 Global investment outlook.

Fixed income views

Our views are from a U.S. dollar perspective over a three-month horizon. Views and comments are from a fixed income-only perspective, and may differ from whole-portfolio tactical views on fixed income in our Midyear 2019 Global investment outlook. For example, we overweight Asia fixed income from a bond portfolio perspective because of their income potential. Yet we are neutral on this asset class in a multi-asset context, where we prefer to take economic risk in equities. Views are as of July 10.

Rates	View	Comments
U.S. government bonds		We have downgraded Treasuries to underweight from neutral. Market expectations of Fed easing seem excessive, leaving us cautious on Treasury valuations, particularly in shorter maturities. Yet we still see long-term government bonds as an effective ballast against risk asset selloffs.
U.S. inflation protected		Real rates have rallied sharply alongside nominal bonds, yet TIPS have lagged as the market has reassessed inflation expectations. With the 10-year breakeven rate at 1.7% and core inflation at 2%, TIPS look inexpensive. We believe they should be part of a portfolio’s government bond allocation.
U.S. agency mortgages		Falling rates have prompted mortgage prepayments and shortened asset class durations. Higher-coupon mortgages have been particularly hit, while lower- and current-coupon mortgages have seen increased demand as hedging vehicles. We do see opportunities in high-coupon mortgages or specified pools and would recommend the latter for long-term asset allocation purposes.
U.S. municipal bonds		Muni valuations are on the high side, but the asset class has lagged the U.S. Treasuries rally. Favorable supply dynamics, seasonal demand and broadly improved fundamentals should drive muni outperformance. The tax overhaul has also made munis’ tax-exempt status more attractive.
Global rates ex U.S.		We remain neutral the asset class overall but have upgraded European sovereign bonds to overweight. We expect the ECB to deliver – or even exceed – stimulus expectations, and see particular value in long-end semi-core (such as France) and peripheral European bond markets. Yields look attractive for hedged U.S. dollar-based investors thanks to the hefty U.S.-euro interest rate differential. A relatively steep yield curve is a plus for eurozone investors.

Credit and other	View	Comments
U.S. investment grade		We remain overweight investment grade bonds even after their strong performance in the first half of 2019. Easier monetary policy that may extend the economic expansion, constrained new issuance and conservative corporate behavior support investment grade. Investment-grade credit remains a key part of our income thesis.
U.S. high yield		We see a favorable backdrop for high yield performance, amid easier monetary policy that may prolong this cycle. Generally healthy corporate fundamentals are also a positive. We like the asset class for its income potential and favor BB-rated bonds even after their recent outperformance. They offer attractive income along with lower exposure to risks associated with decelerating economic growth.
U.S. bank loans		We view bank loans as an attractive source of high-quality income. We see selected opportunities versus high yield, as heightened expectations for Fed rate cuts have challenged investor sentiment for bank loans and improved their relative value. Loans’ floating-rate nature can potentially provide a cushion against rising rates, and they offer attractive risk-reward potential in a scenario where the Fed raises rates less than expected.
U.S. securitized assets		We like securitized assets for their relatively attractive yields and income potential. We favor a diversified approach that balances allocation to residential and commercial mortgage backed securities (RMBS and CMBS), collateralized loan obligations (CLOs) and whole loans, as well as asset-backed securities (ABS).
Euro investment grade		The ECB’s “lower for even longer” rate shift against a backdrop of near-term economic weakness should help limit market volatility and support the asset class. The possibility of renewed ECB corporate bond purchases is another positive. European banks are much better capitalized after years of balance sheet repair. Even with tighter spreads, credit should offer attractive income to both European investors and global investors on a currency-hedged basis.
Euro high yield		We remain overweight, even after impressive performance in the second quarter in response to major central banks’ dovish shift. High yield is becoming the only liquid European market with positive yields in the front end of the yield curve. The asset class would benefit from renewed ECB asset purchases – even if not directly eligible. We see further outperformance of high yield on attractive income, potential spread compression and low default rates. We see the most value in BB-/B+ rated bonds, AT1-tiered securities and corporate hybrids.
Emerging market debt		We like EM bonds for their income potential, despite rising geopolitical risks. The Fed’s dovish shift and a slowing but growing global economy have spurred local rates to rally, helped local currencies recover and driven strong performance by U.S.-dollar denominated EM debt. We believe local-currency markets have further to run and prefer them over hard-currency markets. We also favor high yield over investment grade bonds based on relative valuations. We see opportunities in Latin America and in countries not directly exposed to U.S.-China trade tensions.
Asia fixed income		The dovish pivot by the Fed and ECB gives Asian central banks room to ease. Currency stability and stabilizing growth in China are also positives. Valuations have become richer after a strong rally, however, and we see geopolitical risks increasing. As a result, we have reduced overall risk and moved up in quality across credit, while maintaining long credit risk positioning.