Benoit Anne, Managing Director – Investment Solutions Group of MFS Investment Management – has been sharing his analysis on the current state of fixed income and the possibility of ‘no landing’
Starting off with Europe, Anne says that the continent is lagging in the race to the bottom.
“But that is a good thing. In fixed income spread land, it just looks like a race to the bottom these days. Good for excess returns, but perhaps less so for the valuation backdrop. This begs the question: how low can spreads go? One useful benchmark perhaps is the spread low reached in 2021, following the post-Covid risk rally. With that in mind, we measured the distance to the 2021 low for each individual fixed income sub-asset class. The good news for EUR fixed income valuation is that it is lagging its US peer in a substantial way. This means that there is still plenty of room to go for EUR credit spreads to challenge the 2021 level. Indeed, EUR IG spreads are still 42% away from their 83bp lows. Likewise, EUR HY are 19% away from their lows of 282bp. Meanwhile, US IG spreads are only 14% away from their 2021 bottom. In emerging markets, while there is still some for room for EM Sovereign Debt spreads to go to their lows attained in May 2021, we are already there for EM Corp. Similarly, taxable muni spreads are now trading at multiple-year tights. The last will be the first when it comes to valuation, and that is also excellent news for agency MBS, the ultimate laggard according to our analysis. Current MBS spreads are some 600% away from their 2021 lows. One word of caution nonetheless about MBS spreads: given the highly volatile duration of that asset class, it is best to assess the valuation using a break-even spread measure, and when doing so, MBS valuation appears less appealing.“
We’ve had so much discussion about soft or hard landings in recent months, here Anne goes on to explain what he means by the no landing zone commenting:
“One macro scenario has emerged in the US as a stronger possibility in recent weeks, namely the no-landing scenario. You would think at first glance that it would be ideal, but there are many risks and issues attached to that potential outcome. No landing in the business cycle taxonomy is simply defined as growth staying at or even above its long-term potential. In contrast, a soft landing would be economic growth dipping temporarily to below its long-term potential but not to a point that would trigger a recession. So, what is the main issue with no landing? Essentially, it could reignite the risk of overheating, and with that could cause inflation to flare up again, owing to renewed domestic demand pressures. This is a scenario that global investors would want to avoid at all costs as it would induce global central banks to give up on the idea of rate cuts or, even worse, resume policy tightening. Under a no-landing scenario, rates would correct higher, and risky assets would likely come under pressure, reflecting the fear of another inflation shock. To be clear, this scenario has to be taken seriously. At this juncture, we would attach a higher probability to no landing than to a recession in the US. The latest data seem to support that view, with both the New York and Atlanta Fed GDP nowcast estimates still comfortably well above 2.5%. The good news is that not all growth indicators are flagging that the risk of overheating is imminent. The Conference Board US LEI, for instance, still looks very depressed. Our own overheating risk indicator—which combines eight level and momentum macro variables—remains for now in benign risk territory. This all means that the odds of a soft landing look favorable, which is a positive outcome for global markets.“
