Expect More Volatility on the Short End
As the Federal Reserve adjusts to a tighter monetary policy, expect rates on shorter maturity bonds to move higher from current levels. Both the timing and magnitude of the move may prompt increased volatility in shorter‐maturing bonds relative to longer‐maturing bonds. Should FOMC rate hikes happen sooner than anticipated or more aggressively than projected, the yield curve is likely to flatten as investors weigh the risks of a more proactive Fed inducing a slowdown. Moderating inflation may shrink the yield differential between longer and shorter maturities. We are decreasing allocations to short-term debt to reduce the risk that a flattening yield curve poses.
Corporate Credit: Catch A “Rising” Star
We see 2022 as a year of positive ratings trajectories that will result in a higher volume of “rising stars” or companies upgraded to an investment grade rating (BBB-/Baa3 or higher). During the pandemic-induced volatility in 2020 the credit markets experienced approximately $200 billion in “fallen angels” or companies whose credit rating was reduced from investment grade to junk status (BB+/Baa1 or lower). In 2021, the downgrade trend reversed as “rising stars” outpaced fallen angels by 2-to-1, according to data from JPMorgan. We expect this trend to continue into 2022 and beyond as more companies continue to de-lever, increase free cash flow and improve their balance sheets as the economic expansion enters its second full year.
Most Wall Street estimates call for over $100 billion in rising star candidates in 2022 (and more in 2023). We remain encouraged by the number of companies we follow that are proactively taking steps to improve their credit profiles. Although the credit ratings of some of these companies may still not reflect this improving trend, we ultimately believe the companies will be rewarded, which would further support an environment of potential price appreciation that would benefit active management.
Don’t Count Consumers Out
U.S. consumers continue to be a bright spot in the economic recovery and remain poised to power future economic activity. Thanks to generous fiscal stimulus and a tight labor market, consumers are flush with savings and confidence remains high. We expect consumer spending to remain strong in the coming year. Two key metrics—the household obligation ratio and household debt to net worth—have fallen to their lowest levels in 40 years, suggesting consumers also have room to pay down debt (see display below). Investors in securitized credit card debt and auto loans are likely to see rapid repayments.
Figure 1: A Healthy Consumer Sector Can Pay Down Debt
A New Inflation Regime
Rising wages and housing costs suggest higher inflation in the years ahead; capital spending on renewable energy and carbon‐neutral initiatives will likely be inflationary longer-term. Thus, we think it is unlikely that inflation returns to pre-COVID levels, despite productivity improvements gained by businesses and reductions in supply-chain bottlenecks.
While the Federal Reserve has broadcast a likely shift in monetary policy, it is likely to remain highly accommodative, with real (inflation-adjusted) interest rates below zero. We don’t expect the economy to slow below trend. Debt-financed government spending on infrastructure and social programs is also likely to support demand in an economy already well supported by previous monetary infusions and high savings rates.
Housing Market Rolls On
We expect the supply/demand imbalance in housing to support price increases in 2022. Housing prices have exceeded expectations as limited supply and competition met multi-generational demand. COVID and the advent of hybrid work has meaningfully altered housing preferences.
Low inventories, particularly in the fastest growing cities, are likely to persist with little identifiable new sources coming to the market in the near term. Since the Global Financial Crisis, underwriting standards have improved as evidenced by average FICO scores increasing and Loan to value ratios declining. Importantly, lenders also no longer offer affordability loans such as pay option adjustable-rate mortgages. Rising prices for underlying assets coupled with strong underwriting standards should generally support mortgage-related debt instruments.
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