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    GSAM Insights

    QUALITY CONTROL

    Fixed Income Outlook | 2Q 2023

    April 6, 2023  |  8 Minute Read

    Kay Haigh

    Global co-head of Fixed Income and Liquidity Solutions

    Kay Haigh

    Whitney Watson

    Global co-head of Fixed Income and Liquidity Solutions

    Whitney Watson

    “Today’s backdrop of higher interest rates and elevated uncertainty requires investors to be more selective. Strength of balance sheets will matter more, and we must be mindful that market sentiment can shift rapidly under tighter financial conditions in era of social media and digital transactions. But volatility and uncertainty can also create opportunity, and we remain focused on building both resilient and opportunistic fixed income portfolios for our clients.”

     

    “Recent market stress has served as a reminder of the protective power of bonds in portfolios, reinforcing our view that 2023 will be a pivotal year for raising allocations to core fixed income assets such as high-quality government and corporate bonds. But unpredictable markets and elevated economic uncertainty calls for an active approach to security selection and portfolio construction.”

     

    Fixed Income Perspectives

     

    In our 2023 Fixed Income Outlook, Bring On Bonds, we flagged that a higher rate regime would raise financial instability risks, though we did not foresee the banking sector stress that recently unfolded. Policy interventions appear to have calmed contagion risks, and relative to the period preceding the global financial crisis, bank capital buffers are higher across most jurisdictions. The private sector is also stronger, supported by high employment, savings buffers, and an absence of excess leverage. But tighter credit conditions will reinforce the drag on growth already underway from aggressive monetary tightening. Furthermore, recent events demonstrate that in an age of social media and digital banking, weakness can fast reverberate from one corner of the financial system to another.

    With uncertainty remaining elevated entering the second quarter, we retain our preference for high-quality fixed income; higher yields alleviate the need to go down the quality spectrum or out the curve for income. We also believe recent market stress reaffirms the protective power of core fixed income in portfolios. Credit restraint may substitute for rate hikes, catalyzing an earlier end to rate hiking cycles, but there is also considerable uncertainty over how large and broad the impact on growth will be. Overall, as we push further into a higher rate regime, we remain alert to potential vulnerabilities stemming from weak and rate-sensitive balance sheets.

    Macro at a Glance

     

    Growth

    Notwithstanding positive momentum in early 2023, we expect growth to slow in the second quarter reflecting ongoing drags from monetary tightening and recent banking sector stress. While soft landing prospects have diminished, recession is not our base case given tailwinds from lower energy prices and China reopening, alongside continued strength in labor markets. That said, there is considerable uncertainty over how large and broad the drag on growth from recent banking sector stress will be. Banks have already been tightening their lending standards since mid-2022 and so the impact on credit availability and growth should be smaller than in a situation such as 2008. Further, the private sector is in a healthy financial position and the banking sector is well capitalized. Nonetheless, in an age of social media and digital banking, the risk of another deposit run is high, not least given lingering concerns around uninsured deposits. Overall, we think risks to the growth outlook are skewed in a negative direction.

     

     

    Easing Short-Run and Anchored Long-Run US Inflation Expectations

     

    Source: Macrobond, Goldman Sachs Asset Management, University of Michigan Survey. As of March 2023.

     

     

    Inflation

    Inflation has proved sticky, with certain goods prices reaccelerating and services inflation staying firm. But measures of medium-term inflation outcomes such as wage growth and inflation expectations are either stabilizing or easing. This suggests progress on inflation normalization should resume in the second quarter as demand slows. The disinflationary impulse from tighter credit conditions combined with the lagged impact of past monetary tightening may also help progress on inflation get back on track. That said, we expect regional divergence, with the US pacing ahead of the Euro area in the inflation improvement story, while inflation in Japan continues to firm up.

     

     

    The US is Making Better Progress on Inflation Normalization

     

    Source: Macrobond, Goldman Sachs Asset Management. Euro area HICP, UK CPI and Japan CPI as of March 2023. US PCE as of February 2023.

    Policy Picture

     

    A Fresh Uncertainty

    Market views on the possible path for monetary policy in major economies have seen remarkable shifts over the past quarter. For example, market-implied pricing for the Fed terminal rate reached a peak of 5.7% in early March on overheating fears before dropping to a low of 4.6% amid credit crunch concerns. Recent banking sector turmoil creates a fresh uncertainty and further complicates the task of central bankers.

     

    Final Innings, For Most

    We expect rating hiking cycles to conclude in the US, UK, and Euro area in the second quarter. We think the Fed will deliver a final 25bps rate hike in May for a terminal rate of 5.00-5.25%, while the ECB lifts rates to 3.75% by June to combat underlying inflation pressures from strong wage growth and services prices. Japan will remain an outlier. We expect a hawkish BoJ policy shift following leadership changes and given momentum in wage growth and core inflation.

     

    Separation (in) Principle

    Policymakers have sought to imply liquidity and macro-prudential support will address financial stability, while monetary policy tools such as interest rates address inflation. This is the philosophy of the ECB’s “separation principle” and was reflected in BoE actions last October in response to gilt market volatility. But in practice this separation may be hard to sustain. Sharp tightening in financial conditions could blur the divide between financial stability and price stability objectives, catalyzing an earlier end to rate hiking cycles.

     

     

    Volatile Terminal Rate Expectations

     

    Source: Bloomberg, Goldman Asset Management. As of March 30, 2023.

     

     

    The US Banking Sector is Better Capitalized Versus 15 Years Ago

     

    Source: Federal Reserve, Investment Strategy Group, and Goldman Sachs Asset Management. As of December 31, 2022. Common Equity Tier 1 Ratio refers to a bank's capital, typically common stock, relative to its risk-weighted assets to determine its ability to withstand financial distress. Aggregate refers to 18 bank holding companies at the time. Average for Large Regional Banks is based on data for 15 regional banks using disclosures from their 10-K filings.

    What to Watch

     

    The Labor Market

    As noted last quarter, rebalancing of the labor market—through a reduction in labor demand rather than layoffs—is key to easing wage growth, and in turn inflation, while avoiding a severe recession. High-frequency data like jobless claims remain an important gauge for the extent to which tighter financial conditions are impacting the economy and in turn the inflation outlook.

     

    Commercial Real Estate

    Property is among the most rate-sensitive sectors in the economy and is therefore in focus as we press further into a higher rate regime. Although measures vary by country, stricter lending requirements since the global financial crisis point to robust mortgage loan quality. Still, higher rates present headwinds and sensitivity to higher rates varies by country and sector. For example, the UK, Australian and Swedish economies exhibit greater sensitivity than in the US, where most mortgages are fixed for 30 years. In the US, the commercial real estate (CRE) market faces challenges from higher debt servicing costs and refinancing risks but also rising delinquency rates, particularly in the office sector due to falling occupancy from a shift to remote work. Recent banking sector stress will likely reinforce tightening in financing conditions for the sector given the active role of regional banks in CRE lending in recent years.

     

    The Banking Sector

    Banks can respond to recent stress in various ways. They can lift deposit rates to quell deposit outflows and maintain profits by raising rates on new loans or loans that are due to refinance. Or they can pullback lending to accommodate a smaller deposit base. Either way, credit conditions look likely to tighten further as banks seek to conserve liquidity and bolster capital positions. The speed and scale of deposit outflows, and magnitude of credit tightening will be important to watch to assess spillovers to the economy.

     

     

    Demand For US Labor is Moderating

     

    Source: Macrobond, Indeed as of March 23, 2023, new openings in the Job Openings and Labor Turnover Survey as of January 2023. Standardized over the past 36 months.

     

     

    Small and Midsize Banks Account For 80% of US CRE Lending

     

    Source: Federal Deposit Insurance Corporation, Goldman Sachs Global Investment Research. As of 2022.

     

     

    Navigating Fixed Income

     

    Fixed Income Spread Sectors 

    We have tempered exposure to fixed income spread sectors, either by increasing the extent to which we balance our exposures with rates or currencies, or by reducing exposure outright. Overall, our risk stance is defensive, and the composition of our exposures is up-in-quality, favoring assets like investment grade credit and agency mortgage-backed securities that tend to benefit from lower rate volatility and exhibit resilience to slowing growth.

     

    Interest Rates

    Considering higher yields and growth risks, we believe the protective power and alpha-generating properties of government bonds has strengthened. We retain our bias to be underweight European rates given hawkish risks to ECB policy from firm services inflation, wage growth and loose fiscal policies. We also continue to position for a hawkish policy shift in Japan in response to domestic inflation pressures and a change in BoJ leadership.

     

    Currencies

    Banking sector stress presents mixed implications for the US dollar. On the one hand, tighter bank lending conditions may substitute for rate hikes, presenting dovish implications for the greenback. On the other hand, renewed volatility and downside growth risks could see the dollar appreciate due to its perceived safe-haven status. Given the mixed directional picture, we are neutral on the US dollar and instead favor overweight exposure to other perceived safe-haven currencies such as the Japanese yen and Swiss franc. Elsewhere, we are underweight the Swedish krona and New Zealand dollar given high sensitivities of those economies to higher rates, while we are overweight the euro considering our hawkish ECB policy outlook.

     

     

     

    Income and Total Return Opportunities Remain Attractive

     

    Source: Macrobond, as of March 29, 2023.

    Central Bank Snapshot

    Source: Goldman Sachs Asset Management. As of April 13, 2023. Abbreviations: Quantitative Easing (QE), Quantitative Tightening (QT), Yield Curve Control (YCC), Pandemic Emergency Purchase Program (PEPP), Asset Purchase Program (APP). The economic and market forecasts presented herein are for informational purposes as of the date of this document. There can be no assurance that the forecasts will be achieved. Please see additional disclosures at the end of this document.
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    AM Fixed Income Outlook 2Q 2023

     

     

     

     

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    ¹ Source: Federal Reserve’s latest Senior Loan Officer Opinion Survey released February 6, 2023. ² Source: Goldman Sachs Global Investment Research US Economics Analyst March 15, 2023.

    Risk Considerations

    The risk of foreign currency exchange rate fluctuations may cause the value of securities denominated in such foreign currency to decline in value. Currency exchange rates may fluctuate significantly over short periods of time. These risks may be more pronounced for investments in securities of issuers located in, or otherwise economically tied to, emerging countries. If applicable, investment techniques used to attempt to reduce the risk of currency movements (hedging), may not be effective. Hedging also involves additional risks associated with derivatives.

    Investments in fixed income securities are subject to the risks associated with debt securities generally, including credit, liquidity, interest rate, prepayment and extension risk. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price.  The value of securities with variable and floating interest rates are generally less sensitive to interest rate changes than securities with fixed interest rates. Variable and floating rate securities may decline in value if interest rates do not move as expected. Conversely, variable and floating rate securities will not generally rise in value if market interest rates decline. Credit risk is the risk that an issuer will default on payments of interest and principal. Credit risk is higher when investing in high yield bonds, also known as junk bonds. Prepayment risk is the risk that the issuer of a security may pay off principal more quickly than originally anticipated. Extension risk is the risk that the issuer of a security may pay off principal more slowly than originally anticipated. All fixed income investments may be worth less than their original cost upon redemption or maturity.

    When interest rates increase, fixed income securities will generally decline in value. Fluctuations in interest rates may also affect the yield and liquidity of fixed income securities.

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    Economic and market forecasts presented herein reflect a series of assumptions and judgments as of the date of this presentation and are subject to change without notice.  These forecasts do not take into account the specific investment objectives, restrictions, tax and financial situation or other needs of any specific client.  Actual data will vary and may not be reflected here.  These forecasts are subject to high levels of uncertainty that may affect actual performance. Accordingly, these forecasts should be viewed as merely representative of a broad range of possible outcomes.  These forecasts are estimated, based on assumptions, and are subject to significant revision and may change materially as economic and market conditions change. Goldman Sachs has no obligation to provide updates or changes to these forecasts. Case studies and examples are for illustrative purposes only.

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    Index Benchmarks

    Indices are unmanaged. The figures for the index reflect the reinvestment of all income or dividends, as applicable, but do not reflect the deduction of any fees or expenses which would reduce returns. Investors cannot invest directly in indices.

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    Date of first use: April 6, 2023.  313325-OTU-1773736.

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