Key Takeaways
- U.S. recession risk in 2023 has increased; we expect inflation to peak, the Fed to pivot, and the yield curve to remain inverted.
- We maintain our risk-off view for asset allocation, prefer up-in-quality credits, and underweight risky assets. Cash may outperform equity in the next couple of quarters.
- Long-duration and safe-haven assets, e.g., Treasuries and munis, are preferred, considering our view on recession risk and the potential for lower yields.
- The stage of the current credit cycle may turn in 1H 2023.
- The housing slowdown has started, but healthy consumer balance sheets, constrained housing supply, and strong demand should limit this risk.
- The outlook for commercial real estate has softened somewhat. The agricultural credit cycle has peaked, but we do not expect an uptick in losses.
Rising Recession Risk in 2023
Leading economic indicators continue to signal a further softening of global economic growth. Tighter central bank policies may push the economy into a recession. U.S. — A recession in 2023 is our base case (Figure 2), although there is significant uncertainty regarding the depth and duration of any downturn. Europe — The expectation is that the euro area economy will slow further and may have entered a recession in Q4 2022, as the region absorbs a large, energy-price driven, and negative trade shock following Russia’s invasion of Ukraine. Lingering high rates of inflation and the expected weakening of labor markets are expected to curb real household spending power in 2023. Asia — We stick to our baseline view for growth to slow in 2023, but still outperform most other regions globally as inflation pressures steadily ease over the course of the year. Latin America — Activity is expected to decelerate in 2023, driven by tight monetary policies and commodity-price moderation.
Figure 1 | Tactical Asset Allocation Recommendation
Inflation Peaking, Central Banks Pivoting, and Lower Yields Are Expected
U.S. Treasury — We expect the Fed to end their hiking cycle by mid-2023, given our outlook for slowing economic growth and rising recession risk. JGBs — Despite moves higher in USD/JPY, the JGB market remains relatively calm, moderating over the course of 2022. The recent tweak in Yield Curve Control (YCC), i.e., allowing 10-year yields to rise to 0.5%, has caused the Yen to strengthen. It also increased speculation that BoJ may allow yields to rise further. CGBs — CGB 10-year yields reached a 12-month high of 2.92% at the end of November, as Beijing shifted its stance on Zero Covid policy (ZCP). An easing bias will persist, as evidenced by support measures for the property sector and the policy change on ZCP. Bunds — 2022 was a pivotal year for euro government bond markets, marking as it did the end of the ECB’s net QE asset purchases in June, followed by the July start of its first interest-rate hiking cycle in over 11 years. 2023 will be another pivotal year for the region’s fixed-income markets, with the ECB expected to begin a QT program.
Figure 2 | U.S. Yield Curve Recession Probability Model
Source: Federal Reserve Bank of New York, MetLife Investment Management (MIM)
Figure 3 | CEO Confidence Index
Source: Bloomberg, MIM
The Credit Cycle May Turn in 1H 2023
The credit market suffered historic losses in 2022 as rates rose significantly, and spreads widened. This credit cycle is aging very fast; although we are still in “overheat” stage, we may already be on the brink of a “downcycle” stage. We believe that the credit cycle could turn in 1H 2023. However, we don’t think credit markets have priced in sufficient downside risk just yet. Across credit markets, valuations are still near their historic averages and priced like mid-cycle. At the current spread levels, both U.S. IG and HY markets seem to be pricing in less than a 10% recession risk. Looking forward, we expect spreads will trend wider on heightened recession risk in 2023. However, for 1Q 2023, we believe that there is a chance of a relief rally as the Fed’s hiking cycle comes to an end. That could be an opportunity to “sell into strength” and upgrade portfolio quality. As a result, we continue to recommend “up in quality” as we head into 2023. U.S. Investment Grade (IG) — The outlook remains neutral on slowing profit growth and margin pressures. While EBITDA margins remain at cycle highs, ex-energy EBITDA margins have already peaked. Overall leverage ratio improved further in 3Q22, but the ex-energy leverage ratio started to rise marginally. IG yields rose to the highest levels since 2009, and we believe current yield levels are attractive.
Figure 4 | US Defaulted Bond/Loan Debt
Source: JPMorgan, MIM
European IG — We maintain our view that margins, ex-energy, have peaked, and for the next 12-18 months, it is likely to be a question of how well corporates can protect against declines. Spreads still appear relatively cheap, but we are concerned about further widening on the ECB’s aggressive rate hikes, the ongoing energy crisis, and the recession. As the result, we remain underweight in European IG. High Yield — Similar to the IG market (although overall EBITDA margins remain at cycle highs), ex-energy margins have already peaked. Defaults remained benign in 2022, but total defaults/ distressed exchanges are already more than three times 2021’s full year total. The default rate is expected to rise significantly in 2023. Moody’s expects U.S. default will rise to 5.0% by October 2023 from only 1.5% in October 2022. The bond recovery rate remains around its five-year average. Leveraged Loans — Due to the prevalence of loan-only capital structures, recovery rates are meaningfully lower than historical averages. The recovery rate for first-lien loans fell to as low as 50% in August 2020, but since then it has improved to 65.7%. The ratings-migration trend has been negative as downgrades outnumbered upgrades again in November—the seventh consecutive month that has occurred. Spreads appear cheap, but we are concerned about higher defaults with lower recovery rates and heightened downgrade risk for leveraged loans in 2023 as the credit cycle turns. Municipals — Both general obligation (GO) and revenue bond outlooks remain neutral on a challenging macro outlook. For GOs, total state and local government tax revenue rose 7.0% YoY in 1Q22. We expect continued growth. For revenue bonds, in the health care sector, the Omicron surge this past winter had a more severe financial impact on not-for-profit (NFP) hospitals starting in 4Q21, and that continued into 2022. While EBITDA margins rebounded sequentially in 2Q22 and 3Q22, hospitals must improve productivity, cut costs, or increase revenue. Air traffic continues to recover from the 2020 lows. Toll road revenues have largely recovered to pre-pandemic levels. We believe the taxable municipals market will be relatively more resilient in a challenging macro environment. Emerging market (EM) IG — We expect EM growth to slow down further in 2023 from 2022 and remain well below its pre-pandemic trend. LatAm and EMEA growth will be negatively impacted by the lagged impact of monetary tightening and still high inflation. Asia will likely outperform, driven by China. In 2022, China was hit by Omicron surges along with significant weakening in the housing market. Although significant uncertainty remains surrounding the ZCP, recent announcements to loosen ZCP suggest a modest rebound in 2023 as the economy gradually reopens. For EM corporates, we have changed our outlook to neutral from positive as revenues and EBITDA seem to have peaked in 3Q22, and while we expect margins to remain healthy, they are likely to compress on higher cost pressures.
Housing Slowdown Has Started
Home price declines are taking center stage with select regions officially showing declines. Almost 50% of states have shown recent declines. The widely followed S&P Case Shiller Index registered its first decline since 2018. Residential Credit — As Fed actions prompt higher mortgage rates, the market should cool. Seasonals and a “lock-in” effect could bring home sales to a standstill. While current affordability is down to 104.4, issue-date-adjusted affordability is still close to the long-run average at 157. The recent increase in mortgage rates has not resulted in greater payment for existing borrowers as ARM volumes have been low in recent years. While home prices can decline, consumer home equity has increased to $29 trillion. This should be a significant dampener to distressed selling.
Figure 5 | NCREIF Indices
Source: NCREIF, MIM Asset-backed securities (ABS) — The consumer is beginning to grow credit balances to support spending. The Federal Reserve consumer credit report shows that credit card balances are up to $887 billion and are just below the high of year-end 2019. Lower FICO borrowers will continue to see increasing delinquencies and less access to credit as originators begin to pull back. CLO — CLO collateral pools are beginning to show weakness. The downgrade ratio (i.e., rolling three-months number of downgrades to number of upgrades) continues to deteriorate and is up to 2.24 as of November. Default rates, which lag, have begun to increase but are still low. Most default projections range from 3-5% for 2023. Deals continue to migrate to static or short tenor as the issuance market is challenged due to wide cost of funds. CMBS — Interest rates and the lending environment are finally leading to a decline in commercial valuations (Figure 5). Retail has staged a strong valuation recovery since the very weak 2019-2020 environment. Most loans have ample debt service coverage ratios (DSCR) given past low mortgage rates, but refinancing risk could be a concern as loans come due and are refinanced over the next several years. Agency MBS — Cheap MBS valuations have brought in a larger buyer base, leading most asset manager to move to neutral weight relative to the index. However, on a relative basis across all asset classes, Agency MBS looks attractive given its total yield, valuation, healthy consumer balance sheet, and stable housing market fundamentals. Private Structured Credit — We saw a healthy pipeline of transactions across a diverse range of asset sectors as public market execution became challenging, and issuers increasingly looked for private market solutions with certainty of execution. While spreads may remain volatile in the near term, valuations look attractive, with spreads near the widest level since COVID-19, coupled with all-in yields not seen since the financial crisis. We expect deal flow to remain robust and are currently seeing opportunities in alternatives, solar, energy, trade receivables, and residential credit.
The Outlook for Commercial Real Estate Has Softened Somewhat
Real estate fundamentals remain mostly healthy. Inflation has run above expectations, which has generally benefited property income growth, and vacancy rates remain near historical lows for most property types. Still, looming economic headwinds have tempered growth expectations. The outlook for the economy and commercial real estate performance has softened somewhat. Recent transactions and offerings suggest real estate equity pricing has improved, with discount rates up around 75 basis points, but not sufficient to match the move in Treasury rates. Transaction activity for both real estate debt and equity has slowed.
Agricultural Credit Cycle Peaked, But We Do Not Expect an Uptick in Losses
U.S. farm incomes are forecast to have reached record levels in 2022 due to strong commodity prices, although growth was muted somewhat by rising production costs. The agricultural credit cycle indicator peaked in 2018 and has been contracting. Agricultural loan losses at commercial banks (a proxy for the sector) tend to occur during contractions in the agricultural credit cycle (Figure 6). Strong farm incomes have led to a borrower contraction of short-term credit. Firm farmer repayment capacity has translated into a decline in non-performing loans in the cycle. Rising land values continue to add strength to sector balance sheets. Given these factors, we do not expect an uptick in losses.
Figure 6 | Agricultural Credit Cycle
The Agricultural Credit Cycle measures the deviation in the growth rate of leverage in the agricultural economy from the estimated Sources: MIM, Ag Finance Databook, Kuethe & Hubbs
Cash May Outperform Public Equities
Given our dim economic outlook, corporate profit margin pressures, and rising recession risk, equity may continue its current medium- to long-term downtrend. A market capitulation could provide an early signal for a market bottom and signal an end to the current downtrend. We continue to underweight equity (i.e., underweight risky assets in general). Cash (i.e., 3-month LIBOR), which currently offers 4.7% yield, may outperform risky assets if equity markets remain soft, and bond volatility continues.
Read more from MetLife
Disclosure
This material is intended solely for Institutional Investors, Qualified Investors and Professional Investors. This analysis is not intended for distribution with Retail Investors. This document has been prepared by MetLife Investment Management (“MIM”) solely for informational purposes and does not constitute a recommendation regarding any investments or the provision of any investment advice, or constitute or form part of any advertisement of, offer for sale or subscription of, solicitation or invitation of any offer or recommendation to purchase or subscribe for any securities or investment advisory services. The views expressed herein are solely those of MIM and do not necessarily reflect, nor are they necessarily consistent with, the views held by, or the forecasts utilized by, the entities within the MetLife enterprise that provide insurance products, annuities and employee benefit programs. The information and opinions presented or contained in this document are provided as of the date it was written. It should be understood that subsequent developments may materially affect the information contained in this document, which none of MIM, its affiliates, advisors or representatives are under an obligation to update, revise or affirm. It is not MIM’s intention to provide, and you may not rely on this document as providing, a recommendation with respect to any particular investment strategy or investment. Affiliates of MIM may perform services for, solicit business from, hold long or short positions in, or otherwise be interested in the investments (including derivatives) of any company mentioned herein. This document may contain forward-looking statements, as well as predictions, projections and forecasts of the economy or economic trends of the markets, which are not necessarily indicative of the future. Any or all forward-looking statements, as well as those included in any other material discussed at the presentation, may turn out to be wrong. All investments involve risks including the potential for loss of principle and past performance does not guarantee similar future results. In the U.S. this document is communicated by MetLife Investment Management, LLC (MIM, LLC), a U.S. Securities Exchange Commission registered investment adviser. MIM, LLC is a subsidiary of MetLife, Inc. and part of MetLife Investment Management. Registration with the SEC does not imply a certain level of skill or that the SEC has endorsed the investment advisor. This document is being distributed by MetLife Investment Management Limited (“MIML”), authorised and regulated by the UK Financial Conduct Authority (FCA reference number 623761), registered address 1 Angel Lane, 8th Floor, London, EC4R 3AB, United Kingdom. This document is approved by MIML as a financial promotion for distribution in the UK. This document is only intended for, and may only be distributed to, investors in the UK and EEA who qualify as a “professional client” as defined under the Markets in Financial Instruments Directive (2014/65/EU), as implemented in the relevant EEA jurisdiction, and the retained EU law version of the same in the UK. For investors in the Middle East: This document is directed at and intended for institutional investors (as such term is defined in the various jurisdictions) only. The recipient of this document acknowledges that (1) no regulator or governmental authority in the Gulf Cooperation Council (“GCC”) or the Middle East has reviewed or approved this document or the substance contained within it, (2) this document is not for general circulation in the GCC or the Middle East and is provided on a confidential basis to the addressee only, (3) MetLife Investment Management is not licensed or regulated by any regulatory or governmental authority in the Middle East or the GCC, and (4) this document does not constitute or form part of any investment advice or solicitation of investment products in the GCC or Middle East or in any jurisdiction in which the provision of investment advice or any solicitation would be unlawful under the securities laws of such jurisdiction (and this document is therefore not construed as such). For investors in Japan: This document is being distributed by MetLife Asset Management Corp. (Japan) (“MAM”), 1-3 Kioicho, Chiyodaku, Tokyo 102-0094, Tokyo Garden Terrace KioiCho Kioi Tower 25F, a registered Financial Instruments Business Operator (“FIBO”) under the registration entry Director General of the Kanto Local Finance Bureau (FIBO) No. 2414. For Investors in Hong Kong S.A.R.: This document is being issued by MetLife Investments Asia Limited (“MIAL”), a part of MIM, and it has not been reviewed by the Securities and Futures Commission of Hong Kong (“SFC”). MIAL is licensed by the Securities and Futures Commission for Type 1 (dealing in securities), Type 4 (advising on securities) and Type 9 (asset management) regulated activities. For investors in Australia: This information is distributed by MIM LLC and is intended for “wholesale clients” as defined in section 761G of the Corporations Act 2001 (Cth) (the Act). MIM LLC exempt from the requirement to hold an Australian financial services license under the Act in respect of the financial services it provides to Australian clients. MIM LLC is regulated by the SEC under US law, which is different from Australian law. MIMEL: For investors in the EEA, this document is being distributed by MetLife Investment Management Europe Limited (“MIMEL”), authorised and regulated by the Central Bank of Ireland (registered number: C451684), registered address 20 on Hatch, Lower Hatch Street, Dublin 2, Ireland. This document is approved by MIMEL as marketing communications for the purposes of the EU Directive 2014/65/EU on markets in financial instruments (“MiFID II”). Where MIMEL does not have an applicable cross-border licence, this document is only intended for, and may only be distributed on request to, investors in the EEA who qualify as a “professional client” as defined under MiFID II, as implemented in the relevant EEA jurisdiction.
1 MetLife Investment Management (“MIM”) is MetLife, Inc.’s institutional management business and the marketing name for subsidiaries of MetLife that provide investment management services to MetLife’s general account, separate accounts and/or unaffiliated/third party investors, including: Metropolitan Life Insurance Company, MetLife Investment Management, LLC, MetLife Investment Management Limited, MetLife Investments Limited, MetLife Investments Asia Limited, MetLife Latin America Asesorias e Inversiones Limitada, MetLife Asset Management Corp. (Japan), and MIM I LLC and MetLife Investment Management Europe Limited
