The Year Ahead: 2023 Fixed Income Market Outlook

Guest post by: John Hallacy, John Hallacy Consulting

Most Important Factors for 2023

Market activity was greatly influenced by macro factors last year and will continue into this year.

We all are inclined to take up the art of soothsaying this time of year. We feel a certain kind of pressure to review the recently completed year to focus on the key takeaways for the new year. Many are judged specifically on the results for the last year’s performance. In a down year such as the one we have just concluded, it does not feel especially rewarding to beat the negative results by just a tad.

We need to forge ahead in a clear-sighted way. Examining the record at a minimum gets us sharply focused on where we might be able to do better. In the past year, macro factors appear to have mattered the most. We cannot discount the importance of micro factors or fundamental analysis as it stands. As much as we adhere to the latter, it just did not seem to be as important last year. We know this will change especially as earnings begin their descent next year as the economy slows.

The goal herein is to spare you of the pedantic approach but just to share our views on the important factors. The following flagged items continue to merit time and attention to glean some insight on direction and the implications for the fixed income markets.

The Fed

The Fed actions have been the single most important factor in market activity this past year and will continue to be in 2023.

In the past year, we have spent more time collectively pondering what the Fed’s next moves will be than what we are eating for breakfast, lunch, or dinner. However, these latter decisions are important due to the role of inflation. The Fed’s primary goal is to wrest inflation to a desired stated level of 2% than where it is at present.

We have been informed repeatedly that the Fed will not lose focus until we return to 2% inflation. That stated goal appears to be relatively far off in the future. But steering inflation on a downward trajectory is most important. Given there have been some actual higher surprises than anticipated, we do appear to be making progress on the descent of inflation.

Most pundits now believe that we will be well past the terminal rate of 5.1% or more. The tightening in December of another 50 basis points is certainly destined to be accompanied by future rate hikes. We may debate whether the next increase or increases may be 25 basis points or more, but what is not entirely clear is just how many hikes will suffice. Many believe that at the next several meetings we will have additional tightening moves and then there will be a pause to gauge the effectiveness of the aforementioned increases.

We have two Fed meetings in the first quarter, and many believe that any potential pause will ensue after those meetings.

The Economy

The economy remains strong but is showing some signs of slowing down. The anticipated lower level of corporate earnings will affect growth over the course of the year.

The number of job openings continues to be relatively high at over 10 million but know there is more debate about whether some of these openings will be pulled before they are filled. There is also wide acknowledgment of the mismatch between skills and the openings.

New hires continue a pace at over 200,000 per month. The Fed purportedly would like to see that pace to be more in the 100,000 range in order to bring about the “soft” landing without the onset of a recession. Many observers hope and desire that this may be the result, but most acknowledge that avoiding a recession requires a deft hand and a modicum of luck.

Earnings from wages at over 5% remain strong and have not slowed appreciably. This status has supported strong consumer behavior but there are signs of some slowing in purchases. Since the economy is supported by consumer behavior accounting for some 70% of activity, tracking retail activity will remain in the foreground.
The unemployment rate has been stable at 3.7%. When this level starts to ascend, many will be attuned critically to the prospects for the highly anticipated recession.

The Yield Curve

Higher rates create opportunities for investors, but the inverted yield curve foretells recession.

No matter what favorite spread is selected in Treasury levels, the yield curve stands inverted. The inversion of the yield curve is the most reliable early indicator of a recession. The 3-month Treasury stands at 4.303% and the 2-year stands at 4.42% compared with the 10-year at 3.878% as of this writing. There is every reason to believe that the spreads to the 10-year will continue to widen holding other external factors constant. It does not appear that the spread of 43 basis points between the 3 months and the 10-year Treasury suffices to call a recession, but it is certainly signaling the yellow light.

The select fixed income markets have not moved in lock-step fashion with increasing Treasury yields but have been relatively correlated with them. Part of the nuance of rate activity in each discrete market has been affected by the supply and demand of paper in that market.

New Congress

The House majority is signaling that the direction of fiscal policy will be changing with a focus on reigning in spending.

The new Congress is now seated, and the leadership slots are to be filled. Clearly among the changes, the most important one in terms of future direction is the House will now be led by Republicans. Fiscal policy has been especially important to the successful recovery from the pandemic. Although Covid and its variants have not been completely eradicated, most concede that the large numbers of illnesses and deaths are now behind us. The spending plans that were enacted had their intended salutary effect on the economy.

One may clearly debate whether there was too much or too little largesse bestowed on the citizenry from these programs.

The party in power in the House has put all interested parties on notice that the spending of the recent past will not be continued. Many observers expect that gridlock will be the order of the day. But there will be a great deal more pressure to alter the balance between domestic and other spending. Which leads us to the next topic.

Debt Ceiling

Raising the debt ceiling must be accomplished to avoid a default but any agreement is likely to be accomplished with some new spending restraints or reductions.

The Republican side of the House has made it explicitly clear that there will be no increase in the federal debt ceiling unless spending concessions are made on the domestic spending side. This posture appears to the critical factor going into the debate. The Treasury Department is skilled at buying time by using various techniques to extend the period before action must be taken, but there are limits to these moves.

Most observers believe that action must be taken earlier in the year. We just passed the federal budget through this fiscal year end which serves to take some of the pressure off. However, delaying any action due to gridlock always raises the specter of a default on the debt of the United States that would roil markets across the globe.

We have acute memories from 2011 when real fear was building about the commitment to the federal debt. There were many conference calls with Asian investors into the wee hours in the U.S. about this topic. The downgrade of the credit of the United States by S&P was a seminal event even though markets were not very affected. What is more important is that once a rating has been lowered from the pantheon of AAA, any future rating adjustments possible are much easier to accomplish.

Other Notable Factors

Many other factors are likely to impact markets including regulatory matters, climate change disclosures, and ESG designations among others.

In a brief report of this kind, it is quite challenging to bring all the risks forward for consideration. There are many.

• Regulatory risk is always front and center in an ongoing way. A lot of the attention has been focused on cryptocurrencies of late. But there are many areas of focus. In the municipal market, implementation of a reporting standards update among other topics will be considered. In all markets, how to disclose the potential impacts from climate change are being closely monitored. New standards when fully adopted will require more time and attention.
• Natural hazards and weather events have become more widespread over the last decade. One may spend time debating the science of the origins, but we have become all too familiar with the outcomes. Droughts, floods, hurricanes, blizzards, and many other events are ripe for consideration. Private insurers have been compensated to cover a good part of the risks involved but there is always consideration of the “insurer of last resort”. FEMA and other government insurance programs also have their limits.
• ETFs and Mutual Funds always command a certain degree of attention. Withdrawals of assets from mutual funds and the gaining of assets by ETFs is a topic on its own. We expect that ETFs will be more of a focus in the days ahead simply due to their ability to attract large amounts of investor’s assets.
• ESG investing has grown in prominence over the last several years. The growth in ESG product has been the result of demand pull by investors. The tracking and compliance of ESG credits to their own standards has been a topic of elevated discussion. Does an outside certification process provide an additional layer of protection? In Corporates, outside certification bears little to no debate while in the municipal market there is a great deal of debate about the relevance. Some of these matters may be reduced to the essential consideration of cost but is not the only element in the consideration.

Notes on the Markets

Municipal Market

With elections behind us and the prospect that rates will continue to rise, the municipal market should have a moderately improved year. Credit has been stable but there are some early signs of budget pressures that should be heeded.

The municipal market had similar challenges that other fixed income markets had in this past year. The losses for the year amounted to over 8% – not as negative as for some of the other markets. Supply and demand played a large part in the outcome. Supply was lighter than in years past and was particularly lighter than 2021 when much lower municipal rates prevailed. Supply for the year totaled $384 billion or much lighter than the many years of $400 plus billion.

Retail buyers also had a strong influence. Many were staying shorter on the curve even though rates were quite low. The municipal curve largely remained positively sloping while the Treasury market inverted. Municipal appetite increased as rates climbed.

Especially after the rate hikes of the summer months, demand for municipals improved as supply attenuated. Issuance in December was only $17 billion or down from $40 billion in the same month in the prior year.

Forecasting supply next year is always perilous. Yet, many must engage in the exercise. I am in the camp of $400 billion plus or minus $25 billion for the year. Rates may serve to hold some projects back. Federal infrastructure money may finally start to flow as projects move beyond the initial design and approval phase. Although federal funds will be providing the lion’s share of the financing, we still believe that the municipal side will need to provide some match funding and some companion funding. For this reason, we are cautiously optimistic about the tone in the municipal market in this year. Some major projects will be gearing up for the activity phase such as the Gateway project. A handful of mega projects can make a meaningful difference to the supply dynamics.

We would anticipate a lot more supply out of select states such as California where issuance was down by 45.8% for this past year.

ESG will remain a bit of a battleground from a political standpoint. But I expect that the buyer demand will remain key to the outcome for most states. Let the free market work.

We are not concerned about the municipal tax exemption at the present time, but a new Congress provides another opportunity to reconsider the status. Bringing back advanced refunding is a goal of many in the market that continues to be somewhat elusive due to budget scoring.

Emerging Markets

Sensitivity to the dollar and to the price of oil has contributed to a volatile market.

Emerging markets have had a challenging year with losses more than 15% in this past year. The strength of the dollar has made the issuance of dollar denominated bonds and local denominated bonds that are hedged more expensive to issue. Although there can be outsized returns in this segment, we would urge proceeding with caution. One bright spot is the oil sector. Oil prices have been subject to a great deal of volatility but to the extent the price stabilizes at a higher level, the oil producers in the EM should improve their economies to an extent.

Corporates and Taxables

Corporates have benefitted from a relatively strong economy and have had solid earnings. Investors are more defensive and are supporting high grades. Rising rates will continue to affect the housing segment of the market.

In some respects, despite all the crosscurrents in the markets, we should return to the pace of a more average year. M&A is showing some signs that it may be picking up because there are some good values out there. Debt is often part of the financing package in an acquisition, but it has been a more minor contributor of late. Spreads have not widened appreciably despite the increasing recession risk. One trend is clear, investors are becoming more credit quality conscious and the risk appetite is turning a bit more conservative. Ratings in corporates have been relatively stable with some exceptions.

What is different this time before the highly anticipated recession is that corporate balance sheets are relatively strong. Many companies have ample cash on hand that provides a lot of financial flexibility and provides the ability to move quickly on any advantageous acquisitions or expansions. However, the strength of the economy will dictate how activity will be achieved with cash or bonds. If the cash sits on the balance sheets very long, the prospect of stock buybacks goes up instead of pursuing another project.

MBS will continue to be affected by the higher mortgage rates. The unwinding of the quantitative easing has the potential to be more of a factor but the unwinding has been orderly so far.

High yield has had good performance of late. An onset of a recession would be expected to increase the default rate that has been relatively tame in this cycle. We think high yield will continue to generate a lot of interest and there is likely to be more transactions until the economy turns.

Conclusion

We look forward to a more average year in the markets with some readiness for shocks or surprises. Technology for the markets continues to improve and serves to lower the costs of doing business.

We believe there will be a lot of opportunities in fixed income this year as rates continue to rise and credit spreads are poised to widen appreciably. The goal of monetary policy is clearly focused on bringing inflation down. On the fiscal policy side, we are likely to witness some more restraint than in recent years with the change in leadership in the House.

Technology in fixed income markets continues to advance and improve. AI, blockchain, and an array of bespoke technology solutions will continue to contribute to lowering costs in the fixed income universe.

More about John Hallacy

John is an accomplished municipal and fixed income analyst, respected and recognized by the industry with over 35 years of experience at major financial firms including S&P’s Global Ratings, FGIC, Bond Investors Guaranty, Merrill Lynch, MBIA, Bank of America, Assured Guaranty, and most recently The Bond Buyer. A leading expert in state and local fiscal affairs. John’s experience includes ratings, insurance, public finance and sell side research.

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