So, when you think about the end of 2021, and looking forward into 2022, we’re reasonably optimistic about the backdrop. Growth should be set up pretty well for 2022.
We are optimistic about a couple of different sectors—not just developed-market corporates, high yield, US and Europe. We’re also optimistic about emerging-market (EM) assets, with a strong preference for dollar-denominated—or what they call hard currency—EM sovereigns and EM corporates.
[In] the sovereign space, we have a strong preference for BB- or B-rated sovereigns because of the valuation that’s currently offered. And the tailwinds that we’ve seen from strong growth we think should continue, especially as the vaccine rolls out globally. Trade is starting to pick up globally. We also think the Biden administration will be much more supportive to our trade partners globally. So, it should be supportive for emerging markets.
On the corporate side, we have a preference in between investment-grade and high-yield rated debt. So, we’d like both EM corporates that are BBB-rated and BB-rated. Spreads aren’t quite as attractive on the corporate side, but the diversification offered allows us to build portfolios with an attractive income, strong liquidity and price appreciation potential if emerging-market growth does show as strong as we or others expect for 2022. Within the developed-market corporate space, we still like US high yield, even though spreads are well below long-term averages. We think there’s limited downside in high yield, specifically because the average credit quality of the US high-yield market has increased markedly in the last 18 months.
When we think about securitized assets, there’s two key categories: one, commercial real estate; and two, residential real estate—two totally different positions in the capital markets today.
On the residential side, fundamentals are extremely strong. The securities that we like are floating rate [in] nature. They’re loans that have been provided to homeowners who have lots of equity built in. So, in the last 18 months, we’ve seen strong house price appreciation. We expect that to continue.
That contrasts, though, when we compare that to the commercial real estate side. Investors are still nervous that the commercial real estate side in the US has not fully opened up. Investors are primarily worried about two key portions—retail and lodging. We look at the prices on those two sectors and see that upside/downside for those two sectors look extremely attractive. The loss-adjusted yields, even in a bad environment, are offering an opportunity for investors who can hold for the next 12 to 24 months—returns of potentially between 8% and 10%. We think that’s pretty attractive.
When we think about risk, a few things that are front and center are:
1. How aggressively is the Fed going to raise rates to combat inflation and inflationary expectations. Our expectation for core CPI next year is between 2.5% and 3%. We believe the Fed should raise rates, later, in 2022. We’re also watching inflation expectations. And if consumers or corporations begin to change their actual behavior—meaning spend more now because prices are going to rise in the near future—then the Fed will also need to react with faster and more rate hikes. That’s not our base case view.
2. The second risk to focus on would be China economic growth—and the China property sector, specifically. At the moment, China housing makes up almost 29% of their economy and has driven a lot of the growth since the global financial crisis. And, with the housing market coming under pressure, the negative impact to their economy has investors somewhat concerned. We didn’t have very much direct exposure at all coming into 2021. But at the moment, with where bonds are priced in China property specifically, we’re starting to find that as an attractive opportunity to generate income for our clients. We believe that China property is a systemically important industry and that policy support is forthcoming, even though it’s taken longer than investors would’ve liked to have seen.
For 2022, we’re optimistic about our credit barbell strategies. US Treasury yields have increased, and we think this is an attractive time to start adding modest amounts of duration to balance out the credit risk that comes from developed-market credit—both in the US and Europe.
When you build a portfolio that balances those two key risks—duration with credit risk—you can offer a majority of the income that you would earn just investing in high yield with much better drawdown characteristics, very strong liquidity prospects, and the ability to rebalance if and when spreads actually do reprice at some point. So, you can earn most of the yield with much smaller drawdowns [and] much less volatility in stress markets. This is a good environment for the credit barbell strategy.