Agency MBS is one of CIO's top recommendations in the coming year. (UBS)

While a hard landing is not CIO’s base case, we anticipate slower growth in 2024. Given the outperformance of sectors such as HY and senior loans in 2023, the compensation provided to investors at this stage of the cycle does not warrant a most preferred allocation to these sectors. We remain in higher-quality sectors, especially those whose performance has lagged behind in 2024.

Agency MBS is one of our top recommendations in the coming year. While spreads over Treasury compressed from 190bps in October to 136bps by end-2023, the spread pickup for agency MBS—a risk-free credit asset class—remains nearly 40bps higher than BBB IG corporates. As 30-year mortgage rates fell from 8.01% to the mid-6% level, home purchase applications have risen. While affordability will likely remain an issue in 2024, it should be less of a headwind as rates decline and supply increases. With slower economic growth ahead, the enhanced quality and liquidity of agency MBS should drive returns.

Also, while volatility should remain prevalent at the beginning of the year, we expect it to decline as more economic data paves the way for a clearer Fed path. The Fed’s rate cuts could either be “maintenance cuts” (with inflation trending lower and growth moderating but staying above-trend) or “prevention cuts” (where the economy may be heading toward a hard landing as the labor market falters). While we believe in the former, either outcome should lead agency MBS to outperform those sectors with embedded corporate credit risk. We also expect the Fed will end its quantitative tightening policy, another tailwind to agency MBS performance.

We are watching the CMBS market closely. While BBB CMBS versus HY spreads are at historical wides, the negative headline risks that permeated the CMBS market in 2023 have begun to subside. Again, we are focused on the fixed income component of the capital structure, not pure commercial real estate (CRE) equity. We think higher-quality CMBS offer value for investors with a longer-term investment horizon.
While cheap, we think this is a soft-landing trade, and the volatility of risk within the CMBS asset class should not be overlooked. While lower-quality BBB CMBS can be attractive for investors with a higher risk tolerance, we prefer higher quality until we see the benefits of lower rates without a hard landing.

Main contributor: Leslie Falconio

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