Outlook 2020: US multi-sector fixed income
- We think it will be important to tread carefully this year with valuations at high levels and fundamentals now seemingly deteriorating.
- Global growth may stabilise, but we see little chance of a material upswing. Yields are most likely to remain range-bound with the Federal Reserve on hold.
- We see some selective opportunities in lower-risk and more consumer-related credit, but remain cautious, retaining cash for when better opportunities arise.
If 2018 was the year everything went wrong for bond markets, 2019 was the year where everything went right. The Federal Reserve (Fed) reverted to easing mode, government bond yields collapsed, credit spreads narrowed and overseas demand for US assets was insatiable. Given the starting point, it is unlikely that fixed income returns in 2020 will come close to the double digits many investors have enjoyed this past year.
Our outlook last year painted a fairly compelling case for higher quality fixed income, for 2020 it is a little more nuanced. Government bond yields are almost half what they were in late 2018. Credit spreads - across both high yield and investment grade – are approaching multi-year lows. Investors need to tread carefully.
Valuations across a variety of asset classes, particularly credit, are approaching new highs while many of the fundamental drivers have been deteriorating. This creates an unstable equilibrium, suggesting the risk/reward balance in many assets is less favourable than it has have been in some time. Given this backdrop, we are more defensive across our portfolios. We believe significantly better opportunities to redeploy capital will arise in the coming quarters. Having ample liquidity to redeploy during periods of market volatility is one of the best investments we believe we can currently make.
Prices rising, fundamentals stalling – buyer beware
The continued largesse of central banks, and the increased global stock of negative-yielding debt, which peaked at $17 trillion in 2019, has driven this disconnect between valuations and fundamentals. An indiscriminate demand for debt with positive yields drove investors to US credit despite shrinking earnings, slowing growth, deteriorating corporate balance sheets and increasing political risk.
However, we may be approaching an endgame in this merry-go-round of perpetual accommodation and relentlessly higher asset prices.
Why? Central bank ammunition is running low. The negative consequences of low to negative rates is increasingly in focus, and returns for overseas investors are no longer compelling as the cost of hedging currency risk has risen. Additionally many investors are now buying assets unhedged, which makes demand increasingly vulnerable to any retreat in the dollar. This could prompt a rush for the exit.
Global economy stabilises but downside risks persist
Although the recession fears prevalent a few months ago may have subsided, downside risk to the US economy persists. Projected 2020 global growth will be close to the lowest level in the post crisis era. Any cyclical upswing next year is likely to be mild, as late cycle dynamics of rising wages, limited capex and geopolitical headwinds weigh on economic growth and sentiment. The already modest US growth remains vulnerable to an increasing reliance on US consumer strength and a positive resolution of trade negotiations. Should either of these factors deteriorate, US growth could be substantially weaker.
After three “insurance cuts” through 2019, the Fed hopes to have done enough to alleviate the headwinds weighing on growth, and the motivation to move rates in either direction from here seems low. However, with inflation absent, a strong dollar, and a deteriorating profit cycle, we think rates are more likely to go lower than higher.
We also expect range-bound bond yields over the next 12 months given the same rationale. Modest cyclical improvements may put some upward pressure on rates early next year, but the structural dynamics of growing debt, negative demographics and deflation remain relevant.
Patience is a virtue
If investing through a number of cycles has taught us one lesson, it is that stretching for risk when opportunities are limited rarely ends well. Prudence and patience remain the predominant themes within our portfolios, and allocations to higher rated liquid assets will enable us to take advantage of higher volatility and more attractive opportunities in the coming months.
Current risk/reward in credit assets has become increasingly asymmetric. Credit spreads have been wider than they are today approximately 90% of the time over the last 10 years. Even in the most optimistic scenarios, excess returns will be muted. Combined with unappealing fundamentals, central bank reliance, and a technical environment supported by foreign demand, the opportunity for upside appears limited.
The riskiest parts of corporate debt are flashing even stronger warning signs, with increasing stresses in the lower rated segments of both high yield and leveraged loans. When you scratch below the surface, the record highs for market indices may not be quite as healthy as they first appear.
This means credit risk is low and falling across our strategies. We see more value in securitized assets. Valuationsappear more reasonable, fundamentals are stronger and geared to consumers and they are far less reliant on the continued benevolence of European and Asian investors.
We have been reducing credit and allocating to mortgages. We think they offer more value historically and are geared to the improving consumer balance sheet rather than the corporate one, which is already carrying a lot of debt. The structural protection of the high quality securitized assets also offers significantly more stability in times of volatility. This is an easy relative value decision at this stage of the cycle, looking through our value lens.
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