Outlook 2019: US Multi-Sector Fixed Income
Boring bonds are back
The outlook may be uncertain, and there are clearly risks out there but high quality, liquid, US fixed income is beginning to look attractive on both an absolute and risk adjusted basis. We’re not pounding the table just yet but you should start thinking about good old fashioned fixed income being a bigger part of your 2019.
To be clear we don’t think it’s time to rush blindly to buy risk, but with short dated high quality fixed income offering returns that haven’t been seen in nearly a decade and corporate spreads no longer historically tight, at the very least, it is certainly time to start having the conversation about US fixed income.
Our outlook for the third quarter was a fairly negative piece offering little hope. To summarize it, the challenges faced by fixed income assets are not insignificant. The narrative of synchronized global growth has shifted downwards toward an expectation of a slowdown trend. The decade long support provided by central banks’ quantitative easing (QE) is largely behind us, and with it, the zero cost financing that inflated risk assets across the board. Corporate borrowing has increased significantly, the share of BBBs has ballooned and credit investors need to be paid more to take on those risks. Oftentimes in markets, patience and price are your strongest allies. This sentiment certainly rings true recently as market volatility has increased significantly, resulting in sharply lower valuations across the risk asset spectrum. It also rings true on portfolio positioning, as we began the de-risking process over a year ago based upon the view that valuations were stretched, fundamentals were peaking and the technical environment was turning less favorable. With investment grade corporate spreads approximately 50% wider year-to-date, it’s fair to say that having patience and conviction has been a virtue.
However, something material has changed since then—namely price. Corporate credit spreads have been widening all year, and the move in October and November was the largest two month increase since the energy/commodity related downdraft in early 2016. While fixed income assets have been cheapening throughout the year, corporate spreads are only recently now back to their long-term median levels. While we believe that this correction will continue, recent volatility has led to more interesting relative value decisions within the corporate market as we have seen a wider degree of sector and issuer dispersion. One area that we have become more favorable on is mortgage-backed securities, which presently offer better liquidity and credit characteristics than corporates, and a higher current yield than comparable-maturity Treasuries.
Where do we go from here?
The US economy remains healthy; however the combined impact of higher rates, a stronger dollar and the end of global QE policies has been a toxic combination for risk assets. While markets continue to grapple with questions regarding the global growth outlook, the impact of tighter financial conditions and the end of the easy liquidity regime, we remain steadfast in our focus on valuations. Our view is that valuations across most fixed income sectors, despite having cheapened, remain expensive, particularly in corporates. The strategies that have served investors well in the QE era, in our view, are unlikely to succeed as we move further into an era of quantitative tightening (QT). Despite this year’s sizable correction, credit spreads have only shifted back to their historical averages. But given the technical and fundamental headwinds, this is not yet a significant enough move to increase our risk stance….yet. The technical environment remains challenged as the supply of risk-free assets remains high and is increasing while non-domestic investors—a recent buyer of such US debt—continue to look away from the US due to the prohibitively high hedging costs. We are especially concerned given the environment where corporate debt is close to a record high as a proportion of GDP and balance sheet leverage remains elevated.
What about rates?
Markets love a topic du jour and the current market focus is related to the yield curve, specifically the inversion that has occurred between the 2-year Treasury yield and the 5-year Treasury yield. The spread between these two interest rates is currently trading at a negative level, meaning that one could buy a 2-year Treasury at a higher yield than a 5-year Treasury. This is unusual behavior as one would expect longer maturities to yield more than shorter maturities (e.g., an upward sloping yield curve). Yield curves historically have been a reliable indicator of when the economy has passed it peak growth phase, however the timing of when an actual downturn occurs is somewhat less illuminating. Although it should not be ignored it doesn’t necessarily portend an imminent recession. Observing 40 years of history suggests that peak S&P levels occur 22 months after the first curve inversion and recession occurs on average 27 months after the first inversion. Will we go into to recession in the future? Absolutely. Is it going to happen soon? Not necessarily. Further, very few economic metrics are indicating a recession any time soon. While the leading economic indicators look to have peaked, they remain elevated in any historical context. Job creation remains robust and business sentiment indicators suggest continuing optimism. Despite this economic backdrop, rates markets now believe that the rate hiking cycle will conclude in the middle of next year at a terminal rate of approximately 2.50% (approximately one more rate hike from the present level). While we expect that the Fed will be more data-dependent as the cycle continues, rather than automatically hiking rates 25bps per quarter, we believe that the data is sufficiently strong to warrant more hikes than the market is currently discounting. This sentiment was echoed recently by Fed Vice Chairman Richard Clarida, who cautioned investors against thinking that the Fed would act to halt a decline in risk assets. This is all to say that while we believe the rate of growth in the US is slowing, this cycle is far from over and moves to price an imminent end of the rate hiking cycle should be faded.
Will long-maturity Treasuries provide an easy hedge against my risk assets?
For institutional investors, unfortunately, the answer to this question is not clear cut. Looking at the peak to trough period for equites in 2018, which occurred between mid-September and mid-December, the S&P 500 Index was down just over 10% while long Treasuries have only generated 1.8% in total returns, providing minimal protection from the equity downturn. Our suspicion is that all of the historical examples of long duration providing significant positive returns during times of equity weakness were from periods of much higher Treasury yields. In the event of a significant crisis, we think duration will help, but during more modest equity market corrections we are less convinced, based merely on the level of current yields.
The question asset allocators need to answer is whether or not the interest rate volatility at the long end is worth it while you wait for the next crisis to materialize/emerge. On balance, we think it may be more suitable now to position for capital preservation in a short/intermediate strategy which currently offers yields close to 4%, with lower interest risk on the basis that a correction is more likely than a crisis.
One of the advantages of writing a year-ahead outlook is that it forces us to take a longer-term perspective while watching markets turn themselves inside out. We think it’s just human nature, but many investors seem unable to move beyond the market volatility of November and early December and see the opportunities that have arisen as a result. We think high quality, short duration fixed income is attractive and we are getting closer to becoming constructive about fixed income more broadly, especially if things keep getting cheaper. Either way, it’s time to start having that conversation.
The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.