December 08, 2019
Fixed Income Outlook 2020: From Reset to Recovery
December 08, 2019
In our view, 2019 was what we call a “mid-cycle reset,” where the United States Federal Reserve (Fed) cut rates three times, capital expenditure bottomed out and global GDP slowed. The bad news going into 2020 is that yields are low and investors are long duration, a sizeable risk given that the Fed will likely stay on the sidelines and not lower rates in 2020. The good news may be that we get Research and Development and Capex as the cyclical sector of the economy seems to be bottoming. All told, we expect the Fed to let the U.S. economy continue to run hot in 2020, led by a modest cyclical recovery over the course of the year.
2019: A Mid-cycle Reset
Economics 101 teaches us that economies run in fairly predictable four-part cycles: Expansion, Slowdown, Contraction, Recovery, then back to Expansion. The timing of cycles varies across markets and sectors, but manufacturing and consumer confidence data makes it clear that the U.S. is in contraction territory as we close out 2019. Manufacturing is considered a reliable indicator for the health of the general economy and the ISM Manufacturing index in November 2019 was 48.1 and below expectations, where any data point below 50 represents contraction. Similarly, the Present Situation Index (PSI), based on consumers’ assessment of current business and labor market conditions, decreased for the fourth straight month.
After raising rates four times in 2018, the Federal Reserve cut rates three times in 2019 as part of their “mid-cycle reset.” The last mid-cycle reset was 1996, which may in fact be the blueprint for 2020. In 1994, after a series of rate hikes totaling 300 basis points, the Fed reversed course and cut rates three times from 1995 through January 1996. They referred to their actions as “insurance cuts.” The result? The U.S. Dollar (USD) weakened, U.S. Treasury yields rose and the yield curve steepened. Of note, cyclicals performed well in the midst of that synchronized global recovery.
2020: Cyclical Recovery
Given the current financial environment, we anticipate a cyclical recovery in 2020 for a number of reasons. As noted, manufacturing is in contraction but in the process of bottoming out. And while the ride to the bottom might be turbulent, we expect that things will turn around in the upcoming year. The global economy will have monetary tailwinds at its back. The U.S., ECB, Japan and China central banks were all accommodative in 2019, and monetary policy tends to take 6 to 9 to 12 months to wend its way through the financial system and get real traction.
It is our view that, given its soft policy in 2019, the Fed will be inactive in 2020, where the only deviation would be rate cuts in the face of economic trauma. But as mentioned, we think things have bottomed out for the U.S. economy, and it should be on the way for recovery in 2020. Capex, including tech spending, ISMs, PMI and productivity, are all on the rise. We expect inventories will rebuild and the Manufacturing sector will pick up slack from Consumer. While we are not overly bullish, we are certainly not negative. We believe the yield on the 10-year U.S. Treasury (UST) bottomed at 1.45% during the past year, where we would expect it to rise to 2.00%, maybe 2.25%, in 2020.
Lurking in the Wings: The U.S./China Trade War
The U.S./China trade war remains unsettled ─ and unsettling to global markets. While the Trump Administration does not appear in a hurry to finalize a deal (a negotiating tactic?), we envision an agreement by the end of this year, or early in 2020. However, if additional tariffs are levied against China before the end of this year, it is important to understand that those tariffs will not go into effect until 2020, essentially giving the parties more time to negotiate. While we sit in a “wait and see” mode, a miasma from the trade war has admittedly settled over the global economy.
Assets of Interest
High-quality duration assets performed exceptionally well in 2019, namely Investment Grade and USTs. However, we see that investors are overweight duration and need to look to less-sensitive interest rate plays. We see a value opportunity in manufacturing, namely autos, chemicals, transports and the like, where spreads are already wide, making these assets potentially less sensitive to interest rate movements. Given a sedentary Fed, we do not expect that interest rates will rise appreciably in 2020, creating an environment where these Single B assets will likely deliver better earnings, improve their creditworthiness and make for an attractive investment.
In High Yield, Double B performed well in 2019, but Triple C, especially energy, had a rough year. We do expect though that energy will stabilize in 2020. On a related note, Emerging Markets is an asset class we like in 2020, where an uptick in global growth, a slight softening of the USD, attractive coupons and a stabilization of energy will make certain of these markets compelling in 2020.
In summary, what was unique about 2019 was that central banks cut rates aggressively and pushed bond yields lower to avoid a recession ─ one that never materialized. This may have been an “insurance policy” well worth the premium. However, it created significant performance in interest rate-sensitive sectors of fixed income that may struggle if we get even a modest cyclical recovery in 2020. Said differently, yields are too low and spreads tight in perhaps all the wrong places. We believe the investment opportunity lies within a rotation to the cyclical and less rate-sensitive sectors of the markets, where valuations are, in our opinion, considerably more attractive.
Fixed income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Certain U.S. government securities purchased by the strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. High-yield securities (junk bonds) are lower-rated securities that may have a higher degree of credit and liquidity risk. Sovereign debt securities are subject to default risk. The currency market is highly volatile. Prices in these markets are influenced by, among other things, changing supply and demand for a particular currency; trade; fiscal, money and domestic or foreign exchange control programs and policies; and changes in domestic and foreign interest rates. Investments in foreign markets entail special risks such as currency, political, economic and market risks. The risks of investing in emerging market countries are greater than the risks generally associated with foreign investments. In addition to the risks associated with common stocks, investments in convertible securities are subject to the risks associated with fixed-income securities, namely credit, price and interest-rate risks. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation, and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk).