January 15, 2020
Living the High Life Again…but for How Long?
January 15, 2020
December provided a remarkable ending to a remarkable year. The world’s problems seemed to recede as financial markets melted up. While government bond yields continued to rise for the fourth month in a row following better economic news (and more importantly hopes!) and reduced trade tensions, corporate bonds — both high yield and investment grade — saw meaningful tightening of spreads as did many emerging market bonds. The U.S. dollar reversed course, falling significantly on a trade weighted basis as well as against most individual currencies. The performance of high yield was particularly notable, generating the third best monthly performance this cycle. Most impressive was the performance of previous laggards, CCC-rated bonds and the energy sector, with each returning over 5% for the month. How much of this was a one-off due to December illiquidity and how much a start of a new trend remains to be seen.
One should not expect this Christmas present to investors to repeat itself in 2020. Optimism grew and data improved; and trade war concerns seemed to have peaked. And, most importantly, the monetary easing seen in 2019 will likely not be repeated. Indeed, one of the risks for 2020 might be a surprise rise in inflation. Moreover, risk events are still out there: renewed Middle East tensions, Trump’s impeachment, disappointing business confidence data, particularly in the U.S., and U.S./China trade, to name just a few examples. While we do not think these issues are likely to change the direction of the global economy, we do not think there is a lot of upside for financial markets in the near term, given current asset prices. A focus on security selection remains of paramount importance to take advantage of pockets of opportunity and avoid overvalued sectors/countries.
Note: USD-based performance. Source: Bloomberg. Data as of December 31, 2019. The indexes are provided for illustrative purposes only and are not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See below for index definitions.
Source: Bloomberg. Data as of December 31, 2019. Note: Positive change means appreciation of the currency against the USD.
Source: Bloomberg, JP Morgan. Data as of December 31, 2019
Fixed Income Outlook
December’s returns added to an already stellar year. Only developed-market government bonds sold off in December, as one would expect given the improving economic data and renewed optimism that the economic malaise that had consumed the world for the past two years was coming to an end. Indeed, if we view the last two years as a “mini” recession, this economic expansion is not 10 years old; it could be much younger! While that is a bit of an exaggeration, it does point out that the economic data could improve for several years, like the late 1990s and 2005-2006.
Corporate bonds of all flavors had outsized returns in December, particularly CCC rated bonds and energy related companies. In many ways this was understandable given their poor performance in November and for the year as a whole. The U.S. dollar also sold off notably, but for the year as a whole the currency still appreciated, on a trade weighted basis. A weaker dollar would be a welcome development for the global economy and hopefully a harbinger of good news on the trade front in 2020. But with a mercurial President Trump still directing policy, there are reasons to be cautious, with renewed Middle Eastern tensions certainly a reminder of potential pitfalls in the months ahead.
December’s Christmas present to investors should not be construed in general as a down payment on further gifts. Credit spreads have tightened closer to cycle lows without a lot of “new news” in December. Most bonds, both government and corporate, do not appear “cheap.” That makes us a bit nervous about the market’s ability and willingness to absorb supply in Q1. However, this does not mean we are bearish as fundamentals are quite solid. The general macro environment is improving, absent some surprisingly weak US business confidence indicators (e.g., the ISM and CEO confidence indicators). This makes us more confident that global yields have bottomed and credit is well supported, albeit on the expensive side of fair value. With central banks likely to be firmly on hold in 2020, lagged effects of monetary easing should still support the economy. Fiscal policy is likely to be neutral to easy, inflation stable to slightly higher and the environment is likely to be positive for nongovernment bonds. But we would like to see wider spreads, and/or even stronger fundamentals, before increasing risk exposure further to credit. A small credit long, based on solid and/or improving fundamentals, a more meaningful EM long and modest underweight interest rate risk (concentrated in the US, core Europe, Japan and UK) look appropriate.
For the first time in a while, U.S. exceptional economic and financial market outperformance is abating. It is not yet clear if this will be a 2020 trend or merely a blip, but, it does bode well for a weaker dollar story and stronger emerging market (EM) currencies, the largest laggards in 2019. EM FX is one area where we are comfortable holding more risk as we enter 2020.
In summary, fundamentals are good; government bonds look rich but are supported by still accommodative central banks; credit spreads seem expensive; and emerging markets generally look like a better value than developed markets. For spreads to rally further we will require good economic data, confirming the current optimism, and confirmation that central banks will not rescind on their wait-and-see strategy; holding back on tightening policy until inflation rises to, or above, target levels. The least vulnerable area of fixed income remains securitized credit which seems immune to many of the forces potentially buffeting financial markets given the strength of the household sector, although, even here, after a strong 2019, valuations are no longer exceptionally attractive and are unlikely to repeat 2019’s performance.
Developed market sovereign bond yields rose once again in December, particularly in Australia, New Zealand, and Canada.1 Markets reacted positively to progress around geopolitical risks such as Brexit and the U.S. - China trade negotiations. On the central bank front, the European Central Bank and Bank of Japan are set to continue their purchase programs of fixed income assets through 2020, albeit at a slower pace. In the U.K., the Conservative Party achieved a significant victory at the December elections, winning 364 out of 650 seats and a far larger majority than was anticipated. This result means that the incumbent PM, Boris Johnson, now has a strong mandate to govern the country and negotiating the UK’s exit from the EU. Andrew Bailey was announced as the new Governor of the BoE, to replace Mark Carney who steps down at the end of January.2
Challenges remain to global growth in 2020. Central banks have become more accommodative, particularly in the U.S. and Eurozone, but further accommodation is unlikely unless the growth and inflation outlook deteriorates. Despite recent positive developments, the three major risks we see to the outlook remain Brexit, the U.S./China trade disputes, and the weakness in the manufacturing and trade sectors undermining the consumer sector.
Risk sentiment improved as a “phase one” trade deal between the U.S. and China appeared to be in the making. EM currencies strengthened versus the dollar, leading the way for EM fixed income. Dollar-denominated sovereign debt outpaced corporate debt as both segments were driven by higher-yielding countries and companies. Commodity prices also rose in the period with broad gains in energy, metals, and agriculture products.3
Our baseline scenario envisions a global economic backdrop only marginally better than in 2019, thus leaving global monetary policy accommodation largely in place. Though we see a widening emerging market (EM) - developed market (DM) growth differential supporting EM assets, we expect EM fixed income to deliver more subdued returns relative to 2019, given our views on current valuations and limited scope for aggressive monetary policy accommodation in the developed world.
December saw corporate spreads tighten in the U.S. and in Europe. Risk free yields ended the month higher, continuing the post-summer trend: the U.S. 10-year closed 10bp higher at 1.88%, and the German 10-year closed 18bp higher at -0.19%4. The key drivers of tighter spreads in December were (1) a U.S./China “phase one” trade deal being reported; (2) a Tory victory in the UK election, potentially reducing BREXIT uncertainty; (3) macroeconomic data continued to stabilize with economic surprise indices ticking higher, especially in the Eurozone; (4) minimal negative corporate news; and (5) Little supply in a month of strong demand.
We expect 2020 to be a year of two halves with credit initially well supported by the improving economic backdrop, reduced political risk and strong demand for credit. As we move to the second half of 2020, we expect the uncertainty experienced in recent years to repeat, impacting confidence that the economy is rebounding. Whether the cause is fear of a recession, political volatility, or liquidation of credit positions creating a weak technical, we believe the result will be a year of two halves that warrants active management of credit, and reducing risk following periods of spread tightening by rotating to higher-quality, shorter-maturity credit.
Securitized market activity was fairly quiet in December, and securitized assets generally performed well during the month. Consumer credit conditions remain especially healthy, with historically low unemployment, rising wages and healthy spending rates, and increasing home sales which are being supported by low mortgage rates.
We enter 2020 with a positive outlook for securitized market opportunities. Agency MBS has cheapened meaningfully over the past two years and looks attractive on a risk-adjusted basis for the first time in many years. Securitized credit opportunities also look attractive as fundamental credit conditions remain very positive for residential and consumer lending markets in both the U.S. and Europe. Securitized markets performed well in 2019, but still underperformed corporate credit markets due to less benefit from the rally in interest rates and less spread tightening relative to corporate credit markets in 2019. We believe returns in 2020 will be driven more by cash-flow carry and fundamental performance rather than a general decline in yields. With this backdrop, we expect securitized markets to outperform in 2020, given the wider risk-adjusted spreads, and lower duration-risk profile.
1 Source: Bloomberg, Data as of December 31, 2019
2 Source: Bloomberg, Data as of December 31, 2019
3 Source: JP Morgan, Data as of December 31, 2019
4 Source: Bloomberg Barclays, Data as of December 31, 2019
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. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default, and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. 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. 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). Due to the possibility that prepayments will alter the cash flows on collateralized mortgage obligations (CMOs), it is not possible to determine in advance their final maturity date or average life. In addition, if the collateral securing the CMOs or any third-party guarantees are insufficient to make payments, the portfolio could sustain a loss.