An October to Remember
November 12, 2018
The month of October is infamous for market volatility and this past October lived up to its reputation. Indeed, it has been referred to as “Red October.” Most surprising was the inability of U.S. Treasury yields to rally (move lower) despite the dislocations occurring in equity markets. While credit markets were not as negatively impacted as equities, they sold off in sympathy. Despite very weak asset markets and dire pronouncements about the impending end of the expansion, we are more sanguine. We do not think this is the beginning of a broader bear market in fixed income and we expect markets to improve, if gradually. U.S. Treasury yields are closing in on their likely peak; U.S. economic data is likely to remain firm, if a bit softer than the blistering pace of the last two quarters; the U.S. Federal Reserve (Fed) will continue to hike interest rates but is likely to stop tightening in 2019; Chinese stimulus will hit the global economy; and emerging market (EM) economies should stabilize. The U.S. dollar seems to have made a local peak (although we would emphasize the word “local” for now), also a good sign for EM and the global economy in general.
A notable development in October was the impressive ability of U.S. Treasuries NOT to rally, e.g., see yields fall, despite the selloff across equities and credit markets. Despite an approximate 10 percent selloff in equity indexes, U.S. Treasury 10-year yields barely dropped 10 basis points and have since rebounded higher. Another surprise is that U.S. 10-year real yields, as measured by TIPS (Treasury Inflation Protected Securities), rose above 1.00 percent by the end of October, which breaks to the upside of their post-crisis yield range. The implication is that the U.S. economy may be growing stronger for longer and/or the Fed is going to have to push up short-real rates to slow the economy enough to prevent inflation from rising too far. Interestingly, core European government bonds, despite much lower yields, were able to rally in the face of lower equities and wider credit spreads.
Credit markets followed equities lower and October witnessed a notable widening in spreads. This widening seems a bit overdone considering solid economic and corporate fundamentals. As such, we expect a recovery/stabilization in risk sentiment into year’s end and possibly a narrowing of spreads. High-yield bonds had outperformed other fixed income sectors this year so it was not surprising that the market struggled until the last few days of the month. Again, the selloff looks overdone and we expect to see some rebound (tightening in spreads).
While it is difficult to know exactly what the fed funds rate peak will be, we are comfortable thinking that current market pricing is not too far off, e.g., a 3.25-3.5 percent level. This creates a center of gravity for U.S. rate markets to revolve around. A bold guess might be that U.S. Treasury 10-year yields peak around 3.5 percent. Only negative inflation surprises likely could drive it much higher, a development we do not expect, at least at the current time.
From an investment perspective, we remain biased toward positions that can benefit from still-strong economic growth and low default probabilities. With the widening of spreads this year we think the probability of excess returns has increased and with equities well off their highs, future volatility from that direction is unlikely to be negative. Assets we like both in the U.S. and Europe are non-agency mortgages, high yield and a select portion of investment grade credit, namely financials.
As we look outside the U.S. and Europe, we see improved opportunities in EM. Valuations have improved substantially this year and actions in most countries have been in the right direction. We believe it will only take the absence of bad news, not necessarily more good news, for this asset class to perform well in the fourth quarter and into next year. Small improvements in the Chinese outlook as well as stabilization in U.S. rates and the U.S. dollar will likely create a much more benign external environment. EM could be one of the better-performing fixed income sectors in the remainder of the year.
Euro markets still need to contend with political uncertainty in Italy. We believe there will be a rational outcome, with the European Union (EU) and Italy coming to an agreement over fiscal policy, but the political will to execute is still lacking. It may require a more “crisis”-like environment to get the respective parties to compromise. In the interim, it will be difficulty for European credit markets to rally.
Broadly, we do not expect a continuation of October’s performance in the months ahead. Except for U.S. Treasury yields, most fixed income sectors look oversold. That said, uncertainties surrounding U.S.-China Trade, Italian fiscal issues, Brexit, Chinese stimulus and over the likely direction of the U.S. dollar will keep gains muted for the time being. But with U.S. Treasury yields ever closer to their peak, we are optimistic that fixed income returns will improve in the months ahead.
Monthly Review: In October, risky assets sold off again, driven mainly by DM equity markets. As a result, yields in Germany and other core Euro areas fell. German bunds yields fell 5-10 basis points and U.K. bonds rallied 5-15 basis points across the curve. However, U.S. yields continued their seemingly inexorable rise, with U.S. Treasury 10-year yields up 8 basis points and 30-year bond yields up 19 basis points, steepening the yield curve. Italian government bonds sold off another 28 basis points on the long end of the curve as tensions over budget negotiations continued to rise. Impacts on other peripherals were mixed with Spanish yields up 5-10 basis points across the curve; Portugal bucked the trend, with short maturities rallying around 5 basis points and only marginal increases on the long end.1
Outlook: We believe the Fed will continue its gradual rate-hiking strategy in 2019, allowing a modest inflation overshoot. Recent meetings showed that the Fed reaffirmed its plan to hike interest rates three times in 2019, and the market is coming around to this view, given recent firming pressures in wages and business confidence. As for U.S. 10-year Treasury yields, we believe they will be confined to a 3-3.5 percent range. As we have previously noted, Japanese Government Bonds (JGBs) have served to help anchor yields worldwide (as has European Central Bank (ECB) quantitative easing (QE)). A wider band for JGB trading, as the Bank of Japan (BoJ) adjusts the yield curve control policy, could introduce more volatility and upward pull for risk-free rates, but, for now, the BoJ does not appear to be in a rush. In the Eurozone, the ECB will likely continue to diverge from the Fed’s monetary policy, although it will likely end QE this year, further increasing the global liquidity drain. There is no doubt that the global liquidity environment is getting less friendly.
Monthly Review: EM fixed income assets started the fourth quarter off on weaker footing as the optimism for global growth waned, punctuated by a selloff in equity markets. While not calling for a recession in the near future, global growth estimates have been reduced as reality has underperformed optimism. While global trade headwinds remain, the outlook for North American trade improved as the United States-Mexico-Canada Agreement (USMCA) trade agreement to replace North American Free Trade Agreement (NAFTA) was announced. Over the month, soft commodities rose in price, while energy markets weakened and metals were mixed. Infrastructure commodities such as aluminum and copper weakened, while prices for precious metals such as gold, silver, platinum and palladium rose in the month. Within dollar-denominated EM assets, corporates outperformed sovereigns, while in local debt, currency weakness versus the U.S. dollar weighed on returns. Investors withdrew $1.1 billion in assets from the asset class, primarily from local currency strategies as local currency debt continued to drive volatility in the month.2
Outlook: While we believe second- and third-quarter weakness in EM valuations has created market opportunities to add risk, we have become more selective as the outlook for EM fundamentals has become less certain. At a structural level, the world seems to be leaving global growth synchronicity behind and entering a new phase of diverging growth, as evidenced by still-healthy growth in the U.S., stabilization in Europe and Japan, but a more recent deceleration of activity in EM. Trade issues top the list of concerns, with the U.S. and China locked in what seems likely to be a protracted battle that could undermine growth expectations more broadly. Threats that the U.S. may consider expanding tariffs to the remaining $267 billion worth of U.S. imports from China could unleash another retaliatory round from the latter, thus weighing on global growth/market sentiment. On the positive side, however, the announcement of a revamped NAFTA agreement, named USMCA, highlights the propensity of the U.S. to strike deals and is an important step toward removing one large source of trade-related uncertainty, once national congresses approve the tentative deal.
Monthly Review: Global investment grade spreads widened in October, ending the month at levels last seen in mid-summer. The Bloomberg Barclays U.S. Corporate Index spread over government bonds widened by 12 basis points in October to end the month at 118 basis points, with nonfinancials leading the market wider.3 Spreads in the U.S. have now given back any gains made in the third quarter. For the year, U.S. investment grade corporates are 25 basis points wider on average. In Europe, the Bloomberg Barclays Euro-Aggregate Corporate Index moved 14 basis points wider to end the month at 128 basis points relative to governments.4 European corporate bonds have now materially underperformed U.S. credit, as European investment grade corporates are 42 basis points wider for the year.5
Outlook: Looking forward, the key question markets are asking is whether this is a healthy correction or a sign of an imminent slowdown. Our base case is that the current market volatility is a healthy midcycle correction. Corporates are seeing uncertainty over future demand and some input costs are increasing with oil higher, but in general corporate results remain strong. We believe earnings growth will likely slow, but do not expect leverage to increase. Leverage remains high in the U.S. but the cost of debt is quite manageable, and many corporates have termed out their debt at low rates and have flexibility in their business model if additional steps to de-lever are needed. In Europe, leverage tends to be lower, reflecting lower confidence in the broad market (i.e., European companies tend to be in an earlier part of the business cycle). Uncertainty over Italy remains, which will continue to be a negative for European financials and a key driver of spreads, while ongoing trade disputes are likely to weigh on credits globally.
Monthly Review: Rising interest rates and increased volatility were the primary themes in October, and spreads across nearly all securitized sectors drifted wider as a result. Credit-sensitive securitized securities continued to outperform more rate-sensitive securities, as real estate and consumer credit conditions remained generally positive and the higher cash flow carry on credit-oriented securities served as a buffer from the impacts of higher rates and wider spreads. Material upward rate moves in 2018, which have triggered increased market volatility, have had an impact on both equity and fixed income asset classes. Securitized assets have generally performed well in 2018, but now appear to be feeling some pressure from higher rates and increasing volatility.
Outlook: Our investment thesis remains largely unchanged for November: We remain generally constructive on securitized credit opportunities and cautious on U.S. agency mortgage-backed securities (MBS). We believe the U.S. economy remains strong, due in part to improving consumer and real estate credit fundamentals. We remain underweight agency MBS due to concerns over rising rates, potential higher interest rate volatility, and the deteriorating supply-demand dynamic with the Fed reducing its MBS purchases and large banks potentially also reducing their holdings. Although nominal spreads widened significantly in October and are now more than 25 basis points wider year-to-date, agency MBS still look marginally expensive from a historical spread perspective, and we believe spreads will need to widen to attract new investors in order to offset the Fed’s reduced purchases and potentially weaker bank demand. We may begin to taper our agency MBS underweight in the coming months if the sector continues to cheapen. We believe that most of the duration extension from higher interest rates and slowing prepayment speeds has already been realized.