Too Much of a Good Thing?
A combination of strong U.S. economic data, heightened expectations of additional U.S. Federal Reserve (Fed) tightening and high valuations pushed yields upward. Fortunately, still modest inflationary pressures means the Fed is likely to continue its slow and steady pace of raising interest rates, which will not jeopardize the U.S. economy’s solid economic growth. On the other hand, this pace of tightening is proving to be more problematic for the rest of the world, particularly emerging markets (EM). At present we believe the strong growth data, which is probably still good for the global economy in addition to the U.S., is not a threat to risky assets, although discrimination among EM remains key. While some may argue too much U.S. growth is no longer good for the global economy, too much of a good thing can sometimes be wonderful. We will see!
The behavior/trend in U.S. Treasury (UST) yields remains the key focus of markets. Higher yields should not have been that surprising, as the Fed has been clearly communicating its intention to steadily raise interest rates, but the market had been reluctant to price in much in the way of rate hikes beyond 2019. However, recent strong growth data supports the case for additional hikes and a longer hiking cycle, e.g., the market is for the first time this cycle converging to the Fed’s forecasts rather than the other way around. In addition, with interest rate term premium estimates still negative, there is potential for yields to rise through this channel as well. The correlated nature of global bond markets means higher UST yields are leading to higher yields everywhere, almost regardless of domestic fundamentals. Our view is the risks remain skewed to yields rising further from here, led by the U.S.
The Fed raising interest rates because the economy is doing better should not necessarily be a headwind for risky assets. The risk of over-tightening by the Fed seems small, particularly given that inflationary pressures remain subdued—meaning the pace can always be slowed, as has happened during the current tightening cycle. While there is growing evidence of tight labor markets pushing up wage inflation in both the U.S. and Europe, the pickup mainly supports the argument that monetary policy needs to be tightened rather than accelerating the pace of the measure. This should mean the impact on risky assets, in the U.S., is modest.
However, the concern is whether asset markets outside of the U.S. can cope with higher yields with the same resilience. After briefly converging, it appears the U.S. economy is once again outpacing the rest of the world. Europe is growing notably slower than in 2017, and is being dragged down by political and fiscal uncertainties in Italy. The key concern in EM is the resilience of China’s economy, not helped by an acrimonious dialogue with the U.S. on trade.
On balance we think stronger U.S. growth and higher U.S. yields will not disrupt the global economy and financial markets. This is partly because strong U.S. growth (for now) is still good for the global economy, and also because there is a feedback loop to Fed policy if higher yields prove to be disruptive. That said, we believe discrimination needs to be used in EM, picking between countries that have better and worse fundamentals. The Italian situation also runs the risk of becoming far more disruptive even though there are few signs of contagion so far. And, last but not least, the burgeoning/escalating trade war with China needs to be monitored for more sinister effects.
Stronger growth may be too much of a good thing if it leads to excessive monetary policy tightening and too strong a dollar. But, as Mae West commented, too much of a good thing can also be wonderful.
Monthly Review: In September, we saw risky assets bounce back from the August sell-off. U.S. Treasury yields rose on average 20 basis points across the curve, while German bunds sold off 7-15 basis points. The only exception was the Japanese Government Bond (JGB), where the bonds continued to be well-anchored. Japan yields ended up unchanged this month. Italian bonds reversed some of their previous month’s losses by rallying more than 40 basis points on the front end of the curve, while interestingly the back end of the euro BTP’s curve only rallied 10 basis points. The U.S. 2s10s curve remained a flattish 24 basis points this month.1
Outlook: We believe the Fed is on the path of continuous, gradual rate hikes for 2019, allowing for only a moderate inflation overshoot. Recent meetings showed that the Fed reaffirmed its plan to hike three times in 2019 and the market is coming around to this view, given recent firming pressures in wages and business confidence raising the ante with regard to the appropriate terminal rate. As for U.S. 10-Year Treasury yields, we believe it will fall in the range of 3-3.5%. As we’ve previously noted, JGBs have served to anchor yields worldwide. 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.
Monthly Review: Market sentiment improved in September as headwinds diminished with progress on North American trade talks, improved market technicals and valuations, which sparked investor attention. While year-to-date performance has been poor, there has been limited contagion and no substantial uptick in the outlook for defaults as this sell-off has been more idiosyncratically driven than systemic, in our opinion. Within the dollar-denominated space, sovereigns outperformed corporates during the month, while local debt generally outperformed dollar-denominated debt as EM currencies strengthened versus the U.S. dollar. Commodity prices gained over the month, with broad gains across energy, agriculture and metals, such as platinum and palladium. However, prices for aluminum, gold and silver fell in the period.
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 have 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, and, importantly, a more recent deceleration of activity in EM. Trade issues top the list of concerns, with U.S. and China locked in a seemingly 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.2 On the positive side, however, the announcement of a revamped North American Free Trade Agreement (NAFTA), the so-called United States-Mexico-Canada Agreement (USMCA), highlights the propensity for the U.S. to strike a deal and is an important step towards removing one large source of trade-related uncertainty, once national Congresses approve the tentative deal.
Monthly Review: Global investment grade spreads tightened in September, ending the quarter on a strong note. The Bloomberg Barclays U.S. Investment-Grade Corporate Bond Index tightened by 8 basis points in September to end the month at 106 basis points, with BBB-rated industrials leading the market.3 Spreads in the U.S. are now tighter than at any point since April. For the year, the U.S. investment-grade corporates are 13 basis points wider. In Europe, the Bloomberg Barclays Euro-Aggregate Corporate Index moved 5 basis points tighter to end the month at 114 basis points.4 Relative to the U.S., spreads in Europe have been more range-bound these past few months and remain 28 basis points wider for the year. Global convertibles delivered a small positive return in the month, pulled up by rising stocks and pulled back down by falling bonds. Returns were muted across major asset classes as MSCI Global Equities were up 26 basis points and Bloomberg Barclays Global Credit was down 32 basis points, while the Thomson Reuters Global Convertibles Focus Index performed in between, rising just 3 basis points.5
Outlook: Looking ahead, we remain constructive on investment grade credit. Corporate earnings continue to be strong, heavy supply has been met with even stronger demand, and the macro backdrop continues to improve. Economic indicators remain robust, particularly in the U.S., while some key geopolitical concerns appear to be subsiding. The recent downward spiral from emerging markets has slowed and progress has been made in some ongoing trade disputes. Valuations, while off the widest levels, remain around long-term average levels. With the European Central Bank (ECB) stepping away from the corporate bond market, monetary policy tightening in the U.S., and Italian politics likely to remain volatile, we do not expect spreads to tighten rapidly from here. Rather, we expect spreads to grind tighter as we head into year-end, generating some attractive excess returns in the process.
Monthly Review: Rising interest rates, duration extension and tightening credit spreads were the primary themes in September. Absolute returns were dominated by the impact from higher rates, and credit-oriented securities meaningfully outperformed more rate-sensitive securities during the month. Market sentiment seemed to shift during September and strengthening U.S. economic data seem to be outweighing potential global economic weakness and trade tariff concerns. The Fed raised short-term rates another 25 basis points in September, and market expectations now have the Fed raising rates again in December and potentially a few more times in 2019.
Outlook: Our investment thesis remains largely unchanged for October. We remain generally constructive on securitized credit opportunities and cautious on U.S. agency mortgage-backed securities (MBS). We remain underweight agency MBS due to concerns over rising rates and potential higher interest rate volatility, and also since the Fed continues to reduce its MBS purchases, and as a result, the tradable market supply is increasing. Agency MBS also still looks expensive from a historical spread perspective, and we believe spreads will likely need to widen to attract new investors to offset the Fed’s reduced purchases. While we remain underweight agency MBS, we may begin to taper our underweight in the coming months if agency MBS continue to cheapen. We believe that most of the duration extension from higher interest rates and slowing prepayment speeds has already been realized. The Bloomberg Barclays U.S. MBS Index has already extended a full year in 2018, and we believe that we are nearing the end of the current rising rate cycle. While MBS could still face supply pressure from the diminished Fed MBS purchases, we believe that agency MBS carry could overcome moderate spread widening if interest rates stabilize.
1 Source: Bloomberg. Data as of September 30, 2018.
2 Source: JP Morgan. Data as of September 30, 2018.
3 Source: Bloomberg Barclays. Data as of September 30, 2018.
4 Source: Bloomberg Barclays. Data as of September 30, 2018.
5 Source: Bloomberg Barclays. Data as of September 30, 2018.
The views and opinions expressed are those of the Portfolio Management team as of October 2018 and are subject to change based on market, economic and other conditions. Past performance is not indicative of future results.
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