Market Pulse
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January 12, 2020
If the economy is so darn good, why are yields so darn low?
 

Market Pulse

If the economy is so darn good, why are yields so darn low?

If the economy is so darn good, why are yields so darn low?

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January 12, 2020

 
 

The S&P 500 just ended the year up +30.4%, yet the yield of the U.S. 10-yield Treasury on December 31, 2019 was 1.92%. This may give one the impression that stocks and bonds are not correlated, as the U.S. Federal Reserve’s easy monetary polices are intentionally implemented to suppress interest rates. Which is a risk. And while we expect some manufacturing data in early 2020 to help, we do not expect 10-year rates will materially exceed a 2.15-2.25% range for the year.

Some would argue that uncertainty is the prevalent sentiment in this market. Not in our mind. We think uncertainty is reflected in volatility and the market has become quite adept at effectively incorporating volatility into asset pricing.

Instead, we think the current market reflects ambiguity in the sense that it’s indistinct and has a significant lack of clarity. On the surface, things just don’t make sense. The data is getting better, but bond yields are not following. What’s going on here?

Digging deeper we are seeing an asymmetry of market expectations that is being mirrored in bond prices. Despite a lot of good economic data, the bond market is worried, and therefore puts greater weight on downside risks than upside for the economy. Think about it. Ask the average investor to name ten good things that could happen to the economy and they might have trouble naming one. But ask about ten things that could go wrong? Start with U.S./China trade tensions, Iran, Brexit, impeachment proceedings and election uncertainty (and the list goes on).

To help hedge these risks investors buy high-quality bonds such as U.S. Treasuries to hedge riskier assets. In turn, the distribution of interest rates skews lower, such that current interest rate levels reflect a valuation of risk premia more than economic fundamentals.

 

Update on the jobs report, market risks and investment opportunities

Jobs: There was no “consensus” for December, just a range of expectations, but it is important to pay attention to the technicals

  • According to Bureau of Labor Statistics (BLS) the U.S. added 145K jobs in December (versus a expectation of 160K), while forecasts ranged from 125K to 210K
  • The unemployment rate held steady at 3.5%, while wage growth was +2.9% for the year
    • This is not a Fed-related event. Low wage growth and a low unemployment rate suggest the cycle can go on, reinforcing the Fed’s view that their policy rate is “about right.”
    • The upside risk was based on a strong ADP report of 202K jobs added in December. HOWEVER:
      • It is important to note that over past 2 years the absolute error between BLS and ADP is roughly 65K, thus the range of today’s BLS payroll was 135K – 265K.
      • At 145K, the BLS NFP report came in at the low side of the expected range.
    • The downside risks came from jobless claims rising and jobs component of ISM Manufacturing and non-Manufacturing having softened (trade-war related)?
      • Strength in ADP may just be payback for November’s +266K boosted by the return of 42K GM strikers
      • Shorter holiday season due to a late Thanksgiving
    • Finally, BLS and ADP measure unemployment differently: ADP counts all employees listed on a company’s payroll vs. BLS only counts those who are actually paid

 

Market Risks – Digesting the “Big Four”

  1. U.S. election uncertainty – This is a “known unknown” and will start to matter more in 2Q 2020.
  2. BREXIT – The risk is still post January 31, and hinges on UK PM Boris Johnson finalizing a Brexit agreement by December 2020 (risky) vs. getting an extension (less risky).
  3. U.S/China – Phase 1 is done, representing a cease fire with no new tariffs for the time being. This lowers risk premia.
  4. Geopolitical – There is a lot going on in the world right now. This is an “unknown unknown,” and is extremely difficult to quantify correctly. We recommend keeping an eye on the U.S. Dollar and oil prices as barometers.

 

Investment themes and opportunities

  • Global cyclical recovery. We expect manufacturing sectors and laggards of 2019 will lead a recovery (energy, autos, manufacturing). Global ISMs bottoming. We expect the USD to weaken.
  • Central banks will likely remain easy but we believe inflation pressures will rise and restore term premia. We expect steeper curves and wider breakeven inflation, with the U.S. 10-year Treasury settling in a range of 2.15% - 2.25%.
  • Credit themes: Down in quality and reduced duration. We see consumer and cyclical recovery opportunities:
    • High Yield – 5.10% yield for the Bloomberg Barclays US Corporate High Yield Index, 330 basis point option-adjusted spread (OAS). We are looking at Home Builders, Food & Beverage, Transportation and select Retail
      • BBs are at all-time tights, but we see value in Bs and CCCs
    • Investment Grade – 2.85% yield, 97 basis point OAS for the Bloomberg Barclays U.S. Corporate Index. Cyclical themes include Automobiles, Gaming and select Energy, including pipelines
      • A lot of supply, including energy. $60Bn so far, $110Bn expected in January.
  • Emerging Markets: We see a global cyclical recovery theme. JP Morgan Emerging Markets Global Bond Index is yielding 4.90%. Look at South Africa, Brazil, Mexico, Indonesia, Russia

 

All data as of January 10, 2020. The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See below for index definitions.

 
 

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jim.caron
 
Managing Director
 
 

Definitions

The Bloomberg Barclays US Corporate High Yield Index measures the market of USD-denominated, non-investment grade, fixed-rate, taxable corporate bonds. Securities are classified as high yield if the middle rating of Moody's, Fitch, and S&P is Ba1/BB+/BB+ or below. Bloomberg Barclays US Corporate Index is a broad-based benchmark that measures the investment grade, fixed-rate, taxable, corporate bond market. JP Morgan Emerging Markets Global Bond Index tracks total returns for traded external debt instruments in the emerging markets and is an expanded version of the EMBI+. As with the EMBI+, the EMBI Global includes U.S. dollar-denominated Brady bonds, loans and eurobonds with an outstanding face value of at least $500 million.

Option-adjusted spread is a measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option. Typically, an analyst would use the Treasury securities yield for the risk-free rate. The spread is added to the fixed-income security price to make the risk-free bond price the same as the bond.

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