Déjà vu...Maybe Not
June 25, 2019
What a difference a month makes! In April, the U.S.- China trade negotiations were anticipated to wrap up; U.S. relations with Mexico and Canada were on the mend, and U.S. trade negotiations with Europe were not anticipated to cause too much trouble, at least in the short term. Come May, none of these things happened; indeed, they all deteriorated. Not surprisingly, developed market government bonds rallied significantly; what was more surprising was that peripheral European and emerging market local government bond yields also rallied. Indeed, on our count, ALL bond markets rallied except for Italy and South Africa. Credit markets did not fare as well, though, with both investment grade and high yield spreads widening, but not to the extent that might have been expected. Lastly, the dollar strengthened across the board. Déjà vu? Maybe not.
The January “Powell Pivot” is key to understanding market behavior in May and beyond. The big difference from last year is that the U.S. Federal Reserve (Fed) is in play. We have already seen central banks in New Zealand and Australia cut rates in recent weeks. With few signs of a rebound in the macroeconomic data (just about everywhere) and downside risks to growth growing due to the escalating trade war, the probability of a Fed ease is rising steadily, as it is for most central banks. This is supportive for government bond markets, credit markets and equities (but not supportive of the dollar). Thus, market developments should be materially different from the fourth quarter of 2018. We do not believe a recession either in the U.S., Europe or globally will occur UNLESS unemployment rates start rising and households retrench. This makes government bonds look expensive relative to current conditions; but markets are forward-looking and have correctly anticipated deteriorating global conditions. Until proven wrong, markets will likely keep on their current trajectory. Conclusion: Keep one eye on the U.S. consumer and one eye on Chinese policymakers (oh, and don’t forget to keep that third eye on trade negotiations!). Things should be OK, but better to be prudent and not be too bullish or bearish.
Fixed Income Outlook
Last month, we wrote about continuity. Well, that did not last long. The resurrection of trade war fears has shortcircuited the rise in government bond yields and pressed credit spreads wider. We were sympathetic to the idea of somewhat wider credit spreads on valuation grounds, but we did not anticipate that the underperformance would be driven by trade, especially with central banks globally moving to an easing bias or actual easing. The market implied probability of a U.S. rate cut this year is virtually 100%. Cumulatively, markets are looking for at least three cuts this year and next, fast moving to a full 100 basis points cut by the end of next year. However, while investors are worried about the future, the hard economic data is not that bad currently; without trade war fears, market expectations for rate cuts would likely be much lower. If, somehow, the U.S. and China suddenly, maybe miraculously, sorted out their differences, there could be a significant repricing of yields and rate cut expectations; but that may be too sanguine. The issues in question appear to be more deep rooted and difficult to sort out, meaning any “truce” in the trade war would not be taken too positively by markets, which would anticipate a return to arms, so to speak, at some point in the future. Thus, for now, the trend is your friend, and the direction of official rates is lower, until something changes for the better.
Without a good idea of how this standoff concludes or doesn’t, adopting a neutral view on rates overall seems prudent. We still like to own those markets where good things are happening: Australia and New Zealand whose central banks are cutting rates; Spanish long-duration bonds, which are benefiting from curve flattening and credit spread tightening (and a reach for yield in a world of negative yields); Brazilian government bonds are aided by a steep yield curve and friendly central bank. These are the places we hold above average interest rate risk. In the U.S., and eurozone overall, we would be neutral.
Emerging markets have performed well, given the trade war news. This reflects the very different circumstances this year compared to 2018. Countries with good fundamentals and going in the right direction are doing fine. Those struggling with either poor economic data or following wrong policies (from the market’s point of view) are underperforming. As we have written about many times, focusing on good stories at the right price is key to good performance. There are countries that meet these criteria, and we believe they should do fine in a period of easier-developed market monetary policy (subject to not being in the crosshairs of U.S. trade negotiators).
Clearly, the world changed once again in May. How long this lasts and its final impact are unknown. The combination of deep uncertainty (difficult to hedge) and poor economic data makes credit investing a challenge. Valuations have gotten cheaper and on our assumption that the world will escape a recession this year and next, credit should do okay. However, credit markets are holding up because the market expects the Fed to ease substantially, starting in fact, in July. A failure of the Fed to act in either June or July could easily lead to disappointment and further spread widening. We are sticking with our view that portfolios with relatively modest credit risk, choosing the right bonds and sectors in investment grade and high yield can generate meaningful carry, either outright or versus a benchmark. Our underweights in government bonds are generally much lower than they were in April. We must remember that 2019 is not 2018, and different strategies are warranted in these very different circumstances.
Developed Market Rate/Foreign Currency (FX)
Monthly Review: In May, investors once again fled to safe-haven assets, with sovereign bond yields across developed markets tumbling to historic lows. Benchmark yields in Australia, New Zealand and Germany fell to their lowest levels ever. The U.S. 10-year Treasury yield dropped to its lowest level in nearly three years, coupled with the fact that U.S. Treasuries had their best May since 2003, with the 10-year Treasury up 3% in total returns.1 Additionally, a key measure of the yield curve inverted over the month, with the spread between the 10-year U.S. Treasury and three-month U.S. Treasury bill falling into negative territory. Global geopolitical risks, including trade issues with China and Mexico, and central bank rhetoric within the developed markets have caused uncertainty among investors, pushing markets into a risk-off mindset within fixed income.
Outlook: U.S. growth is likely to be lower for the remainder of 2019 as the fiscal impulse wears off and the lagged effect of higher rates bite, but not collapse. Central banks have become more accommodative, particularly in the U.S., Antipodea and eurozone, and we expect that to continue. Recent speeches from the Fed policymakers give us further confidence that the Fed is committed to being “patient” and “flexible” regarding future rate hikes and cuts. With that being said, at this point, it is distinctly possible the Fed will cut rates in 2019. The bar for cuts may be higher than the market thinks and even higher for the magnitude being discounted, but further market turbulence and weak economic data over the summer could lead them to act.
Emerging Market (EM) Rate/FX
Monthly Review: EM fixed income assets gained during the month. Within hard currency, investment grade outperformed high yield, and sovereigns outperformed corporates, as falling U.S. Treasury yields aided longer-duration assets.2 With a few exceptions, EM currencies continued to weaken versus the U.S. dollar, though local bond performance more than offset the negative impact from currency depreciation.3 Commodity prices were broadly lower in the period, with oil prices falling more than 13% and most base metal prices also in decline.4 Iron ore and gold were the exceptions, with metals supply disruptions supporting the price of iron ore.5 Soft commodities outperformed, as wheat, soybeans, coffee and corn prices rose, while cotton and cattle prices weakened.6 The Institute of International Finance estimated that portfolio flows out of EM were $5.7 billion in May, with $14.6 billion flowing out of EM equities, one of the worst months for that asset class since the Taper Tantrum of 2013. Meanwhile, $9 billion flowed into EM debt markets.
Outlook: One of the risks we have consistently flagged in previous outlooks, namely, heightened trade tensions weighing on global growth, materialized in May, prompting us to take a more cautious view toward risky assets in the near term. Moreover, trade risks are likely to increase in the next weeks, on the back of additional U.S. tariffs on the remaining imports from China, the latter’s more belligerent anti-U.S-rhetoric, and diminishing hopes of a breakthrough at the G-20 meeting later this month. Furthermore, U.S. President Trump’s inclination to use tariffs to deal with issues beyond trade (such as his threat of tariff hikes on Mexico for doing too little to address undocumented immigration into the U.S.) contributed to deteriorating market sentiment. Rising odds of a more serious trade war are negative for risky assets, since they weigh on the global growth outlook, as declining business confidence stunts business investment. Furthermore, trade war fears, via increased global risk aversion, are also undermining our thesis that USD weakness would boost risky assets in the current year. However, the downside on EM fixed income has been relatively contained (this is more so in hard-currency debt than in local-currency-denominated debt), helped by a sharp rally in U.S. Treasuries, as the market prices in Fed rate cuts.
Monthly Review: Concerns around global trade, weaker economic growth, rising equity volatility and lower risk-free yields all contributed to May being a weak month for corporate bonds. The Bloomberg Barclays U.S. Corporate Index widened by 17 basis points in May to end the month at 127 basis points over government bonds, with longer-duration and BBB nonfinancial credits underperforming.7 As measured by excess returns versus government bonds, the U.S. investment grade index generated an excess return of -1.39% for the month.8 European investment grade underperformed the U.S. market by widening 20 basis points in May to 127 basis points, as measured by the Bloomberg Barclays Euro-Aggregate Corporate Index.9 High-yield bonds suffered their largest setback of 2019 in May amid worsening trade tensions and lower Treasury yields, and a drop in stocks and oil prices. Spreads widened 74 basis points to end the month at 433, and yields rose 45 basis points to 6.57%.10 Despite the meaningful move wider in spreads, total returns were only modestly negative (-1.19%) last month.11
Outlook: While valuations following the widening in May are again attractive, absent a recession, the risks of recession have increased. The increase in risk premium and wider spreads is reflective of the uncertainty in political policy and weaker growth data. Both of these factors combine to make the short-term outlook for corporate earnings less clear. Our base case does not call for a recession; rather, we expect continued low global growth and low inflation, supported by low real rates and easy financial conditions. We are carefully monitoring the incoming economic data (with heightened focus on employment trends) as well as comments from central banks to see if the central bank economic put will be rekindled (such as another targeted longer-term refinancing operation (TLTRO) in Europe), which would likely quickly turn market confidence. Technicals remain much improved compared to 2018, and we expect conservative risk positions across the street and steady inflows to credit will keep the risk of forced liquidations low.
Monthly Review: The Bloomberg Barclays U.S. Mortgage-Backed Securities (MBS) Index was up 1.29% in May but significantly underperformed the Bloomberg Barclays U.S. Treasury Index, which returned 2.35% in May, as MBS durations shortened as interest rates declined.12 Current coupon agency MBS nominal spreads tightened 3 basis points in May to 85 basis points above interpolated U.S. Treasuries.13 The duration of the Bloomberg Barclays U.S. MBS Index shortened by nearly a year to 3.38 years during May, as mortgage prepayments sped up and are expected to accelerate further as a result of lower mortgage rates.14 National mortgage rates were 6 basis points lower in May ending at 4.03%, down 80 basis points from November.15 Lower coupon agency MBS outperformed higher coupon MBS as prepayment concerns have a greater negative impact on the higher coupon securities. The Fed’s MBS portfolio shrank by $28 billion during May to $1.555 trillion and is now $82 billion lower year to date.16 Mortgage mutual funds saw net inflows of $0.7 billion in May, increasing year-to-date net inflows to $7.5 billion.17 Mortgage mutual fund inflows in 2019 have essentially matched the 2018 mutual fund outflows of $7.6 billion and have helped partially offset the decline in Fed MBS holdings but, overall, the Fed’s balance sheet MBS reductions significantly outweigh incremental fund inflows and present a headwind for agency MBS valuations in 2019.
Outlook: We expect credit spreads to continue to drift wider in June, mirroring the spread widening in other credit markets, although to a lesser extent. While securitized credit spreads are tighter in 2019, they have not tightened nearly as much as other credit markets, and are less likely to widen to the same extent. Securitized spreads have generally been less volatile than other credit sectors over the past few years, stabilized by continued supportive fundamentals. We believe that securitized fundamental credit conditions will remain positive and that credit-sensitive mortgage and securitized assets will continue to perform well. From a fundamental perspective, we believe the U.S. economy remains reasonably strong with healthy consumer and real estate market conditions, and we remain overweight credit-oriented securitized investments in our portfolios. Overall, we expect agency MBS to continue to underperform in the coming months, but we anticipate reducing our agency MBS underweight further if agency MBS continues to underperform.
1 Source: Bloomberg Barclays, as of May 31, 2019.
2 Source: Bloomberg, as of May 31, 2019.
3 Source: Bloomberg, as of May 31, 2019.
4 Source: Bloomberg, as of May 31, 2019.
5 Source: Bloomberg, as of May 31, 2019.
6 Source: Bloomberg, as of May 31, 2019.
7 Source: Bloomberg Barclays, as of May 31, 2019.
8 Source: Bloomberg Barclays, as of May 31, 2019.
9 Source: Bloomberg Barclays, as of May 31, 2019.
10 Source: Bloomberg Barclays, as of May 31, 2019.
11 Source: Bloomberg Barclays, as of May 31, 2019.
12 Source: Bloomberg, as of May 31, 2019.
13 Source: JP Morgan, as of May 31, 2019.
14 Source: Bloomberg, as of May 31, 2019.
15 Source: Bloomberg, as of May 31, 2019.
16 Source: Federal Reserve Bank of New York, as of May 31, 2019.
17 Source: Lipper US Fund Flows data, as of May 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 the current rising interest rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. Longer-term securities may be more sensitive to interest rate changes. In a declining interest rate environment, the portfolio may generate less income. 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.
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