By Douglas J. Peebles
We answer some of today's most pressing investor questions - from the effect of trade wars with China to our expectations for rising rates and a correction in high yield.
Keep Your Eye on the (Most Important) Ball - Liquidity
Markets can react somewhat capriciously to short-term pressures and surprising or unusual events. Sometimes news seems to matter too much, sometimes not enough. Market volatility in general - particularly the tendency for markets to overreact and then correct - is a reflection of overall levels of liquidity.
That's why it's important that investors stay focused on the overriding force at play in this environment: the transition from massive liquidity levels to less-than-ample liquidity. The former was the result of global central banks' decade-long QE campaigns and low, low rates. Our global transition to the latter has only recently begun, now that the US Federal Reserve is hiking rates and reducing its balance sheet. There is much more to come, with quantitative tightening to begin in Europe too.
The shutting of the liquidity spigot - how fast, how much, how tight - is likely to have a bigger influence on financial markets than it does on most developed markets' economic growth rates. This shouldn't be surprising, since financial markets have dramatically outperformed the global economy since QE began nearly 10 years ago. To expect a reversal of this pattern under a quantitative tightening regime is well within reason.
Of course, each region and country will be affected differently by global and domestic pressures. For instance, an escalation of trade tensions will have a dampening effect on the global economy, but with greater hits to those economies where trade is more important. And although the Fed's influence is designed to most directly impact the US, its second-order impacts on non-US economies and markets are greatest on those that cannot as easily withstand the burden of this changed liquidity environment.
That's what continues to hold our attention, even as we recognize and assess the many other influences on the market. With that as the backdrop, here are our answers to the questions we're hearing most often today.
How will a trade war impact the bond markets?
Although President Trump has threatened additional tariffs on all Chinese imports, which would represent more than $500 billion, the direct impact of the tariffs announced thus far will probably be small. For example, we expect the effective US tariff rate on overall imports will rise from 1.4% - the average since 2000 - to just over 2%. Other countries, with smaller GDPs and more trade-dependent economies, will experience relatively bigger direct impacts.
But first-order, direct impacts aren't the only effects we're paying attention to. There are second-order effects as well. Already, the US dollar has climbed sharply since trade tensions moved to center stage, and volatility has ramped up in the financial markets. Longer term, the net effect on the US dollar will be determined by relative changes in growth rates, underscored by companies' varying ability to pass on the costs of tariffs to consumers. Remember: the weak US dollar helped global asset prices in 2017; conversely, a strengthening dollar today could be troubling for financial markets worldwide.
Additionally, it's important to consider the potentialities if we take the trade wars to their logical conclusion. And these seem considerably more serious.
The US currently runs an enormous trade deficit, leaving China - and every other country against whom the US runs a deficit - with a large supply of dollars. Chinese economic participants are constantly affecting markets by either returning those dollars to the global system - exchanging dollars for renminbi - or by investing them in the financial markets, much of it the US capital markets. This circulation of goods, US dollars and investments (with China and with the US's other trading partners) has existed in a happy equilibrium - until now.
Now, with a stated aim of reducing the US trade deficit, President Trump is choking trade, effectively shrinking the supply of US dollars available outside the US. Fewer available dollars means fewer dollars sold back into the global currency markets, causing the relative value of the dollar to climb. (And remember that a strong dollar is generally bad for financial asset prices.) Fewer available dollars also means a disruption to direct investment in the capital markets.
In other words, by decreasing the US's trade deficit, Trump will be decreasing flows into financial assets, especially foreign purchases of US securities, from Treasuries to company stock to direct real estate investments. Should the president pursue a path that takes the US trade deficit down to zero, the US dollar would soar, and the financial markets would plunge.
Thankfully, we don't think this apocalyptic vision is likely to be realized. Instead, it's more likely that cool heads will recognize the potential for damage to global growth and the capital markets and negotiate a compromise. Still, tensions are likely to worsen before they improve, so we are monitoring the situation closely.
For now, we see a trade war as a reason to trim exposures to emerging-market (EM) currencies, particularly if China purposefully weakens its renminbi. Although we do not see a deliberate weakening of the Chinese currency as the base-case scenario, the effect of such a weakening would ripple through Asian EM currencies and through EM currencies generally.
Who will be the US winners and losers in a trade war with China?
With the above backdrop in mind, we see the clear US winners as being sectors that benefit from US tariffs but do not sell into China. These include metals and chemicals. The clear losers are sectors that do not benefit from US tariffs and that sell into China, particularly agriculture - apples, cherries, wheat, seafood, dairy products and more. Somewhere in the middle are sectors that potentially benefit from tariffs but also sell into China: industrials, capital goods, technology, transportation and autos, and retail.
Additionally, it's important to weigh the secondary impact of tariffs and a trade war. They're especially negative for sectors exposed to rising input costs (steel, resin, plastics) and with limited pricing power: consumer goods, food and beverage, and retail.
We're also concerned about the potentially negative effect on US companies' capital investment decisions as uncertainty around tariffs continues. An associated slowdown in productivity gains could overwhelm the otherwise constructive backdrop of last year's US tax cuts and the ability of companies to repatriate overseas cash. This dynamic could have an impact even on businesses currently flush with profits, but it's more likely to hurt those with less wiggle room.
Lastly, a prolonged trade war could throw Fed monetary policy into question. While the Fed's inflation target of 2% was recently reached, that may not stick: one effect of a trade war would be pricier imports, which would add to inflation pressures. And rising inflation would keep the Fed tightening for longer.
What's the significance of a flatter US Treasury yield curve?
An inverted yield curve - when long yields dip below short yields - has heralded every recession since the mid-1970s. So it's understandable that a flattening yield curve causes investors to prick up their ears.
We do not anticipate a recession in the US anytime soon. Rather, we expect continued strong, stable growth over the next few quarters, with a modest slowdown developing as gradually higher rates and tighter monetary conditions take effect.
It's important to understand the other forces that shape today's yield curve. One such force is the sheer amount of liquidity that's been pumped into the market by global central banks. But perhaps the most significant force right now is the volatility backdrop. Market jitters around trade wars, especially, have led to Treasury buying, even as the Fed is propping up the shortest Treasury yields via tightening. The result? A flattening curve.
The flatness of the curve is particularly interesting given the market's current supply/demand technicals. We know that there are two large participants increasing supply. First is the Fed, as it shrinks its balance sheet. Second is the US Treasury Department, which needs to issue a larger amount of debt to finance the expected budget deficit following the tax cuts and the fiscal package agreed upon earlier in 2018. Additionally, foreign central bank holdings of US Treasuries have diminished, indicating that they too are sellers.
Yet, the price of Treasury bonds has not dropped much. We must therefore assume that there are equal or larger buyers on the other side. To us, that means the flattening of the curve shouldn't be ignored.
We have some recommendations in this environment. One is to position investments toward the middle of the curve. Rather than shifting into cash, which incurs its own risks, or taking on nearly twice the duration at the long end of the curve for hardly any increase in yield, investors can earn nearly 2.75% in yield on five-year Treasuries today. Just two years ago, that would have put smiles on a lot of faces.
Another recommendation is to invest in a credit barbell strategy. This approach combines credit assets with US Treasuries and other high-quality government bonds in a single strategy run by a single manager. As rates continue to rise, the manager can strike a balance in the bond portfolio between rates and credit, then dynamically shift the allocations as conditions change.
Where should I invest in today's volatile bond markets?
Six months ago, we warned that 2018 would be a year of transition for financial markets. With the global economy humming along, we predicted that central banks, led by the Federal Reserve, would gradually tighten financial conditions by hiking rates and shrinking their balance sheets, causing volatility to rise and investing to get more challenging. We simply didn't expect it to happen so quickly.
By midyear, the yield on the benchmark 10-year US Treasury note had risen from 2.40% at the start of the year to 2.90%, with a brief run to 3.11% in mid-May. And the US dollar has appreciated sharply, provoking a broad sell-off in EM bonds and currencies.
We don't expect a prolonged sell-off in risk assets, however. That's because this kind of turbulence is part of the ebb and flow we expected when the year began. The global economy remains healthy, making it easier for corporate borrowers and most EM governments to service their debt even as rates rise. And Fed tightening will be somewhat offset by a more gradual reduction in monetary accommodation elsewhere. Still, we don't see this as a time to ramp up portfolio risk.
The European Central Bank, for example, announced it would end quantitative easing in December. Together with Fed tightening, this should cause continued pressure on credit spreads. And a stronger US dollar means EM central banks can no longer afford to loosen monetary policy to offset tightening financial conditions as we and other market participants expected they would.
Beyond that, there's concern that a drawn-out trade war could dent business confidence and undermine the world economy and markets. Meanwhile, Western governments from Rome to DC are embracing ambitious fiscal spending plans despite high deficits and, in the US's case, an economy that's already at full employment. These developments are likely to lead to higher inflation over time and could curtail global growth.
We think it makes sense to rebalance overall portfolio risk. Our interaction with investors around the world indicates that, on average, their overall bond exposure is heavily overweight credit-sensitive assets and very underweight interest-rate risk. We believe that the best course is to reduce that underweight in duration and, within credit markets, focus on select opportunities in dislocated areas of the market. Investors should also consider inflation protection and favor shorter-maturity, higher-quality credit exposure.
How do I protect my portfolio against rising US rates?
To shield capital against the effect of rising rates, some investors are moving their bond allocations into cash or even hedging the duration out of their bond strategies altogether. We don't think that's prudent.
At the risk of pounding the table, the most sensible strategy in today's environment for many bond investors is likely a credit barbell. This approach balances interest-rate risk and credit risk in a single strategy. The manager alters the exposures to each as valuations and conditions change. This kind of strategy helps minimize risk by preventing investors from reducing duration too much, as well as from titling too far into credit. It also takes advantage of the interplay between the two risks. Today, that interplay is itself the most important risk for investors to manage.
For investors who need a high level of income but can't stomach high risk, it might be time to consider a limited- or short-duration high-yield strategy that focuses on shorter-maturity, higher-quality securities.
Lastly, a note on whether non-US investors should ditch their US holdings for the time being. Short-term interest-rate differentials have widened, thanks to Fed tightening. That's increased hedging costs for euro-based investors, for example. But rather than summarily ditching global strategies, investors need to take hedging costs into the equation when evaluating individual opportunities.
For example, euro-based investors will find that US high-yield bonds still compare favorably, as do some commercial mortgage-backed securities and select EM debt. Conversely, those same interest-rate differentials boost the attractiveness of European debt such as subordinated banks to US dollar-based investors.
Is high yield due for a correction?
The answer to this question depends on what counts as high yield. Investors who have loaded up on high-yield bank loans have reason to be concerned. More than half of today's loan issuers have no unsecured bond debt on their balance sheets. That means default recovery rates are likely to be much lower than in the past. And the quality of those loans has worsened. "Covenant-lite" deals lacking basic protections for lenders now represent more than 70% of the market. This suggests that loan default risk is far higher than many investors realize.
But there is a world of difference between bank loans and high-yield bonds. We don't see a massive correction brewing for high-yield bonds. There are typically three warning signs that precede such a correction, and none of them is flashing: high and rising leverage ratios, a dominating CCC sector, and a surge of defaults.
Our advice: Employ a global, multi-sector high-income strategy to navigate today's choppy markets, and be selective. But don't shun high-yield bonds, one of the highest potential income generators out there.
Paying Attention to What Matters Most
To be sure, trade wars and escalating trade tensions are important. However, it's critical that investors keep their attention trained on the most important factors at play in today's bond markets: the transition from quantitative easing to quantitative tightening, and more restrictive liquidity conditions. These are what have caused the weakest links in the capital markets to decline this year, and these are what will eventually cause risk assets to roll over.
Even the most skilled bond manager can't time when that will happen. That's why we believe that a sensible, balanced approach to fixed-income investing is best.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.