By Brad Tank, Chief Investment Officer - Fixed Income
The Fed is prudently downshifting gears to avoid slamming on the brakes in 2019.
Some things in the financial markets tell you a lot; others don't tell you very much at all, despite the attention and commentary they get.
In our view, the shape of the U.S. Treasury yield curve is in the second category.
If you read any market commentary last week, you'll know that when the spread between the two- and 10-year yields has inverted in the past, it has been followed by a U.S. recession in 18 months, on average. Same for the spread between the two-year and five-year yields, which did invert last week.
We no longer believe the U.S. yield curve contains information about imminent U.S. recession, simply because, while rates at the short end of the curve are indeed influenced by the Federal Reserve responding to the domestic economy, yields at the long end are set by global growth and inflation. The U.S. might well be in recession in two years' time, but a flat yield curve today tells us little besides the fact that the Fed is running higher rates than most of the rest of the world.
Still, something is evidently spooking investors. We think it is just an overreaction to what ought to be a "soft landing" for the U.S. next year.
Until October, investors were pricing in an environment in which U.S. growth could power ahead undimmed even as the rest of the world slowed down. We have long expected the situation to re-converge, not least because U.S. stimulus is due to wear off and China stimulus is being reintroduced. There are undoubtedly tail risks out there, such as a failure either of China's stimulus efforts or U.S. - China trade talks, which were not helped by the confusion around the G20 outcome and the arrest of Huawei's CFO last week. Nonetheless, our central scenario is for the U.S. to revert to its long-term trend growth rate of around 2.0 - 2.5% in 2019, as the rest of the world did this year.
Twelve months ago, the Fed was forecasting flat forward rates in 2020. It didn't call that a soft landing, but that's what it implied. Our view is that the likelihood of these conditions has simply shifted from 2020 to 2019.
The market's concern is that the Fed fails to see this slippery patch on the road dead ahead and keeps pressing its foot down on the brakes. Overshoot with rate hikes in these conditions and it could send the economy into a skid. Sure enough, the last set of Fed dots for 2019 appear too high and, even after the correction last week, we think the market is pricing in more hikes than 2019 will ultimately need.
But as we have seen, the Fed is already shifting down the gears in its rhetoric. Chairman Jerome Powell could not be clearer that the central bank's attention to the economic data will become more acute as its ability to forecast conditions 12 months out diminishes. That gives us confidence that we will likely see a rate-hike pause soon - perhaps even as soon as this month's meeting.
What does a soft landing - slower U.S. growth and the Fed on pause - imply for investors?
It likely means a steady, flat yield curve; the potential for equity multiples to expand modestly even as earnings growth declines; elevated market volatility; and higher cross-asset correlations paired with wider, fundamentals-driven dispersion within asset classes.
Overall, it means that we are not likely to see the end of the cycle in 2019, and so we do not believe now is an opportune time to avoid credit risk indiscriminately, but rather a time to emphasize patience and selectivity in the credit risk one takes.
For us as investors, that means short- to intermediate-maturity credits in medium-quality issuers are more attractive. Remember, we have had the risks associated with BBBs and bank debt on our minds for some time, and that cautiousness has served us well in the recent volatility. It has given us the opportunity to select carefully from emerging markets, the higher-quality names in high yield, and some of the riskier names in investment grade and structured products.
The markets are echoing with a tremendous amount of noise right now, but we think that is distracting investors from what we view as the most likely outcome of 2019: a pause at the Fed, a soft landing for the U.S., and a re-convergence of global growth around the slower levels that have generally prevailed post-financial crisis. With that as the background, adding some quality credit spread to what are relatively high short-dated U.S. yields has the potential for risk-adjusted returns that could be attractive next to longer-dated fixed income, broad high yield or equities.
- Andrew White, Investment Strategy Group
|S&P 500 Index||-4.6%||-4.6%||0.3%|
|Russell 1000 Index||-4.5%||-4.5%||0.0%|
|Russell 1000 Growth Index||-4.8%||-4.8%||2.6%|
|Russell 1000 Value Index||-4.3%||-4.3%||-2.9%|
|Russell 2000 Index||-5.5%||-5.5%||-4.6%|
|MSCI World Index||-3.7%||-3.7%||-4.4%|
|MSCI EAFE Index||-2.3%||-2.3%||-11.0%|
|MSCI Emerging Markets Index||-1.3%||-1.3%||-13.1%|
|STOXX Europe 600||-2.8%||-2.8%||-13.5%|
|FTSE 100 Index||-2.9%||-2.9%||-8.2%|
|CSI 300 Index||0.3%||0.3%||-19.3%|
|Fixed Income & Currency|
|Citigroup 2-Year Treasury Index||0.3%||0.3%||0.9%|
|Citigroup 10-Year Treasury Index||1.5%||1.5%||-1.5%|
|Bloomberg Barclays Municipal Bond Index||0.7%||0.7%||0.8%|
|Bloomberg Barclays US Aggregate Bond Index||0.9%||0.9%||-1.0%|
|Bloomberg Barclays Global Aggregate Index||0.9%||0.9%||-2.3%|
|S&P/LSTA U.S. Leveraged Loan 100 Index||-0.5%||-0.5%||2.1%|
|ICE BofA Merrill Lynch U.S. High Yield Index||-0.1%||-0.1%||-0.2%|
|ICE BofA Merrill Lynch Global High Yield Index||0.0%||0.0%||-2.3%|
|JP Morgan EMBI Global Diversified Index||0.8%||0.8%||-4.7%|
|JP Morgan GBI-EM Global Diversified Index||0.4%||0.4%||-7.1%|
|U.S. Dollar per British Pounds||0.0%||0.0%||-5.7%|
|U.S. Dollar per Euro||0.6%||0.6%||-5.1%|
|U.S. Dollar per Japanese Yen||0.8%||0.8%||0.0%|
|Real & Alternative Assets|
|Alerian MLP Index||-1.2%||-1.2%||-4.5%|
|FTSE EPRA/NAREIT North America Index||0.4%||0.4%||5.1%|
|FTSE EPRA/NAREIT Global Index||0.6%||0.6%||-0.1%|
|Bloomberg Commodity Index||1.2%||1.2%||-3.6%|
|Gold (NYM $/ozt) Continuous Future||2.2%||2.2%||-4.3%|
|Crude Oil (NYM $/bbl) Continuous Future||3.3%||3.3%||-12.9%|
Source: FactSet, Neuberger Berman.
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