Bond Compass: The Fixed Income Outlook

by: CFA Institute Contributors

Four rate hikes by the US Federal Reserve in 2018 and the promise of more to come in 2019 sent the markets into a swoon.

Growth forecasts have been reduced everywhere, especially in Europe.

With the end of QE at the close of 2018, hopes that the ECB would begin to tighten in 2019 have already been dashed as growth forecasts have tumbled.

The last year has been an uncertain one for bond markets. Four rate hikes by the US Federal Reserve in 2018 and the promise of more to come in 2019 sent the markets into a swoon. If further tightening was on any central bank's agenda, an inverted yield curve, the first since 2007, quickly moved it off the table.

For context on these developments and insight on what lies ahead, we sat down with Michael Metcalfe, head of Global Macro Strategy for State Street Global Markets, to hear his perspective. He shared some compelling data points from State Street's quarterly Bond Compass publication and offered an intriguing prediction about the second quarter of 2019:

"I think Q2 is likely to be a watershed moment for financial markets."

What follows is a lightly edited transcript of our discussion.

CFA Institute: When it comes to fixed income flows, what key investor sentiment trends did you notice in Q1 2019?

Michael Metcalfe: Few expected central banks to capitulate on monetary tightening quite as quickly as they did in Q1. As a consequence, long-term investors were not prepared for the stellar bond market returns that followed. Nevertheless, investors have adjusted their fixed income portfolios, revealing what they believe could happen next.

Demand for Treasuries surged into the top quartile as investors chased returns, but they did so primarily at the front end of the curve. Investors are not yet betting on a recession, even though they have reduced their holdings of high-yield corporate debt.

Growth forecasts have been reduced everywhere, especially in Europe. However, investors' demand for yield appears to be trumping both growth and fiscal fears, for now, amid continued recovery in flows into Italian sovereign debt and European corporates at the expense of bunds.

Equity investors in emerging markets appear to be waiting for a trade deal, but bond investors have already seen enough and are in the process of buying back their underweight. The inflation outlook for emerging market debt is also improving.

What were the leading and lagging indices for fixed income performance in the quarter? What were the drivers?

I think Q2 is likely to be a watershed moment for financial markets. The investor and market panic in Q4 2018 has been swiftly followed by a rapid and broad capitulation by central banks. The question now is, does this reflect the elevated risk of a coordinated global slowdown (or even recession) that markets worried about in Q4, or the restart of a new reflation wave.

US fixed income markets provide some clues as to which way investors are leaning on the recession or reflation question. They began the year with near-neutral returns in Treasuries but have rapidly chased returns this quarter. Aggregate demand for US Treasuries hit a 12-month high at the end of March, and investors are now beginning to build an overweight. This demand has not come entirely at the expense of riskier fixed income instruments. While demand for US mortgage-backed securities (MBS) and investment-grade corporates remained robust, high-yield bonds did see some outflows in the quarter - a trend we flagged in the Q1 edition of the Bond Compass.

Investors Flows in US Corporate Bonds and US Treasuries

Demand for Treasuries at the front end of the curve, which rose to a five-year high during the quarter, has led this year's surge. This trend stands in contrast to 2018, when demand was entirely led by appetite for the longer-dated Treasuries. Just as there was a clear desire to lengthen portfolio duration last year, so there is a desire to shorten duration today. Also of note, demand for the belly of the curve, which typically performs well during recessionary periods, has so far been relatively neutral. So, investors are enthusiastically buying Treasuries, although they are not betting on a recession just yet and are reluctant to add to their overweight at the long end of the curve at these yield levels.

Treasury Flows by Maturity

Looking outside the United States, what are you seeing in terms of performance? What's your outlook?

With the end of QE at the close of 2018, hopes that the ECB would begin to tighten in 2019 have already been dashed as growth forecasts have tumbled. In markets, this is not so much a question of the shape of the curve or a coming recession but whether a recession is already here and how to deal with the returning challenge of negative yields across swathes of European sovereign debt.

The response has been interesting. Rather than panic about what growth means for Italy's fiscal sustainability, investors have continued to buy Italian government bonds. Yields trump fear for now, and the same can be said of the inflows into European corporate debt, too. It is worth noting, though, that investors remain skeptical of French bonds, which have some of the same risks as Italy without the yield.

Outside of mainland Europe, gilts have also continued to sell. Rather than serve as a safe haven amid the ongoing Brexit negotiation, gilts risk losing in either outcome. There could be a return of BoE [Bank of England] hikes in the case of a long delay or the risk of capital flight and sterling-induced inflation in the event of a no-deal Brexit.

Investor Flows in European Bonds

Local currency emerging market sovereign debt is recovering. The Fed's capitulation means the risks of rising US rates and a strengthening dollar are modest. On balance, news about the US-China trade war appears to be meandering to a more constructive outcome. And, the recovery in EM currencies means that the inflation threat has turned, too. In response, even though recession risk has risen in developed markets, long-term investors continue to return to local currency debt markets. This trend is especially true in Mexico, Indonesia, and South Africa. Meanwhile, investors have remained more cautious on Turkey.

In your quarterly Bond Compass piece, you have a tool called PriceStats. What data does it track? What does it look to predict?

PriceStats began life as an MIT (Massachusetts Institute of Technology) research project called the Billion Prices Project, and the offshoot of that was a company called PriceStats with which State Street (NYSE:STT) now has a joint venture. What it does is it scrapes tens of thousands of publicly available retail prices off the internet in more than 30 countries, and we aggregate those prices up into a measure of inflation that in a number of countries is very similar to the inflation rate that's produced by the statistical agencies. You can see in the Bond Compass that in the US and the eurozone that it has tracked the official data very well.

The advantage of calculating inflation this way and collecting it online is that we can do it daily, and we can almost do it in real time, so we only have a three-day publication lag before we know what the inflation rate is on a daily basis. It gives us an almost real-time pulse on retailers' pricing decisions. It can show and give insight into demand trends or obviously, most recently, how quickly oil prices are feeding through into consumer prices. So, it's like a real-time pulse into the economy, which in periods like the Q4 sell-off, where we've had such a drastic change in the market's view of growth, these real-time indices are very helpful to get a check on what retailers are doing.

You featured a portfolio manager colleague discussing his approach to actively managing short-term duration debt. What's that look like and what's the outlook, given the shape of the current yield curve?

Jim Palmieri, senior PM and head of structured credit at State Street Global Advisors, manages our active ultra-short-term strategy. What makes the method unique is employing both quantitative and fundamental techniques in the total return process. Because fixed income markets are persistently inefficient, Jim and his team use a three-pronged approach - with structural, cyclical, and tactical elements - to extract alpha from these inefficiencies throughout a market cycle.

The structural process establishes modest portfolio risk for markets that are considered fairly valued to take advantage of some of the longer-term inefficiencies the team identifies. An example of a current structural inefficiency is the kink in the yield curve in the space between cash-like securities and intermediate duration bonds.

Next, the cyclical process revolves around the firm's monthly asset allocation meeting. This meeting incorporates feedback from all the members of the active team to establish risk targets for duration, curve, and asset allocation. This framework allows us to take advantage of market pricing that, Jim and his team feel, has deviated from fair value.

The final component is a tactical process where individual securities are carefully selected to construct the portfolio. This has been a key source of alpha over time. Ultimately, the top-down asset allocation decisions and bottoms-up security selection combine to provide a consistent and diversified source of alpha over the long term, as evinced by the team's long-term track record.

In early 2019, you identified the opportunity that convertibles represented to investors. Does that still hold true today or has volatility whipsawed that a bit?

I think that anything that could offer a bit more yield and a bit more upside - because investors are still income-hungry - is still relatively attractive. As you say, it probably needs volatility to calm down a little bit, but I think we're going through a phase now where markets have - to some extent - gotten ahead of the data. So, your market risky assets have dislocated far more, I would say, than the data would suggest they should have, and I think there's been a little panic in markets about a coming recession. If we get calmer data like we seem to be getting in the US, then I think some of that volatility will calm down, and investors will be refocused on trying to pick up yield.

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