By Kathy A Jones
Returns for fixed income investors have been very strong year-to-date in 2019. If you were invested, it's likely that you got a positive return. Every fixed income asset class, from the "risk-free" to the riskiest, has posted gains thanks to the steep drop in long-term interest rates over the past six months. We expect returns to remain positive in the second half of the year, but we don't expect a repeat performance of the first half's sharp gains.
Fixed income total returns have been strong year to date
Source: Bloomberg, as 6/2/2019. Past performance is no guarantee of future results. Asset classes are represented by the following indexes: US Aggregate = Bloomberg Barclays U.S. Aggregate Bond Total Return Index; Short-term core = Bloomberg Barclays U.S. Aggregate 1-3 Years Bond Total Return Index; Intermediate-term core = Bloomberg Barclays U.S. Aggregate 5-7 Years Bond Total Return Index; Long-term core = Bloomberg Barclays U.S. Aggregate 10+ Years Bond Total Return Index; Treasuries = Bloomberg Barclays U.S. Treasury Index; TIPS = Bloomberg Barclays U.S. Treasury TIPS Total Return Index; Agencies = Bloomberg Barclays U.S. Agency Bond Total Return Index; Securitized = Bloomberg Barclays U.S. Securitized Bond Total Return Index; Municipals = Bloomberg Barclays Municipal Bond Total Return Index; IG Corporates = Bloomberg Barclays Corporate Bond Total Return Index; HY Corporates = Bloomberg Barclays U.S. High Yield VLI Total Return Index; IG floaters = Bloomberg Barclays US Floating Rate Notes Total Return Index; Bank loans = The S&P/LSTA U.S. Leveraged Loan 100 Index; Preferreds = Merrill Lynch BofA Preferred Stock Total Return Index; Int. developed (x-USD) = Bloomberg Barclays Int'l Developed Bonds (x-USD) Total Return Index; EM = Bloomberg Barclays Emerging Market Bond (USD) Total Return Index.
In the second half of 2019, returns are likely to be primarily driven by the income generated on bonds, and not as much by price appreciation. A slowing economy, tame inflation and the prospect of easier monetary policy down the road should all contribute to keeping interest rates low. However, the market has already gone a long way toward factoring into current yields the likelihood of interest rate cuts by the Federal Reserve. Those expectations may be overdone.
Slowdown or recession?
The key question facing the market in the second half of the year is whether the economy is just slowing down - or if it's heading into recession.
- In a slowdown scenario, the Fed likely would hold off on any rate cuts until the fall to gauge the extent of weakness, and 10-year Treasury yields would likely range between 2% and 2.5%.
- In a potential recession scenario, the Fed likely would begin to lower interest rates as early as July, and we would expect 10-year Treasury yields to fall below 2%.
We believe the slowdown scenario is the most likely, but worry that trade conflicts could be the catalyst for a recession longer term. Recessions are notoriously difficult to forecast, because they often are triggered by some shock to the economy that isn't easy to see in advance. The risk from trade wars is visible, but difficult to quantify given the uncertainty surrounding negotiations.
Recent data suggest the economy's growth rate has begun to slow, but it appears to be returning to a rate consistent with the long-run trend. After nine rate hikes by the Federal Reserve since December 2015, slower growth is to be expected. Also, the impact of the tax cuts and government spending increases that went into effect last year are starting to fade away. Recent data suggest that U.S. gross domestic product (GDP) growth will likely average around 1.5% to 2% in the second half of the year, after exceeding 3% for most of the past year.
Notably, GDP growth in the 2% region is in line with the Fed's long-run forecast for economic growth. The Fed views 2% as the sustainable growth rate for the economy based on demographic and productivity trends. GDP growth is defined as the sum of the growth rate in the labor force and the growth rate in productivity. Due to the aging population, the labor market expected to grow at a pace of about 0.5% as the baby-boom generation retires. Productivity is harder to forecast, but it has averaged about 1.25% to 1.5% in recent years. Combining the two produces an estimate of 1.75% to 2% GDP growth - in line with the Fed's base forecast.
The Fed's forecast for long-run GDP growth is around 2%
Source: Federal Reserve. Longer Run FOMC Summary of Economic Projections for the Growth Rate of Real Gross Domestic Product, Central Tendency, Midpoint, Fourth Quarter to Fourth Quarter Percent Change, Not Applicable, Not Seasonally Adjusted. Quarterly data as of Q1 2019.
What about the inverted yield curve?
Much has been made about the yield curve's inversion as a leading indicator of recession. It's widely known that when short-term interest rates are higher than long-term interest rates, it has been a reliable signal of recession in the following 12 to 18 months. With the yield spread between 10-year Treasury bonds and three-month Treasury bills inverting recently, predictions of recession have been rising.
It's an indicator we are watching closely. It should be noted, however, that the lag time between an inverted yield curve and a subsequent recession can be long and variable. Also, there have been a few false signals in the past. Finally, the length and depth of an inversion historically hasn't correlated with the length or depth of the subsequent recession.
We would be more concerned about an imminent recession if other indicators, such as credit spreads - the difference between yields on corporate bonds and Treasury bonds-were also signaling increased risk. Currently, credit spreads are slightly below the long-term average. Consequently, the economy isn't witnessing a major tightening in financial conditions.
The Federal Reserve has different models to estimate the risk of recession. One, based on the yield curve, has shown the risk jump to 30% recently-the highest level since 2007. However, another model, based on credit spreads, isn't showing a significant recession risk. It's showing an estimate of less than 15%.
Signals are mixed on the probability of a U.S. recession
Note: Smoothed recession probabilities for the United States are obtained from a dynamic-factor Markov-switching model applied to four monthly coincident variables: non-farm payroll employment, the index of industrial production, real personal income excluding transfer payments, and real manufacturing and trade sales. Source: Federal Reserve Bank of New York and Federal Reserve Bank of St. Louis. Smoothed U.S. Recession Probabilities, Percent, Not Seasonally Adjusted. Monthly data as of April 2019.
Global risks: Trade is a wild card
The global economy is a source of potential risk for the U.S. economy. Economic growth has been slowing around the world for the past year, and central banks in major developed countries have moved short-term interest rates to zero or even into negative territory. Further policy easing abroad could be a catalyst for the Fed to lower rates to limit the spillover effect on the U.S. economy. Yield spreads between the U.S. and other major countries are already at or near record-wide levels, another factor keeping domestic bond yields low.
U.S. bond yields are above other developed-market countries' yields
Source: Bloomberg. Data as of 6/5/2019. Past performance is no guarantee of future results.
Trade conflicts heighten the risk of a more substantial global slowdown. If tariffs on goods imported from China ratchet higher as threatened, and China retaliates with restrictions on U.S. companies, then the risk of recession would grow. The U.S. economy isn't as reliant on exports as most major economies, which provides some cushion, but some sectors of the economy are feeling the pinch already. A widening of the conflict could increase the impact on the United States.
What to expect when you're expecting a rate cut
In our view, the Fed is likely to cut interest rates later this year, but the market may be pricing in more-aggressive policy easing than is actually likely to happen. Based on the futures market, expectations are for Fed rate cuts to begin as early as June, with a potential total of three rate cuts likely this year. We believe the Fed may be more cautious. It was only a few months ago that the Fed's forecasts included rate hikes-shifting swiftly to rate cuts probably requires more evidence that the economy is at risk.
Some have argued in favor of a pre-emptive rate cut by the Fed to stave off the risk of recession. We wouldn't rule it out, but the voting members of the policy committee may need more evidence that lower interest rates are needed before acting. Some at the Fed have expressed concern that inflation is undershooting their 2% target. However, there doesn't appear to be a consensus and various inflation indicators are mixed.
Based on past cycles, there are a handful of indicators that have tended to precede Fed rate cuts:
- A rise in the unemployment rate
- Tightening financial conditions
- A decline in the Institute for Supply Management (ISM)'s manufacturing index toward 50 (an index score below 50 indicates manufacturing activity is contracting)
- An inverted yield curve
So far, only one of these four indicators-the yield curve - is signaling an imminent rate cut. The ISM index is getting close, but is not in contraction territory yet. Financial conditions indicate credit is widely available, and the unemployment rate is near a 50-year low.
Unemployment remains very low despite slowing job growth
Source: Bureau of Labor Statistics. Civilian Unemployment Rate and Underemployment Rate, Total unemployed, plus all marginally attached workers plus total employed part time for economic reasons (U6 Rate), Percent, Monthly, Seasonally Adjusted. Shaded areas indicate past recession. Monthly data as of May 2019.
The Bloomberg U.S. Financial Conditions Index remains in positive territory
Note: The Bloomberg U.S. Financial Conditions Index tracks the overall level of financial stress in the U.S. money, bond, and equity markets to help assess the availability and cost of credit. A positive value indicates accommodative financial conditions, while a negative value indicates tighter financial conditions relative to pre-crisis norms.
Source: Bloomberg. Bloomberg U.S. Financial Conditions Index (BFCIUS Index), daily data as of 5/31/2019.
The outlook for manufacturing activity expansion has softened, but isn't contracting
Source: Federal Reserve Bank of St. Louis. ISM Manufacturing: PMI Composite Index. Shaded areas indicate past recession. Monthly data as of May 2019. An index with a score over 50 indicates that the industry is expanding, and a score below 50 shows a contraction.
Note: ISM Manufacturing Index: Index based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders and supplier deliveries. A composite diffusion index is created that monitors conditions in national manufacturing, based on the data from these surveys.
Lower for longer is back
For income investors, it looks like the "lower for longer" world is back. To most, it probably seems that it never really went away. The opportunity to capture Treasury yields above 3% was fleeting last year, and we don't see a rebound to those levels any time soon. Ten-year Treasury yields may bounce back to the 2.5% level if the economic news improves and trade tensions ease, but a move back to 3% seems unlikely in the second half of the year.
We came into 2019 suggesting investors extend duration to lock in higher yields. For investors looking to enter the market now, it's more challenging. It's tempting to hold most fixed income assets in short-term maturities, but that means investors risk having to reinvest at lower yields down the road.
With the Treasury yield curve inverted, we would consider barbells, holding some short-term and some intermediate-term bonds. The short-term investments provide liquidity and flexibility to reinvest if rates move up, while the intermediate-term bonds provide a set level of income in case yields move down. The barbell can be weighted more heavily to short-term bonds for greater flexibility if yields rise.
Intermediate-term yields are lower than both short-term and long-term yields
Source: Bloomberg, data as of 6/5/2019. Past performance is no guarantee of future results.
We also continue to suggest investors focus on higher-credit-quality fixed income investments. Whether it's an economic slowdown or a recession, we believe it's wise to avoid too much exposure to economic risks. Lower-credit-quality bonds, such as high-yield and emerging-market bonds, or leveraged loan funds, are more sensitive to the ups and downs of the economy and the stock market than Treasuries or investment-grade municipal and corporate bonds. Moreover, the yields offered compared to Treasuries are not high by historical standards, making valuations less compelling.
Overall, we suggest holding a diversified portfolio of fixed income investments, limiting exposure to the riskier segments of the market.