Investment Grade Bonds Behave as Expected During Recent Bout of Market Volatility

The breakdown of the negative correlation between bonds and stocks has been a hot topic in financial circles this year. Typically, when equity markets experience negative price volatility, high quality bonds do well as investors seek out safety. For much of 2018, this has not necessarily been the case. Most asset classes around the globe, including bonds, have had a difficult year. Look no further than the Federal Reserve raising the Fed Funds Rate as the reason most investors are citing for the poor return environment.

For much of 2018, investors have been focused on what a tightening monetary policy environment means for not just bonds but also for global risk assets (think equities). In other words, the rising interest rate environment has presented a challenge to most investors; Specifically, bondholders because rates are rising, and equity holders as liquidity is being drained from the financial system.

Thus far in December however, historic normalcy has taken over. See below for December month-to-date returns through last Friday.

S&P 500 -4.55%

1-10yr UST/Agency 0.56%

1-10yr Municipal 0.45%

1-10yr Corporate 0.38%

*Benchmark Data 11/30/18 – 12/7/18. Bond Indices are ICE/BAML

Why the return to “normal?” In recent weeks, the main focus has been on how late we are in the economic cycle and how things like trade wars can impact the domestic and global economies. The Fed has also hinted that we may be closer to the end of rate hikes than the beginning. This is bond friendly and likely why we’re seeing positive returns so far this month. Moving forward, the Fed will continue to be in focus as investors attempt to understand how much further the FOMC has to go with rate hikes. There is also a renewed focus on the economy as investors assess how much further the economy has to run. What is most likely is that we haven’t seen the end of volatility, and to the extent the volatility stems from economic concerns, high quality bonds should provide the traditional “ballast” that we’ve grown accustomed to over the years.

Source: Bloomberg, ICE/BAML

Releasing the Doves? Powell Cheers Equity but Not Credit Markets

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Fed Chair Powell gave a boost to equities last Wednesday by saying the current Fed Funds rate is “just below the broad range of estimates of the level that would be neutral for the economy.” This is important as it suggests the Fed may be close to pausing its series of interest rate hikes. Over the last two months the markets have become increasingly skittish in the face of both rising rates and concerns over trade and slowing world growth. Through Friday, the S&P is down close to 7% since early October, and credit spreads are more than 25 bps wider.

Mr. Powell’s dovish comments came one day after the Fed’s Vice Chair, Richard Clarida, offered some detail on the Fed’s more accommodating rethink of the neutral rate, explaining that the Fed is close to meeting its twin targets of full employment and 2% inflation. Mr. Clarida added that labor markets may not be overheating, as some feared, since “there may be some further room for participation” by non-workers. Additionally, productivity growth is better this year, suggesting wages can continue to grow without pushing up inflation.

There is little indication inflation is a problem that requires higher rates. PCE (core) came out last Thursday at a below consensus 1.8% year-over-year. Looking forward, many economists are expecting growth to slow in the U.S. in 2019 as the impact from fiscal stimulus wains, previously enacted rate hikes begin to slow growth (look at the housing markets), and trade and tariffs increase costs, all while China and the rest of the global economy slows.

The credit markets widened modestly on the day, suggesting a less than dovish interpretation of the Fed comments. The credit market’s alternate interpretation of Fed comments is that a pause could signal that the Fed thinks economic prospects are weakening more than anticipated. If the economy is on the verge of slower growth, this is not good for credit.

Our in-house Fed policy discussions often center on the divergence between the Fed and the market’s anticipation of further rate hikes. How will this difference be resolved: will the Fed reduce its targets or will the market increase its expectations for rate hikes?

Maybe a release of the doves is a sign, but it won’t be the last!

Sources: Wall Street Journal, the Financial Times, Bloomberg, BMO Capital

Recent Corporate Bond Market Weakness

The investment grade corporate bond market is notably weaker over the last few weeks. Corporates have underperformed relative to other investment grade sectors for most of 2018, but the velocity of the recent selloff is now front-page news. We are not surprised by this selloff and have been positioned for corporate weakness across our various strategies.

The recent widening in credit spreads can be attributable to a host of general market factors, including concerns over rising rates, trade wars, slowing growth in China and round the globe, increased geopolitical risk and a stronger dollar. In addition, credit spreads have been relatively tight compared to historical averages, meaning that corporates have not offered tremendous relative value. None of these factors are new.

On top of the general market factors, we have seen company specific problems with some issuers, including General Electric, Ford, and Pacific Gas & Electric. Taken together, these general and specific factors can cause investors to become bearish, and overly weak sentiment can accelerate spread widening.

And while our expectation is for corporate spreads to continue moving wider, we believe concerns over the corporate market may also be exaggerated by the market at this time. We see two major strengths keeping the corporate market upright in the face of current weakness. First, corporate profitability is robust and third quarter earnings in the S&P 500 (a good surrogate for the corporate bond market) were exceptional. Second, the U.S. economy continues to grow above trend, with the last quarter GDP at 3.5%, unemployment at 3.7% (remaining at 50 year lows) and core CPI at 2.1% (suggesting inflation is still tame).

These positives will likely keep the market from continuing to experience the current pace of spread widening. However, in the latter stages of an economic cycle where a central bank has been tightening monetary policy, we aren’t excited about adding exposure on this current bout of weakness, either. Instead, we are staying the course with our conservative positioning, continuing to keep a close eye on the issuers we do own and waiting for more attractive entry points before taking more risk.

Sources: Bloomberg, BofAML

Muni Technicals Weaken, but Relative Performance Holds Steady

When evaluating the municipal market, a consistent topic of conversation for us is the technical environment, which is basically a measure of supply and demand.

Municipal bond funds and ETFs have exhibited a fairly consistent pattern over the last 10 years whereby redemptions occur during periods of rising Treasury rates. The last few weeks have been no exception. Since late August, the 10-year U.S. Treasury yield has risen from around 2.8% to 3.2%. The two main data providers on fund flows, Lipper and ICI, have reported that muni funds and ETFs have faced outflows for seven straight weeks through 11/7, the first sustained period of outflows since immediately following the 2016 presidential election.

On the supply side, in October the market absorbed two of the heaviest weeks of supply this year, as several large new issues came to market.

Despite these headwinds, the municipal market generally remained on stable footing. As shown in the chart below, the ratio of municipal bond yields versus Treasury bond yields (a proxy for municipal richness/cheapness) remained fairly close to August levels, before any outflows had occurred. Credit spreads, or the additional yield demanded by investors to take municipal credit risk, have also remained relatively stable and currently sit at the YTD average. Looking at total return performance of the market broadly, the ICE/BAML municipal master index has performed in line with the ICE/BAML Treasury index in recent weeks.

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It is expected that technical factors will become more supportive through January, as supply is expected to slow. With Treasury yields having stabilized and the midterm election cycle behind us, we would expect the pace of outflows to slow or reverse as well.

Both the market’s ability to absorb outflows and an uptick in primary supply without a major hiccup should be viewed as positive. Coupled with the improving technical environment, performance relative to Treasuries is likely to be supported through the end of the year.

Sources: Barclays, ICI, Lipper

Jobs Report Indicates Labor Market Remains Healthy, Fed to Stay on Track

Employers added 250,000 jobs during October, continuing the healthy pace of hiring that we’ve seen over the last several years. In fact, jobs have been added for a record 97 consecutive months. The unemployment rate was steady at 3.7%.

The main headline in the report however, and in most papers over the weekend, was wage growth. Average hourly earnings rose 3.1% year/year, the largest gain since 2009. Earlier last week the employment cost index, another proxy for worker compensation, showed a tick up as well.

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Many economists have been waiting for wage growth to emerge after years of steady hiring. And while a print above 3% may indicate some tightening in the labor markets, we are still far away from the 4%+ figures seen in past economic expansions. Of course, those types of wage gains were present during periods of higher inflation. As we discussed on our recent Q3 webcast in early October, wage growth tends to coincide with inflation, not lead it. With inflation around 2%, it makes sense that wage growth, while increasing, is still well contained.

We watch these figures with great interest as they have implications for the Federal Reserve. A healthy labor market and inflation at the Fed’s 2% target makes it very likely that the Fed will continue on its steady path to policy normalization. This means another four rate increases by the end of 2019. It also means that with economic fundamentals at the Fed’s targets, market volatility, like what we saw in October, will not necessarily knock the committee off its path. We will hear from the Fed this week after its November meeting. All indications are that the committee will hold rates steady and will next raise the fed funds rate in December.

With these dynamics in play our broad market outlook, which is highlighted by a flat yield curve environment and pockets of market volatility as policy normalization takes place, remains unchanged.

Source: JP Morgan, WSJ