What a difference a quarter makes!
Markets pivoted dramatically 1Q19, veering from the expectation rising rates would hurt the stock market and slow the economy to the belief that growth could be extended with a more accommodating Fed and Chinese stimulus. The yield curve flattened as rates declined in the 4th quarter, and then fell further and inverted in the first quarter with the hope of Fed rate cuts. By the end of the first quarter, the one-month Treasury yielded more than the ten-year Treasury. During the same period, corporate credit spreads ballooned 52 bps on economic fears, and then abruptly pivoted and tightened 38 bps with the hope Fed patience could extend economic growth. This is not normal middle of the cycle behavior.
1Q19 Total Return*
1-5yr Index 1-10yr Index Total Market Index
Treasury/Agency 1.21 1.56 2.17
Municipal 1.35 2.09 2.95
Corporate 2.63 3.80 5.01
*ICE/BAML Index Return Data
Munis: Municipals had a great quarter and easily beat treasuries. This outperformance was due to very strong technicals resulting from large flows into mutual funds in conjunction with light supply from issuers. As usual when there are more buyers and fewer sellers, prices go up.
As the price of municipal bonds increase, yields fall. We saw that, for some muni investors in lower tax brackets, lower muni yields made it possible to sell municipals and buy taxable bonds to earn a superior all in after-tax return. This was an important trade in some of our Blend Strategy accounts during the quarter.
Corporates: This was an exceptional first quarter for corporate bonds, with spreads tightening 38 bps. In conjunction with lower interest rates, corporates produced market leading returns.
It appears the markets awoke in 2019 and decided that corporate bonds had become too cheap and that the world was not as scary as it seemed. As the quarter evolved, the Fed moved from patient to dovish, and Chinese stimulus was formally announced on January 14th. However, as soon as all this good news was digested in early February, the rally in spreads started to lose some steam.
It is difficult to see corporates continuing to produce Q1 type excess returns as we move through the rest of the year.
Overall: So, was the first quarter a durable pivot to economic stability or just some noise at the end of a long economic cycle?
We see the potential for some short-term stability as the Fed and other central bankers have grown more accommodating and willing to stay accommodating for as long as it takes. We see unemployment low and wages rising, and we see banks still willing to lend. The cycle could go on for a while longer.
But we also see recent market noise as yet another telltale sign of a weakening U.S. economy. The trend of slowing GDP growth is evident in the U.S. and more pronounced in China. Furthermore, one can argue some parts of Europe are now bordering on recession. Slower growth is not surprising, as the Fed has raised rates over the last two years, fiscal stimulus is waning, world trade has been noticeably weakened by protectionism and corporate profit margins are past peak.
With all this noise in a slowing economy, we will continue to position portfolios conservatively and stay prepared for the next pivot and next opportunity.
Sources: Federal Reserve, Bloomberg