A Look Back, A Look Ahead

As we entered 2018, fixed income investors were primarily focused on the Federal Reserve and what a normalizing monetary policy environment would mean for fixed income returns. As we exit 2018 and look ahead to 2019, all eyes continue to be on the Fed, but for very different reasons.

For much of 2018, financial markets enjoyed a strong domestic and global economic backdrop, robust corporate revenue and earnings growth, and solid market performance from investment sectors ranging from stocks to high yield corporate bonds. This environment allowed the Federal Reserve to continue the monetary policy normalization process it began in late 2016 by raising the Fed Funds Rate a total of four times.

The environment has now changed.

Late in 2018 investors suddenly began to price-in a more downbeat outlook. Estimates for economic growth, earnings growth and inflation have all declined, yet the Fed expects to continue raising the Fed Funds rate another two times during 2019. The market is pricing-in no additional rate hikes. As such, all eyes remain on the Fed, but unlike 2018, when investors were fixated on how the near certain rate hikes would play out, this time they are waiting to see if the Fed will raise rates at all.

Rates: A regular topic of conversation in 2018 was the flattening of the yield curve. Short-term rates tend to be tied to Fed action, while long-term rates are typically correlated to economic growth and inflation. With estimates for inflation and future economic growth subdued, long-term rates, such as 10-year and 30-year yields, remained stable throughout 2018 after a sharp rise in Q1. Short-term rates moved higher with the Fed, but because short-term bonds have less sensitivity to rate increases than long-term bonds, the price impact on returns was limited. This dynamic, coupled with interest income generation, allowed bond returns to be positive, despite the Fed’s rate increases.

2018 Total Return

1-5yr Index 1-10yr Index Total Market Index

Treasury/Agency 1.53 1.44 0.83

Municipal 1.79 1.69 1.04

Corporate 1.00 -0.17 -2.25

*ICE/BAML Index Return Data

Munis: Tax-free municipals led all investment grade sectors in 2018 and are positioned to perform well again in 2019. A strong technical backdrop was the main driver for muni returns, as supply fell by more than 20% year/year due the elimination of advanced refunding transactions. This year, the expectation is for technicals to remain supportive. Broadly, fundamental credit quality has strengthened over the last several years as the improving economy and strong financial market environment has improved the financial position of many municipalities. The issues around underfunded pension and healthcare liabilities remain acute, however, and must be analyzed thoroughly when making municipal investments.

Corporates: Volatility in risk markets spilled over into the investment grade corporate market during the year, causing corporates to underperform most investment grade sectors. The additional yield on corporate bonds compared to risk-free assets like U.S. Treasuries, a metric known as credit spread, increased as investors began to price-in a riskier environment. Elevated debt levels across much of corporate America, as well as rising borrowing costs as outstanding debt comes due, are two areas of investor concern. While yields in the corporate space have increased, they do not yet offer enough value to create a compelling risk/reward tradeoff in our minds. As such, we are maintaining what has been a very conservative allocation to the sector.

Overall: Moving forward, 2019 brings a new level of uncertainty for investors. Monetary policy has tightened and the U.S. economy is set to continue growing. But this growth is expected to proceed at a slower rate, and both trade and geopolitical tensions to remain high. We believe that financial market volatility is likely to continue into next year, and have positioned our portfolios for it, with a high percentage of AA and AAA rated bonds held across our strategies. At some point in 2019 it is possible that more attractive entry points to take risk in investment grade bonds will present themselves, but we are not there yet. In the meantime, we will continue to let our portfolios perform as investment grade bond portfolios are meant to, especially in markets such as these: with stability.

Source: ICE/BAML

The Fed Hikes Again

As widely anticipated, the Federal Reserve Open Market Committee raised the Fed Funds rate by 0.25% last week to a range of 2.25-2.5%. This marked the fourth rate increase of 2018 and the ninth since the tightening cycle began in late 2015. Just as important, the FOMC updated its famous (or infamous) “dot plot,” which details expectations for future rate increases. The committee anticipates raising the Fed Funds rate two additional times next year (down from a previous expectation of three increases). One additional rate increase is expected in 2020 and none in 2021. The committee’s expectation for the “neutral rate,” meaning the rate at which the economy is performing at its long run average, is 2.5-3.5%, meaning the current rate is at the lower bound of what the FOMC would consider “normal.” In his press conference, Fed Chair Powell indicated that the balance sheet runoff process has been smooth and will continue.

Clearly the risk markets did not welcome this news. Stocks and other risk assets sold-off while high quality bonds rallied. U.S. Treasuries saw the best performance in the investment grade markets. Corporates rose in value, but underperformed other sectors. Municipals traded well.

Moving forward, 2019 brings a new level of uncertainty for investors. Monetary policy has tightened and the U.S. economy is set to continue growing. But this growth is expected to proceed at a slower rate, and trade/geopolitical tensions remain high. We believe that financial market volatility is likely to continue into next year, and have positioned our portfolios for it, with a high percentage of AA and AAA rated bonds held across our strategies. At some point next year it is possible that more attractive entry points to take risk in investment grade bonds will present themselves, but we are not there yet. In the meantime, we will continue to let our portfolios perform as investment grade bond portfolios are meant to, with stability, especially in markets such as these.

Happy Holidays!

Source: Federal Reserve

The ECB Slowly Tightens the Monetary Screws

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On Thursday of last week Mario Draghi announced, unsurprisingly, the end of the European Central Bank’s (ECB) bond buying program. The ECB supported the European markets and economy over the last four years by buying euro 2.6 trillion of sovereign and corporate debt. This was a large and important program, and announcement of its ending is a major milestone in removing crisis era stimulus. With the removal of this stimulus, the monetary screws are slowly tightening.

Very slowly.

The ECB will not sell any of the debt it purchased, will reinvest all proceeds, and perhaps most importantly will keep the main interest rate at zero at least through the summer of 2019 or until inflation meets the target of slightly below 2%.

We could be waiting some time for the ECB’s first interest rate hike. The ECB’s target of 2% inflation looks to be a long-term aspirational goal considering recent slower growth forecasts and the increasing risks to its economy. Just 24 hours after the ECB announced the end of its bond buying program, both the Eurozone and China reported weaker economic data. In sympathy, U.S. stocks sold off and bond prices rallied. Stocks down and bonds up is the normal reaction to bad news, as we discussed last week.

So, what does this mean for portfolios?

It reinforces our belief that it is good to be cautious! When both the Federal Reserve and the ECB are in the process of slowly tightening the monetary screws, and just as global growth looks to be slowing, the result will be more volatility, with the possibility of even slower economic growth.

Sources: ECB, Financial Times, Bloomberg

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