Excerpted from Guggenheim Investments’ First Quarter 2019 Fixed-Income Outlook
Our last several installments have reiterated a central theme: The Federal Reserve (Fed), seeking to normalize policy and temper above-trend economic growth, was on course to cause a recession that we projected would begin in the first half of 2020. This timing is important because history has shown us that market conditions typically deteriorate in the 12 months leading up to a recession. This meant we had to manage around an overvalued market knowing that soon enough we would see dramatic spread widening and liquidity issues.
In the fourth quarter, this late-cycle drama began to unfold, and risk assets sold off. After setting peaks in October, equities and credit sectors began a wild ride down. The selloff intensified in December amid a severe lack of liquidity. Before the December Federal Open Market Committee (FOMC) press conference, the S&P 500 had set a new low of 2,546. It took another 7.7 percent dive following a series of policy blunders that included Fed Chair Jay Powell’s "autopilot" comments about the Fed balance sheet runoff, President Donald Trump’s attack on Fed independence, and Treasury Secretary Steven Mnuchin's call to major banks confirming that they had adequate liquidity. Financial markets had zero tolerance for policy mistakes in an already weak seasonal correction environment.
Learning from its mistake, the Fed will be sure to quell any uncertainty around its policies in 2019. The Fed has indicated it will move to the sidelines, and we expect it will deliver only one more hike later in 2019 and remove its balance sheet runoff from autopilot. This has calmed markets for now, but headwinds remain. Global economic data look increasingly poor, with Europe leading the way down. More policy action will be needed to ward off the recession we see on the horizon. We put the odds of a Fed rate cut at 50/50, and we believe the European Central Bank (ECB) will introduce another targeted program to encourage bank lending.
The experience we recount in this quarter’s Fixed-Income Outlook should serve as a preview of what is to come when the cycle ultimately turns. For now, we expect risk assets to enjoy another rally while the Fed stays on hold, but the pause will only allow excesses we have highlighted before to become more pronounced. The defensive positioning we established in the third quarter of 2018 will remain intact, which will enable us to avoid the volatility that characterizes late cycle market behavior and give us the opportunity to pick up undervalued assets when others are being forced to sell.
Chairman of Investments and Global Chief Investment Officer
Portfolio Management Outlook
Liquid and Patient
Reduced spread duration of our investment portfolios helped dampen market volatility in the second half of 2018.
Global economic data weakened throughout the course of the fourth quarter. Macroeconomic and geopolitical events, including a trade war between the United States and China, falling oil prices, and concerns over slowing growth, triggered a broad selloff in risk assets. Spreads widened across all sectors, while interest rates fell over the quarter.
At its December meeting, the FOMC voted to raise the federal funds rate by 0.25 percent to a range of 2.25–2.5 percent. At the press conference, Fed Chair Powell failed to convey flexibility around the Fed’s balance sheet policies. The Treasury yield curve bull steepened as future Fed interest rate hike expectations collapsed while risk assets sold off further. More recent Fedspeak, particularly during the January post-FOMC meeting press conference, calmed markets by confirming data dependence and flexibility around interest rate and balance sheet policies.
Risk reduction in our portfolios continued in the fourth quarter and was concentrated in the first half of the quarter, prior to the most significant spread widening. All strategies pared back exposure to remaining credit sectors, including CLOs, non- Agency RMBS, and other ABS, with proceeds going toward government-guaranteed sectors, and cash and cash equivalents. As a result, portfolio credit quality further increased and spread duration was further reduced over the quarter.
In the Core Plus strategy, long-duration assets in our portfolio contributed to positive absolute performance as rates beyond one year fell between 20–45 basis points. Our investment strategy continues to employ a duration barbell by allocating key rate exposure on the very long end of the curve while remaining overweight floating-rate exposure on the short end, resulting in an underweight duration relative to its benchmark. While spreads widened in all credit sectors over the fourth quarter, the Core Plus strategy outperformed its benchmark on a spread basis as structured credit spreads held in better than corporate credit spreads.
In the Multi-Credit strategy, our prior risk reduction program and relatively low allocation to below investment-grade credit led to relative outperformance over the quarter. Similar to the Core Plus strategy, our senior structured credit exposure outperformed corporate credit, particularly AAA CLOs. Our short spread duration helped dampen performance volatility.
We believe that the Fed will pause rate increases in the first half of 2019, with the risk that this pause could last longer. Additionally, the possibility of a rate cut cannot be ruled out. Further weakness in global economic growth may spill into the U.S. economy, which could spur the Fed to react. Such events have occurred in the past. The Fed ultimately cut rates in 1995, in the aftermath of the Mexican peso crisis. Then, after a short hiking cycle, it cut rates again in 1998 due to the spillover effect from the Asian financial crisis.
The Fed pause is supportive of a rally across risk assets in the near term, but it will also allow excesses to continue to build in the system. Many of the concerning trends previously discussed by our sector teams, including the potential for high downgrade volume in the investment-grade market and defaults in certain credit sectors, remain at the forefront of our long-term thinking. In this environment where we believe credit spreads are not enough to compensate for these risks, it is prudent to stay up in quality and maintain adequate liquidity to pick up undervalued credits during more opportune times.
Fixed-income sector performance trends reversed course in the fourth quarter. Panicked selling exacerbated market volatility as some investors attempted to de-risk amid dwindling market liquidity.
-Anne B. Walsh, JD, CFA
Chief Investment Officer, Fixed Income
-Steve Brown, CFA
It’s All Downhill from Here
Global growth has peaked, but a tight U.S. labor market will ultimately prompt the Fed to tighten again.
U.S. economic growth was solid at an estimated 2.6 percent in the fourth quarter of 2018, but we expect first quarter growth to slow to about 1.0 percent. This stems in part from tighter financial conditions, but reported growth is also likely to be weighed down by seasonal adjustment issues along with the temporary impact of the government shutdown.
The good news is that sequential growth is likely to rebound in the second quarter as statistical and shutdown distortions are reversed. Nevertheless, growth is now on a downward trajectory in year-over-year terms. The combination of tighter Fed policy and fading fiscal stimulus will ensure that growth in 2019 is weaker than it was in 2018. Leading indicators confirm that the peak in growth is behind us (see chart, top right), and our recession forecasting tools continue to point to a downturn starting by mid-2020. However, there is a chance that a Fed pause could delay a downturn until late 2020 or even early 2021.
Meanwhile, the steady softening in global manufacturing purchasing managers’ indexes illustrates how global growth momentum has faded (see chart, bottom right). Growth in Europe is sputtering, and the ongoing Brexit saga is still unresolved. The steady slide in Chinese growth has prompted authorities to announce a series of stimulus measures with more forthcoming, but policy lags will delay any positive impact.
Against this backdrop, the Fed has moved to the sidelines. A pause in the hiking cycle is likely for the first half of the year, but we do not believe the Fed is done tightening just yet. The labor market continues to strengthen, and we see further wage gains ahead. And while core inflation should remain soft in coming months, we expect it to rebound in the second half. Our baseline forecast now envisions one more hike later in the year. Further rate hikes may be required in 2020 should inflation expectations begin to rise meaningfully. Balance sheet runoff should conclude in the third quarter, with details likely to be announced at the March meeting. This will allay market concerns about balance sheet reduction being on “autopilot.”
A more patient Fed and multi-pronged stimulus in China should foster a recovery in risk assets in the near term. Additionally, the ECB may add liquidity through long-term refinancing operations (LTRO) or targeted LTROs. This would support our call for an Indian Summer for risk assets , which is characterized by the warm spell that follows a cold snap. We see this as a window of opportunity to further de-risk portfolios in preparation for a 2020 recession.
Leading indicators confirm that the peak in growth is behind us, and our recession forecasting tools continue to point to a downturn beginning in by mid-2020.
The steady softening in global manufacturing purchasing managers’ indexes illustrates how global growth momentum has faded.
Head of Macroeconomic and Investment Research
-Maria Giraldo, CFA
-Matt Bush, CFA, CBE
The Beginning of the End
With one more rate hike expected by our macro research group, we believe this is the beginning of the end of the upward move in rates.
The fourth quarter of 2018 experienced a substantial increase in capital market volatility. The poor performance of risk assets drove a flight to quality. Treasury yields declined 20–45 basis points across the curve, with the belly outperforming as forward-dated FOMC rate hikes were priced out of the market (see chart, top right). Nominal yields declined more than real yields, as the broad move lower in commodity prices drove a decrease in breakeven inflation rates (see chart, bottom right).
The significant move lower in U.S. Treasury yields generated strong returns for the asset class, delivering a total return of 2.6 percent for the quarter and resulting in a total return of 0.9 percent for the year. Meanwhile, the Agency index produced a total return of 1.9 percent for the quarter, and a total return of 1.3 percent in 2018. Longer maturity Agency auction bonds were not immune to the selloff, as they cleared 20–30 basis points wider in spread than comparable Treasury bonds.
Fed Chair Powell stated that the December hike put short-term rates at the lower end of the FOMC’s estimate range for the neutral rate. Recent experience shows a high sensitivity of modest rate changes on economic activity, supporting this statement. Previous work from our Macroeconomic and Investment Research Group found that given the level of nonfinancial corporate debt to gross domestic product, U.S. corporates could only support rates somewhere in the range of 2.50– 3.25 percent before the increase in borrowing costs makes it difficult to continue to service heavy debt burdens. Thus, our Macroeconomic and Investment Research Group’s forecast of one more rate hike in the second half of 2019 suggests this could be the beginning of the end of the upward move in rates for the cycle. One more rate hike implies that 30-year Treasury yields, currently 3.00 percent, will peak below 3.25 percent. It also leaves some room for the Treasury yield curve to flatten, but most of the flattening we expected to see in this cycle is behind us. The 2s/10s and the 10s/30s Treasury yield curves have flattened by 113 and 38 basis points, respectively, against 225 basis points of monetary policy tightening since December 2015. Once the hiking cycle is over, we think more attractive buying opportunities will materialize around the belly of the curve.
Note: “Rates” products refer to Treasury securities and Agency debt securities. Treasury and Agency returns are represented by the Bloomberg Barclays Treasuries index and the Bloomberg Barclays U.S. MBS index, respectively.
Treasury yields declined 20–45 basis points across the curve, with the belly outperforming as forward-dated FOMC rate hikes were priced out of the market.
Nominal yields declined more than real yields, as the broad move lower in commodity prices drove a decrease in breakeven inflation rates.
Senior Managing Director
-Tad Nygren, CFA
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