This article was contributed to us by Charles Schwab Singapore.
Returns for fixed income investors have been very strong year-to-date in 2019. If you were invested, it is likely that you got a positive return. Every fixed income asset class, from the “risk-free” to the riskiest, has posted gains due to the steep decrease in long-term interest rates over the past six months. We expect returns to remain positive in the second half of the year, but not a repeat performance tof the first half’s sharp gains.
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 in the U.S., modest 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 is heading into recession.
In a slowdown scenario, the Federal Reserve will likely begin to lower interest rates as early as July , and 10-year Treasury yields would likely range between 2% and 2.5%.
In a potential recession scenario, the Federal Reservewill also likely begin to lower interest rates as early as July, and we would expect 10-year Treasury yields to fall below 2%.
We believe the former is more likely but worry that trade conflicts could be the catalyst for a recession in the longer term. Recessions are notoriously difficult to forecast because they often are triggered by some shock to the economy that is not easy to foresee. The risk from trade wars is apparent, but difficult to quantify given the uncertainty surrounding negotiations.
Slowdown Scenario
Recent data suggests that the U.S. 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 increases in government spending effected 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.
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?
There have been many discussions about the yield curve’s inversion as a key indicator of an impending recession. It is widely known that when short-term interest rates are higher than long-term interest rates, it is likely that recession will follow in the next 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 on the rise.
It is an indicator we are watching closely. However, it should be noted that the lag time between an inverted yield curve and a subsequent recession can be long and variable. There have also been a few false signals in the past. Lastly, the length and depth of an inversion historically have not 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 lower than the long-term average. Consequently, the economy is not witnessing a major tightening in financial conditions.
The Federal Reserve has various models to estimate the risk of recession. The first is based on the yield curve which has shown the risk jump to 30% recently—the highest level since 2007. However, another model which is based on credit spreads, estimates the risk of recession at only 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 in 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 Federal Reserve 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.
Trade conflicts heighten the risk of a more substantial global slowdown. If tariffs on goods imported from China escalate higher as threatened, and China retaliates with restrictions on U.S. companies, the risk of recession would increase. The U.S. economy is not as reliant on exports as most major economies, which provides some cushion, but some sectors of the economy are already feeling the impact. 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 Federal Reserve 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 July, with a potential total of two 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.
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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. 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 that investors extend duration to lock in higher yields. For investors looking to enter the market now, is more challenging. It is 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 increase, 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 encourage investors to focus on higher-credit-quality fixed income investments. Whether it is an economic slowdown or a recession, we believe it is 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 U.S. 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.
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Overall, we suggest holding a diversified portfolio of fixed income investments, limiting exposure to the riskier segments of the market.
Important Disclosure
Investment involves risk. Past performance is no indication of future results, and values fluctuate. International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market, economic, and political conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.
Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.
Diversification strategies do not ensure a profit and do not protect against losses in declining markets.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.
International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.
The Bloomberg Barclays U.S. Aggregate Bond Index is a market-value-weighted index of taxable investment-grade fixed-rate debt issues, including government, corporate, asset-backed, and mortgage backed securities, with maturities of one year or more. The 1-3 year, 5-7 year, and 10+ year indexes are all components of the broad U.S. Aggregate Bond Index.
The Bloomberg Barclays U.S. Treasury Index measures U.S. dollar-denominated, fixed-rate, nominal debt issued by the U.S. Treasury. Treasury bills are excluded by the maturity constraint, but are part of a separate Short Treasury Index. STRIPS are excluded from the index because their inclusion would result in double-counting.
The Bloomberg Barclays U.S. Treasury Inflation Protected Securities (TIPS) Index is a market value-weighted index that tracks inflation-protected securities issued by the U.S. Treasury. To prevent the erosion of purchasing power, TIPS are indexed to the non-seasonally adjusted Consumer Price Index for All Urban Consumers, or the CPI-U (CPI).
The Bloomberg Barclays U.S. Agency Bond Index includes securities issued by US government owned or government sponsored entities, and debt explicitly guaranteed by the US government). It is a component of the Bloomberg Barclays U.S. Government Bond Index.
The Bloomberg Barclays U.S. Securitized Bond Total Return Index is part of the broad Bloomberg Barclays U.S. Aggregate Bond Index and is designed to capture fixed income instruments whose payments are backed or directly derived from a pool of assets that is protected or ring-fenced from the credit of a particular issuer (either by bankruptcy remote special purpose vehicle or bond covenant). Underlying collateral for securitized bonds can include residential mortgages, commercial mortgages, public sector loans, auto loans or credit card payments. There are four main subcomponents of the securitized sector: MBS Pass-Through, ABS, CMBS and Covered.
The Bloomberg Barclays U.S. Municipal Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed tax exempt bond market. The index includes state and local general obligation, revenue, insured and pre-refunded bonds.
The Bloomberg Barclays Corporate Bond Index covers the U.S. dollar (USD)-denominated investment-grade, fixed-rate, taxable corporate bond market. Securities are included if rated investment-grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody’s, S&P and Fitch ratings services.
The Bloomberg Barclays U.S. High-Yield Very Liquid (VLI) Index measures the market of U.S. dollar-denominated, non-investment grade, fixed-rate, taxable corporate bonds. Securities are classified as high yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below, excluding emerging market debt. The U.S. Corporate High-Yield Index was created in 1986, with history backfilled to July 1, 1983, and rolls up into the Barclays U.S. Universal and Global High-Yield Indices.
The Bloomberg Barclays U.S. Floating-Rate Notes Index measures the performance of investment-grade floating-rate notes across corporate and government-related sectors.
The S&P/LSTA U.S. Leveraged Loan 100 Index is a market value-weighted index designed to measure the performance of the U.S. leveraged loan market. The index consists of 100 loan facilities drawn from a larger benchmark – the S&P/LSTA (Loan Syndications and Trading Association) Leveraged Loan Index (LLI).
The BofA Merrill Lynch Fixed Rate Preferred Securities Index tracks the performance of fixed-rate USD-denominated preferred securities issued in the U.S. domestic market.
The Bloomberg Barclays Global Aggregate ex USD Index provides a broad-based measure of the global investment-grade fixed-rate debt markets. The two major components of this index are the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices.
The Bloomberg Barclays Emerging Markets USD Aggregate Bond Index includes USD-denominated debt from emerging markets in the following regions: Americas, Europe, Middle East, Africa, and Asia.
Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.
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