Fixed Income Outlook: The more things change, the more they stay the same

01-13-2017

While the 2016 election is being viewed by many as a game-changer for equities, the same doesn’t really apply to fixed income. The strong risk-on rally following the Republican sweep and Donald Trump’s victory only served to intensify trends already in place in the bond world. In reaction to a tightening labor market, uptick in inflation and signs of accelerating economic growth—conditions that appear to have continued into the new year—the yield on the 10-year Treasury had jumped 26 basis points in the five weeks prior to the Nov. 8 election.

This isn’t to suggest Trump didn’t matter. Among the reasons for a post-election spike that sent the 10-year yield to an intraday high of 2.62% by mid-December was a recognition that his pro-growth agenda of tax cuts, regulatory relief and infrastructure/defense spending could combine for wider deficits and accelerating inflation. But the devil’s in the details, which also may explain why yields have retraced somewhat, ending the year at 2.45%, still up 84 basis points for the final quarter. There’s always a difference between what’s promised and what’s delivered when rhetoric and reality collide in Washington.

The next ‘jobs’ president?
Perhaps the most interesting macro-economic dynamic to observe in the new Trump administration is his desire to be the “greatest jobs president.” While this could be a case of “don’t take Trump literally, take him seriously,” the numbers suggest he has a tough act to follow: the outgoing administration presided over 75 consecutive months of job growth and six consecutive years in which new jobs exceeded 2 million, a number that was reached only half the time in the previous 50 years. This has resulted in an unemployment rate of 4.7%, a level generally consistent with the notion of full employment. So either the existing labor participation rate will have to increase or we are going to have to grow the population if we are going to find workers for the new jobs. This will test the ongoing debate of whether the relatively stagnant labor participation rate is a function of aging demographics or a moderate/ slow growth economy.

Credit remains a focus, but possibly less so
What does this mean for fixed income? It depends on the sector. On the Treasury side, we expect another difficult year. Those debating the necessary yield level for the start of the “potential bear market in bonds” may have lost sight of the fact that the price return of the U.S. Treasury Index has been negative in four of the last five years, leading to a paltry annualized total return of 1.3% for the last half decade. On the credit side, however, returns have been very constructive during that same time period, as tightening spreads overwhelmed modest Treasury yield increases, resulting in annualized returns of 4.2% and 7.3% for investment-grade and high-yield corporate bonds, according to their respective Bloomberg Barclays and Merrill Lynch indexes. Continuing economic growth, improving earnings and solid balance sheets still favor those two sectors, where we remain overweight. But with spreads—the difference between their yields and that of comparable maturity Treasuries—near historical medians, the opportunity for sector alpha is not as great as it was last year, when returns topped 17% for high yield and nearly 6% for investment grade.

Staying short duration, nimble on curve
As for interest rates, we believe the bias remains higher, the recent pullback on the long end notwithstanding. Immediately after the election, we moved significantly shorter on duration across our portfolios and have stayed there, and went to a steepening bias on the yield curve even though our model argued to remain flat—largely in recognition of the uncertainty that the Trump election would bring to the bond market. While both moves proved profitable, we have since shifted to neutral on the yield curve with an underweight to the belly, i.e., 3- to 7-year maturities, where we anticipate more cheapening.

What we don’t foresee is the sort of two-sided volatility trade on rates that we got last year. Even though the 10-year Treasury yield rose just short of 20 basis points on the year, it had swings of 70 basis points down early in the year and 90 basis points up in the back half. At this point, after some modest beginning of year position squaring, we believe rates are more likely to either grind a little higher or go significantly higher—odds of retesting 2% on the 10-year seem relatively low.

Dollar adds to muscle
We believe that the dollar could keep strengthening, doing some of the tightening work for the Federal Reserve (Fed). However, our positions are modest, as it does appear to be a crowded trade. Stronger economic growth and higher U.S. rates relative to other developed countries are dollar bullish, as is potential repatriation, although more for its impact on growth than for currency reasons. Unlike 2004’s repatriation holiday, when a lot of foreign-sourced earnings were in local currencies that forced dollar purchases, a large portion of the estimated $2.6 trillion in overseas profits that U.S. companies could return home is already denominated in dollars.

Keep an eye on inflation (and Twitter)
What could go wrong with our outlook for modest credit returns? Inflation. Rising commodity prices and worker wages could cause prices to increase faster than expected, which in turn could cause the Fed to move more quickly. Trump also introduces market uncertainty over trade and immigration policies, as well as a propensity to weigh in on specific companies and industries. Our guess is that an interventionist style could eventually wear thin with market participants. And there’s always the longer-term worry over what to do about ballooning entitlements as baby boomers keep exiting the labor force. But these risks would appear to be a little down the road, particularly since it’s not clear what Washington will and won’t do over the next few months.

Putting it all together: a nod to risk management
Within Federated fixed income, we have always stressed a diversified process utilizing multiple decision tools. For the bulk of the last eight years, coming out of the 2008 crisis, we have focused more of our risk budget on sector allocation, utilizing spread sectors to add considerable value in our clients’ portfolios. In mid-2016, we reached an inflection point. More of our predicted benchmark variance now comes from the rate side—duration and yield-curve positioning—than the credit side. While our directional views have not significantly changed, the level of conviction of these moves has. Our expectation is the most effective fixed-income risk management will require portfolios to be more nimble in this regard as the market adjusts to the new political and economic landscape.