Finding pockets of opportunity
Story remains the same for municipal market
The municipal bond market experienced a solid first half and is off to a good start in the second on favorable credit dynamics and strong demand. Rising property values, favorable employment trends and significant revenue growth continue to benefit state and local finances as the economic expansion celebrates its 10th birthday, making it the longest in U.S. history. Technicals also are strong, with the muni market supported by low supply and market rates amid record inflows, much of it from affluent investors in high-tax states seeking haven as a result of the tax law’s $10,000 cap on state and local tax deductions. Negatives also remain the same: idiosyncratic cases of pension underfunding and lower bank demand as a result of the new lower corporate tax rate, with the latter diminishing the diversity of buyers for intermediate and long-term muni bonds.
—R. J. Gallo, senior portfolio manager
It’s been a good year so far for fixed income. Interest rate declines have resulted in positive price movements in high quality bonds and credit has continued to deliver, with high yield (HY) returns reaching 10% through the first six months and both investment-grade (IG) and emerging markets (EM) up more than 9%. But opportunities in duration and sector increasingly are becoming more of a clip-the-coupon than total-return variety as tight spreads, an aging cycle, interest-rate uncertainty and policy whiplash argue for caution over conviction. This has us sitting near neutral on most credit bond products—HY, EM and IG—and viewing yield-curve positioning, currencies and security selection as higher probability sources of alpha during these summer months.
Spreads—the difference between yields on comparable-maturity Treasury and credit bonds—are sitting near cycle lows, leaving little to gain on a price-appreciation basis. Rates are a bit more of an enigma. It would seem a 10-year Treasury yield hovering around 2% in a still-expanding economy would be near a bottom. But global bond yields remain low and in a downward trend, with some $13 trillion of global sovereign debt now trading at negative yields. Thus, it’s hard to be less than constructive when so many dovish central banks are acting against any sustainable move up in long U.S. yields.
The part of the yield curve bond investors care about is steepening
While the curve has inverted on the short end, generating a lot of media attention as a recession-warning signal, the portion of the curve in which bond investors predominantly invest—2-year maturities and up—has been steepening. This gap between short and long rates could widen further if the Fed goes ahead with rate cuts despite signs the economy is emerging from its late-spring soft patch, as suggested by June’s unexpectedly strong jobs report and above-consensus ISM manufacturing read. Research shows that when the Fed has eased as part of a mid-cycle reacceleration, longer rates have tended to move higher a month or two out (a bearish steepener). But let’s say the early inversion signals prove correct and the Fed acts aggressively to stave off recession. It’s certain to slash short rates faster than long rates would fall (a bullish steepener). So whether bearish or bullish, a steepener position is potentially profitable.
A Fed easing regime wasn’t expected this year
Much of the dollar’s strength the last few years was due to a significant differential in central bank policies, with much higher U.S. interest rates relative to others. Investors could just take the carry, i.e., borrow in lower-rate markets, convert it to dollars and then invest those dollars in higher-rate U.S. securities. Now, with many other central banks having gone about as low as they can go, the Fed—if it holds to its dovish pivot—has plenty of room to cut. This could slow carry trade flows and potentially weaken the dollar, creating alpha opportunities for defensive dollar positions. Other factors also could support dollar weakness, including foreigners’ lower inclination to hold dollars either because of decreased level of trade activity or even as a manifestation of their distaste for Trump administration policies.
Other pockets of opportunity
In an environment of trade disruptions, declining rates and tight credit spreads, we feel diversification is particularly important. We have been active in some smaller credit sectors, notably trade finance and bank loans. And on the government front, we could see ourselves moving back to an overweight position as Treasury Inflation-Protected Securities (TIPS), which worked well for us throughout 2018. If the breakeven rate on 5-year TIPS, currently at 1.6%, continues to trend lower, one has to wonder, short of a global recession, what’s the downside, especially with a Fed seemingly willing to let inflation run above 2% for some time to bring symmetry around that number? In addition to currency and yield-curve alpha, we will continue to seek security-selection alpha, rounding out our active management approach that tends to be effective during uncertain times by pursuing value through sector, duration, currency and yield-curve positioning and a stringent security-selection process.
Looking ahead, we’re keeping an eye toward what we believe may be the next big bout of volatility—a debt ceiling showdown once Congress comes back from its August recess. To be sure, trade and the Fed remain concerns, but one could argue we are approaching some type of resolution on both fronts. On China, that doesn’t necessarily mean a trade deal but an acceptance that we are at an equilibrium and both sides don’t want to ramp the trade war up further. And with the Fed, it more or less has signaled it’s going into a short-term pattern of eases, the only question being how many and how deep. In the meantime, we believe morphing our alpha sources from a duration/sector dominant model to the aforementioned secondary sources should let us build on the alpha cushion that we established in the first two quarters.