Finishing the task with all our players
It was a volatile but nonetheless positive third quarter for most U.S. financial assets. Across the fixed-income spectrum, bonds rallied as the yield on the 10-year Treasury fell 33 basis points over the three months and by as much as 68 points from an intra-quarter high of 2.14% in mid-July to 1.46% in early September. The activity coincided with a cascade of worrisome headlines, from a widening trade war and global manufacturing recession to geopolitical uncertainties over Brexit, Hong Kong riots, Saudi oil-field attacks and an impeachment inquiry. The Federal Reserve twice cut rates a quarter-point, its first cuts since the depths of the global financial crisis almost 11 years ago, seemingly as much to calm nerves as to prop up a slowing economy.
Credit takes a breather
As we look to close out the year in the final three months, we’ve reached a milestone. After many quarters of winnowing our significant overweight to both investment-grade and high-yield corporate bonds, a position we’ve held for more than 10 years and one that generated substantial alpha over that period, we are now neutral in each. A combination of macroeconomic uncertainty and lack of compelling value has led us to this point. We also have turned neutral in mortgage-backed securities, leaving only a tactical overweight in developed international, and have a modest overweight in emerging as rates relative to those in the U.S. could narrow further.
With sector taking a strategic breather, where do we expect to achieve alpha? We had been getting some from duration but believe that, after the third quarter’s dramatic move, the prospect for adding much additional value looks fair at best. We were tactically neutral to slightly long as the 10-year yield bounced down in late summer, putting us on the right side of the trade. But with the yield on the 10-year now around 1.53% and inflation running 1.5-2.0%, the biggest upside on this trade arguably has played out. So as we head into the fourth quarter, two of our major macro sources of alpha—sector and duration—are on the sidelines.
Yield curve and currency move up
The good news is we see the potential for significant opportunities to add value in both yield curve and currency positions. We anticipate that once recession worries ease, as we expect they will, the curve will steepen further. 2-to-10-year Treasury yields already have shifted from a slight inversion to a gap of almost 13 basis points in the past several weeks, and on the long end, the 10-to-30-year gap is nearly 50 basis points. As for the dollar, it’s been strong, with everyone arguing the dollar can’t lose because if it’s risk off, the dollar’s supported by the flight to quality and if it’s risk on, it’s supported by the growth. History tells us whenever a trade is one-sided, there are tactical opportunities to play the other side.
This is why we believe in active management
The final element where we believe we can generate alpha is through security selection. In past cycles, we have found that as our macro sources of alpha play out—sector, duration, yield curve and dollar—security selection takes center stage. Everyone can win when the macro trends are going the same way. Now may be the point where it comes down to credit and security analysis, a strength we believe is inherent in our process. This is when credit teams earn their keep. So in coming months, we expect our focus on the macro side to be through strategic and tactical plays. But as we wind down the fourth quarter, security selection will represent the blocking and tackling that can get us across the goal line.