Fixed Income Outlook: Something ... or nothing
Depending on one’s perspective, the bond market’s performance in the second quarter was either a warning sign that something is askew in the economic landscape or simply a “nothing burger.”
On the one hand, the market was essentially flat—the Bloomberg Barclays U.S. Aggregate Bond Index returned -0.16% for the three months as Treasury rates as measured by the yield to maturity on the U.S. Treasury Index moved upward by less than 20 basis points. No great shakes there. On the other hand, U.S. and foreign credit spreads (particularly emerging markets) widened in general—unusual for a period of relatively stable rates. Additionally, the yield curve—whose shape often is used as a predictor of possible recession—hit its flattest level since 2007, with the gap between 2- and 10-year Treasury yields narrowing from 54 to 33 basis points. And despite a marginally positive S&P 500 (up nearly 3% in Q2), world equity markets had their weakest quarter since 2010, led by a 10% decline in China’s Shanghai Composite Index.
All of this occurred against a backdrop of a U.S. economy that’s estimated to have grown at an annualized rate above 3% and potentially at its fastest pace in almost four years. Inflation, not surprisingly, also continued to march upward, reaching 2% and higher across virtually every broad metric. This type of environment should have led to relatively positive performance for risk assets (i.e., higher stock prices, tighter spreads, higher Treasury rates and a stable yield curve). However, market activity seemed to be more driven—or at least tempered—by geopolitical events, with escalating trade-war concerns front and center. This made it difficult to get a true “read’’ on the market.
About that Trump ‘put’
You may recall that last quarter we wrote about the “Trump put”—our expectation that the administration was “negotiating” and would pull back from a significant trade war at the appropriate time. While this is still our base case, we must admit to being surprised that if anything, the rhetoric has intensified, not mellowed, and that “the game” seems to be defined more in relative than absolute terms. Indeed, defenders of the tariffs appear to view the U.S. as winning, for now, because its markets are experiencing less pain than others, China in particular.
Hopefully the end goal of the administration’s actions is to eliminate tariffs across the globe, thus optimizing the benefits that free trade can provide. But our concern is it views trade as a one-dimensional “zero sum” game and puts more value on simply reducing the trade deficit, a notion that ignores the concept of comparative advantage in which all sides can benefit by playing to their strengths. Add in the complication of supply chain issues, and tariffs arguably could represent “something.” Oxford Economics estimates tariffs and restrictions already proposed will result in 4% less global trade than otherwise be the case—a significant number on the margin.
When will trade really begin to bite? We already have begun to see signs. The most recent ISM delivery index slowed considerably, not because demand is so strong that suppliers can’t keep up, but because delivery times are being extended on worries supply chains may be vulnerable to negative trade shocks. This represents a potential manifestation of both the start of tariffs and the difficulty U.S. companies are experiencing in finding properly skilled workers. Having said that, June’s employment report displayed more labor slack, with the unemployment rate rising to 4% despite the above-consensus addition of 213,000 nonfarm jobs. Were companies possibly staffing to front-load activity before tariffs really go into effect while delaying capital spending due to longer-term uncertainty? Only time will tell.
Fed in a tough spot
How do Federal Reserve policymakers react to all of this? Minutes from their most recent June meeting spent significant verbiage on the subject of business investment and confidence being affected by the uncertainty of tariffs and how to factor this in going forward. The minutes also showed concern over the flatness of the yield curve—historically a recession indicator but only many months after it actually inverts, with short rate exceeding long rates—and the notion that Fed policy is no longer accommodative. All of this will make for an interesting rate decision not so much in September, when a hike is a near certainty, but rather for a potential December hike, which Chairman Jerome Powell and others had spent a good deal of time previewing over the last few months.
Positioning: Holding steady, for now
For now, we have decided to stay the course. On the rate side, we remain modestly defensive on duration without a major yield curve position on the expectation rates could move up with a resolution, or at least a respite, to the trade skirmish. On the credit side, we continue to be tentatively constructive given the supportive economic backdrop, with small overweights to investment-grade and high-yield corporate bonds, commercial mortgage-backed securities and emerging markets. The EM overweight is based more on value as this sector has been the greatest underperformer year to date, due largely to the strength of the U.S. dollar, which we expect to be more balanced moving forward.
More fundamentally, with the drivers more geopolitical than economic, the investing landscape is challenging. Because of this, our fixed-income portfolios’ risk profiles are about as close to benchmark (i.e., low predicted tracking error) than they have been in some time as we look to manage through the trade skirmish to see what awaits on the other side. We’ll keep you posted.
Municipal outlook solid
Municipal bonds outperformed comparable maturity Treasuries in the second quarter—muni yields were steady to lower, while Treasury yields crept up—and it wouldn’t be surprising if this trend were to continue for basic reasons of supply and demand. On the supply side, the new tax law severely limited the ability of municipal issuers to refinance their tax-exempt debt prior to call dates, causing gross issuance to drop off significantly. At the same time, the new law in some ways encouraged demand from many individual investors who experienced a somewhat modest tax cut overall (the top income tax rate fell from 39.6% to 37%, for example) and are looking for protection from the tax man now that the federal deduction for state and local taxes is capped at $10,000. Muni demand from banks and insurance companies has declined somewhat as a result of the dramatic cut in the headline corporate income tax rate from 35% to 21%, and we have seen some liquidation of their portfolios that have been manageable to the market. Meanwhile, with the U.S. economy relatively robust, the muni credit picture looks good in general, although there are some longer-term issues relating to underfunded pensions and structural imbalances in a few states such as New Jersey and Illinois that ultimately will need to be addressed and currently are causing bonds in those states to trade cheap in the market.