Fixed Income Outlook: Well, this is interesting
The first quarter certainly was unique. As the calendar turned, a risk environment that was going strong on tax cuts, deregulation and free-market capitalism quickly gave way to 2018 themes of interventionism, trade wars and rising fiscal deficits. By the time the 3-month period ended, the S&P 500 and Bloomberg Barclays U.S. Aggregate Bond Index had both posted negative quarterly returns for only the ninth time in 136 quarters. Low volatility had been replaced by high volatility—Q1 had 23 days of daily moves greater than 1% in the S&P versus seven such days for all of last year, and the first few weeks of the second quarter have seen similar swings. In the credit markets, both investment-grade and high-yield corporate bonds had negative returns for the first time in eight quarters, with down-in-quality subsectors in each unconventionally outperforming higher quality ones. Indeed, outside of bank and floating-rate loans, there were few places for fixed-income investors to hide in Q1 as Treasury yields rose across the curve and the Treasury Index returned -1.2% on the three months.
What happened? Early on, there was concern inflation was threatening to break out, as wage growth appeared to shoot out of the gate with the new year. Price pressures do appear to be building across other indicators as steady monthly increases in PCE, CPI and PPI replace transitory low numbers from the first half of 2017. These have caused the market to vacillate between three and four rate hikes in 2018. Either way, new Fed Chair Jerome Powell’s measured and steady performance before Congress and the media reassured investors, settling the markets somewhat against a backdrop of supportive fundamentals, led by globally synchronized growth, massive new fiscal stimulus and robust corporate earnings. Then in mid-February, the 2017 pro-business version of President Trump was replaced by his populist campaign version. He took a harder line on immigration, particularly along the Mexican border. He drove out market-stabilizing aides Gary Cohn, his chief economic advisor, and Rex Tillerson, his Secretary of State. Most notably, he unleashed steep import tariff proposals against steel, aluminum and all things China, fanning fears of a costly showdown between the world’s two largest economies.
Will there be a Trump ‘put’?
So what’s next? One thing the market will look for is whether there may be a Trump “put.’’ For years, market participants got used to the concept a Bernanke or Yellen put, i.e., a sort of implicit understanding that the former Fed chairs would act to put a floor under risk assets by easing further if necessary. In Trump’s case, this is a little trickier. His administration has shown a willingness to put forth disruptive concepts, be it on trade, immigration or interventionist actions on individual companies such as Amazon. Then it waits to see market reaction and how far it can push, the idea being that if the market makes clear it won’t be supportive, he’ll back off—the Trump put, if you will. It’s an “Art of the Deal’’ approach: start with an extreme position first to get to modest one. The problem for the market is this creates uncertainty, causing risk premiums to be wider than they otherwise would be. In this environment, credit spreads have a more difficult time getting back to and staying at their lowest points in the cycle despite positive fundamentals. So whereas spreads have sold off somewhat, creating some opportunity, it’s hard to be aggressive with the trade. Just clip the coupon and carry on.
Rate strategies lead sector allocation
This leaves us roughly in the same position that we started the year, slightly overweight to spread product, i.e., investment-grade and high-yield corporate bonds and emerging markets (more recently, we also went back to a slight overweight on commercial mortgage-backed securities). But we do this cautiously, realizing not only that this trade is getting stretched but that volatility’s shift higher over the course of recent months has raised the stakes. It’s definitely more of a tactical market, but our investment style in the fixed-income group is such that we’re not going to be incredibly active in jerking our positions around—that is, we aren’t much for making daily or weekly shifts in our model portfolio positions. Our alpha transmission process centers on making key decisions across all four of our alpha pods—duration, sector allocation, yield curve and currency. Sector allocation had been the primary generator of returns of that process since the global financial crisis, but our rate-oriented strategies led by a duration position short of benchmark were the big contributors during the first quarter, and we would anticipate our rate strategies will continue to be the biggest source of alpha in the near to intermediate time frame as yields across the curve look set to keep moving up.
Supply and demand favorable for munis
Like most sectors of the fixed-income market, municipal bonds struggled in the first quarter as yields climbed higher. That said, we expect the laws of supply and demand to favor the asset class in coming months. The new tax law significantly limited the ability of municipal issuers to refinance their tax-exempt debt prior to call dates, and many deals were accelerated into the fourth quarter of 2017 before enactment of the tax bill. Both of these factors are now cutting into current and future supply, with new issuance in the first quarter falling nearly 30% versus the year-ago period. On the demand side, individual investors and mutual funds are still buyers, as individuals experienced a somewhat modest tax cut overall (the top income tax rate fell from 39.6% to 37%, for example) and many 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 should decline somewhat after the large corporate federal income tax rate cut from 35% to 21%, but we don’t expect widespread liquidation of their portfolios. Looking at yields after taxes, muni bonds remain attractive, with tax-equivalent yields significantly above those of comparable maturity corporate and Treasury bonds