Inching closer to neutral
Even though the third quarter felt “noisy” amid China trade tensions, Italian populism, idiosyncratic emerging-market (EM) turmoil and last-minute drama over a U.S. Supreme Court nominee, interest rates continued to climb while the gap between yields on Treasuries and similar maturity non-government bonds narrowed further. This proved beneficial to Federated’s fixed-income lineup as rising rates and tightening spreads were representative of our base-case forecasts and portfolio positioning. With the final three months of 2018 upon us, we find ourselves in a similar place. The fundamentals—strong economic growth, robust earnings and moderate (but not accelerating) inflation—suggest a continuing upward bias on rates and some potential further tightening in spreads.
The big question—the caveat—is what happens in the midterm elections. Conventional wisdom currently has the Democrats regaining control of the House and the Republicans retaining control of the Senate, an outcome that arguably is priced into the market. But as we learned in 2016, the conventional view isn’t always the correct view. So we are deploying the same strategy as we did in 2016 before the early summer Brexit vote and the presidential election, moving closer to benchmark in duration and sector. Even at a potential cost of some marginal return until the midterms, this move to minimize portfolio risk should help offset possible short-term volatility going into—and following—the election.
Municipal bonds continued to outperform comparable maturity Treasuries in the third quarter—muni yields rose at a slower rate than Treasury yields due to a favorable supply and demand mix. 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 decline. At the same time, the new tax 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. This favorable supply/demand mix seems to have deteriorated somewhat lately and could challenge near-term muni bonds relative performance looking forward. Specifically, mutual fund flows have recently turned negative as investors appear to be reacting to the recent rise in rates, and demand from banks (who experienced a large tax cut) continues to be muted. Meanwhile new issuance has picked up somewhat. On the credit front, dynamics remain favorable for most sectors except for hospitals, where the combination of flat financial trends and health policy uncertainty are drags. Local governments are benefitting from rising property values and favorable employment trends, while state governments have experienced significant revenue growth. Pension underfunding continues to fester, however, creating idiosyncratic volatility.
— R.J. Gallo, senior portfolio manager
Duration: Taking some profits
As we entered the fourth quarter, we took advantage of September’s run-up in rates to cycle highs to take some profits, reducing our duration short to a more modest position. This may cause us to leave some money on the table if rates continue to rise in the short run, but the payoff is that we are a little less vulnerable in case of an unexpected midterm outcome or any risk-off event such as the stock market decline in early October. Moreover, from a broader perspective, we still capitalized on the 20 basis-point increase in 10-year Treasury yields during the third quarter and the 65 basis-point rise since the start of the year. Besides, as we learned in 2016, there should be time to take advantage of post-election opportunities if they arise. Given our view that rates are still normalizing and the 10-year could reach 3.50% or higher, it’s just as likely our next duration move will be to shorten as it would be to lengthen.
Spread product: Fighting for pennies
Spreads clearly aren’t as attractive at this point as they were earlier in the cycle, having fallen below their medians across the high-yield, investment-grade and EM universe. There may be room for a little more tightening, and history tells us that once spreads hit cycle lows, they can stay there for a long time—three to four years in the past two cycles. In such an environment, you are fighting for pennies, but pennies can add up. That’s why we’re not short anywhere yet in our spread product (neutral investment-grade corporate bonds, slight overweights in high yield, EM and commercial mortgage-backed securities). That’s because we still believe these sectors are as good if not better investments than U.S. Treasuries. That said, our next move likely will be to go to neutral/underweight relative to the appropriate sector benchmarks.
As we move late into this rate cycle, the Federal Reserve is in a somewhat difficult spot. While there has been little evidence of inflation accelerating above its 2% target, inflation is a lagging indicator and many forward-looking indicators are signaling it will continue to move upward (hourly wage increases, employment costs, manufacturing prices paid and received, etc.) This should keep the central bank on its pattern of quarterly rate increases despite rhetoric from the Trump administration; the difficulty is determining when it should pause. The dot plot suggests there will be a pause in 2019; the question is when. Sticking the landing between accommodative and restrictive is not an easy proposition. It doesn’t help that the yield curve has not assigned much of a risk premium out on the curve, meaning the Fed doesn’t have a lot of flexibility to raise rates without potentially inverting the curve. Fundamentally, an inverted curve shouldn’t mean much. But the optics are sure to spook investors as everybody knows the relationship between an inverted curve and recession (what they may not know is that recessions tend to occur as much as a year or later after inversion, not immediately). It also doesn't help that the president has doubled down on his criticism as now all of the Fed's decisions will be made against a backdrop of the market looking for signs of the Fed's independence.
Trump drift risk
By most indications, the U.S. Supreme Court debate seems to have solidified the Republicans’ hold on the Senate; however, the House remains very much in play, with most political pundits calling for a Democratic majority. If this happens, we expect that the Trump administration will be willing to work with Democrats on infrastructure, and may be more closely aligned with Dems on trade, as well. With tax cuts already baked in the cake, and deregulation coming from the White House as much as Congress, it will be hard for the Dems to undo what’s already been done short of large majorities, which they almost assuredly won’t get. So maybe what happens is the Trump and the Dems strike a partnership. Depending on how it’s structured, it could prove risk-on and further deficit inducing, providing additional catalysts for higher rates down the road.