Trade tensions have escalated, geopolitical risks have been rising and an increasing number of signals indicate the global economy could be losing steam. The Fed has responded with a dramatic turn in its policy, leading to a sharp rally in interest rates.
The benchmark 10-year U.S. Treasury yield dipped 72 basis points from its 2.79% peak in January to a low of 2.07% in early June. Market expectations now indicate interest rate cuts are coming. While trade disputes have dominated headlines, economic data has been weaker across the U.S., Europe and China. Industrial production has declined in China, falling to a 17-year low in early 2019.
Just a year ago, the Fed appeared prepared to hike the fed funds rate well into 3% territory. But when equity volatility spiked in late 2018, monetary policymakers quickly changed their tune. The market expects the 2.5% U.S. fed funds rate established last year to be the peak for this cycle. What do we expect?
“It wasn't that long ago that the Fed was talking about three to four hikes in 2019, and now the market's pricing in two cuts in each of the next two years,” explains Mike Gitlin, head of fixed income at Capital Group.
The Fed’s dovish stance has spurred a broad-based rally across equities and credit assets. The Bank of Canada and other central banks look to be taking a more aggressive tone on fighting against the next downturn, rather than merely accepting the inevitable.
Fed Chairman Jerome Powell implied as much earlier this month. He indicated that the Fed is ready to lower rates if economic indicators begin to deteriorate due to factors like trade disputes. “We are closely monitoring the implications of these developments for the U.S. economic outlook and, as always, we will act as appropriate to sustain the expansion,” he said.
The market appears to believe him: Following Powell’s comments, the 10-year U.S. Treasury yield dropped to a 20-month low.
One concern on investors’ minds is the U.S. Treasury yield curve. The spread between two- and 10-year Treasuries going negative — the curve inverting — often indicates economic stress or outright recession. Although the curve hasn’t inverted yet, it’s getting closer.
“With the Fed more open to rate cuts, and the possibility that tariffs could lift inflation, positioning portfolios for a steeper yield curve makes a lot of sense to me,” says Ritchie Tuazon, fixed income portfolio manager.
One catalyst may be in the corporate credit market. "Investors have been worried about rising interest rates for most of the last few years," says Pramod Atluri, fixed income portfolio manager. “But the cycle has turned. In this part of the cycle exposure to interest rates can actually reduce volatility and preserve the value of an investor’s overall portfolio. Instead investors need to focus their attention on credit risk.”
“For the last 10 years, companies have leveraged their balance sheets to make large acquisitions, buy back shares, increase their dividends and invest in their business. But when the credit market turns and the late cycle turns into a recession, some of these companies are going to find that their earnings stream won’t cover all the debt that they've issued. Investors who have been focused on interest rate risk and reached for higher yielding bond funds may find that their portfolios have large exposures to many of these companies.”
He adds that we’re facing an uncertain environment. “We don't know exactly what the next year or two will look like. With trade and the regulatory environment in flux, there will be winners and losers. And given today's rich valuations, investors are not being paid enough for the risks they are taking in many parts of the credit market.”
Keep an eye on other potential sources of risk in credit markets, including the possibility that a prominent U.S. telecom company could be facing a downgrade and that Italy’s fiscal woes could trigger a credit event, potentially sparking a selloff in European credits.
1. Shore up your core.
In an environment of elevated geopolitical risks and a late-stage U.S. economy, ensuring a portfolio can withstand higher market volatility would be prudent. One approach is to upgrade the core bond portfolio allocation for better resilience in the face of equity volatility.
Research firm Morningstar U.S. took a step this year to help make this task a little easier when it decided to split its largest Intermediate-Term Bond category in the U.S. on the basis of credit risk. Those bond funds with less than 5% high yield were relabeled Intermediate Core, while those with more high yield now fall into the Intermediate Core-Plus category.
“This should clarify for end investors and for advisors that there are risks in the bond market. They need to be very aware of those risks,” Gitlin explains. “A core portfolio will provide diversification from equities, capital preservation, income and a measure of inflation protection. We refer to these functions as the four roles of fixed income in a balanced portfolio. The core portfolio should be able to provide that with much less volatility than you'll see from a core-plus fund.”
And remember, rates look more likely to fall than rise from here. That means a focus on limiting credit risk instead of worrying about interest rate risk probably makes more sense when evaluating a bond allocation.
2. Consider high income outside of high yield.
Of course, in a low rate environment income still matters — and it’s more challenging to come by. However, that doesn’t mean investors necessarily need to turn to expensive high-yield corporate bonds. An alternative exists that can provide similar levels of after-tax income but less exposure to credit volatility: emerging markets debt.
“Emerging markets is a sector that I'd point to as a place that has really benefited from the Fed's pivot,” Atluri says. “Our analysts have found a lot of attractive opportunities in this asset class, which is relatively high quality compared to high-yield corporates.”
Trouble often hits emerging markets for idiosyncratic reasons and affects only a subset of countries. Deep credit research can therefore add value within the asset class. This allows fund managers to confidently pursue emerging market debt where economies have the strongest fundamentals and stable-to-declining debt trajectories.
Pramod Atluri is a fixed income portfolio manager at Capital Group. He has 20 years of investment industry experience and has been with Capital Group for three years. Prior to joining Capital, Pramod was a fixed income portfolio manager at Fidelity Investments where he also worked as a fixed income strategist and corporate bond analyst. Before that he was a management consultant at McKinsey & Company. He holds an MBA from Harvard Business School and a bachelor’s degree in biological chemistry from the University of Chicago where he also completed the requirements for bachelor’s degrees in economics and chemistry. He holds the Chartered Financial Analyst® designation. Pramod is based in Los Angeles.
Michael C. Gitlin is a partner at Capital Fixed Income Investors, part of Capital Group, with primary responsibility for leading the fixed income business. He is chair of the Fixed Income Management Committee and also serves on the Capital Group Management Committee. He has 25 years of investment industry experience and has been with Capital Group for four years. Prior to joining Capital, Mike was the head of fixed income at T. Rowe Price, and earlier its global head of trading. Before that, he was head of U.S. equity sales for Citigroup Global Markets, where he also served as head of Asia-Pacific sales trading, head of Asia-Pacific cash equities, and head of international cash equities. He also served as head of Asia-Pacific trading for Credit Suisse Asset Management and traded Japanese equities and bonds for George Weiss and Associates. He holds a bachelor’s degree from Colgate University, graduating cum laude. Mike is based in Los Angeles.
Ritchie Tuazon is a fixed income portfolio manager at Capital Group. He has 18 years of investment experience and has been with Capital Group for eight years. Earlier in his career at Capital, as a fixed income investment analyst, he had analytical responsibilities for Treasuries and TIPS. Prior to joining Capital, Ritchie was a trader at Goldman Sachs with experience trading TIPS, Treasuries, and Interest Rate Swaps. He holds an MBA from MIT Sloan School of Management, a master’s degree in public administration from Harvard's Kennedy School of Government and a bachelor’s degree from the University of California, Berkeley. Ritchie is based in Los Angeles.