Fixed income outlook: Fed’s pivot buys time for investors to rebalance | Capital Group Canada | Insights

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ARTICLES  |  JULY 2019

Fixed income outlook: Fed’s pivot buys time for investors to rebalance

Featuring
Pramod Atluri, fixed income portfolio manager
Mike Gitlin, head of fixed income
Ritchie Tuazon, fixed income portfolio manager

The U.S. Fed has pivoted, and the market now expects rate cuts. This presents an opportunity for investors to upgrade their fixed income allocation.


Key takeaways

  • With the economic outlook uncertain, the Fed appears poised to cut rates in 2019.
  • The flat yield curve reconfirms that the U.S. economy is late cycle.
  • Investors should prepare for rising market volatility and consider holding a high-quality fixed income portfolio.
  • High yield has fared well, but elevated valuations mean this is not the time to add exposure.

 

Remember when equity markets were skidding and the Federal Reserve was fearlessly hiking rates every quarter? That was just six months ago. So much has changed in such a short time.

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.

Why the Fed pivot?

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.

Based on U.S. dollars.

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.

Don’t be distracted by the yield curve.

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.

2 key implications for investors

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.

Chart_Cumulative-returns-916xVar_CIAM

Based on U.S. dollars.

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.”

Chart_EM-ratings-916xVar_CIAM

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.

 

About

Pramod Atluri Fixed income portfolio manager

Pramod has 20 years of investment industry experience, three with Capital Group. Prior to joining Capital, Pramod was a fixed income portfolio manager at Fidelity Investments and a management consultant at McKinsey & Company. He holds an MBA from Harvard and a bachelor's in biological chemistry from the University of Chicago. Pramod is also a CFA charterholder.

Mike Gitlin Head of Fixed Income

Mike is a partner at Capital Fixed Income Investors, chairs the fixed income management committee and serves on the Capital Group management committee. He has 25 years of investment experience, four with Capital. Mike was previously the head of fixed income and global head of trading for T. Rowe Price. He has also held positions with Citigroup Global Markets, Credit Suisse Asset Management and George Weiss & Associates. Mike earned a bachelor's from Colgate University.

Ritchie Tuazon Fixed income portfolio manager

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.


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