Portfolio Manager Michael Keough discusses his positive outlook for U.S. fixed income markets given the stabilization and continued strength of the U.S. economy, but notes that careful sector and security selection remain prudent.
- The Federal Reserve’s (Fed) accommodative stance has provided support to the U.S. economy, which should persist throughout 2020, but risks – including trade disputes and the 2020 elections – do remain.
- Our base case is that U.S. GDP stabilizes and global demand for both U.S. government bonds and U.S. credit provides support to bond markets in 2020, resulting in another year of positive total returns.
- Nevertheless, given broadly tighter credit spreads going into 2020, careful sector and security selection remain critical.
Global central banks were an important driver of markets in 2019, with the Fed’s abrupt pivot to accommodative policy powering a stabilization in economic fundamentals and an improvement in leading indicators. The current environment of subdued growth and contained inflation, which combined with strong demand for U.S. fixed income assets amid the swath of negative-yielding debt throughout the global financial markets, provides a backdrop that should lead to positive, but more modest, returns for fixed income in 2020.
With the yield on many spread products, such as investment-grade and high-yield credit, near their historical lows, some caution is warranted as key drivers of potential returns, including trade de-escalation, presidential elections and changes in corporate fundamentals, also have the potential to result in volatility. Such volatility, however, can create opportunities across markets, and our base case scenario of stabilized U.S. economic growth creates room to be positive on fixed income broadly.
The Importance of Active Management
With risk-free rates now measured in basis points rather than percentage points in many developed markets, there is less yield – across the bond markets – on which to build another year of strong returns. As such, we believe a more active investment approach will be appropriate in the year ahead.
Valuations across credit markets, including investment-grade and high-yield corporate bonds, asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS), became stretched in 2019. The Bloomberg Barclays U.S. Corporate Bond Index returned 14.5%, the strongest total return for investment-grade corporate bonds in a decade. With many credit spreads so near their tightest levels of this credit cycle, there is little cushion should markets be hit by a shock. Indeed, today the market looks to be barely distinguishing between the cost of debt for high-yield-rated BB issuers and higher-rated BBB investment-grade issuers.
While we believe corporate credit, in aggregate, will find support from a stabilizing U.S. economy, earnings are relatively low and corporate debt-to-GDP is at or above prior peak levels, requiring – in our view – careful security selection. A bias toward issuers that are focused on balance sheet improvement seems prudent, and following years of elevated mergers, we are finally witnessing some that have cut dividends to equity shareholders or sold assets to accelerate deleveraging.
The financial sector has also continued to benefit from strong balance sheets, because of regulatory oversight, and we believe the sector stands to benefit from a stabilization in economic growth and steeper yield curves in the months ahead. We do acknowledge, however, that the November 2020 presidential election could result in a significant impact on a variety of industry sectors, including banking, as well as health care and energy. While the election is still some time away, we believe diligently diversifying risks at the sector, industry and company levels will be critical in 2020 so as not to be overly exposed to the various risk factors.
Meanwhile, the U.S. consumer has proven resilient throughout the cycle – buoyed by strong employment and improving wages – and is likely to remain a bright spot in the fixed income landscape. We believe asset- and mortgage-backed securities – the latter of which was the only major spread market to see widening in 2019 – may provide both exposure to the more positive consumer sector and attractive risk/reward in 2020. While excessive mortgage debt was behind the Global Financial Crisis, we do not envision the cause of the last crisis to cause the next. Indeed, in this cycle the increase in U.S. mortgage credit compares favorably to that in the corporate sector. As investors search for yield in today’s low-yielding world, asset- and mortgage-backed securities may prove increasingly attractive.
Modest Returns Add More than Modest Value
Looking into the new year, we remain positive on fixed income but alert for signs of trouble. Labor markets and consumer incomes will be important to monitor as we assess the probability of a recession, and both geopolitics and the ebb and flow of sentiment shifts will likely cause moments of market volatility. Central bank monitoring remains, as always, key, and 2020 may offer a new wrinkle insofar as the Fed may be looking to adopt a more symmetrical 2% inflation target – in which case, we would expect the U.S. yield curve to steepen.
Nevertheless, we believe sovereign fixed income, even at low yields, remains an important diversifier from equities. And while a low-yielding world might reduce nominal returns, it does not reduce the opportunities available to active investors. The world’s central banks may be responsible for determining yield, but excess returns will remain in the hands of those who incorporate bottom-up research and astute security selection.
Which market trends should investors
watch in the year ahead?
Subscribe for relevant insights delivered straight to your inbox