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AAM Viewpoints – Where Do We Go From Here?


It is no surprise the sell-off across risk assets in December 2018 brought about renewed concerns about global growth, the role of central banks and the future direction of global monetary policy. In turn it should also not come as a surprise that we have seen broadly lower interest rates throughout developed global economies through the first half of 2019 with many currently in negative yield territory. The more interesting observation is that the aggressive move down in global interest rates has co-existed with tight U.S. labor markets, price performance on the S&P 500 north of 16% year-to-date and credit spread tightening in U.S. High Yield markets driving returns north of 9% through the first half of the year. These dynamics could lead one to the conclusion that we are seeing late-cycle economics at work.


Interest rates around the world are lower on evidence that central banks are shifting to a more accommodative monetary stance while U.S. equity markets – which still look to be on firm footing albeit with pockets of weakness – are exhibiting strength only amplified by the prospects of accommodative monetary policy. From a fixed income perspective, these undercurrents have led to a strong first half for global bond markets across the board but with interest rates in the United States near 20+ month lows it begs the question: “Where do we go from here?”We would consider the following themes in fixed income markets for the remainder of 2019.  


Be Cautious on Duration


A move to add any significant duration in the current environment seems predicated on a belief of sustained weakening in the economic backdrop moving forward, if not recession. The longer the duration, the more ballast a fixed income portfolio provides during periods of equity market volatility that includes lower interest rates. While the role of duration as ballast during periods of economic uncertainty and equity market distress cannot be understated, conditions in the United States seem to point to a strong potential for slower but sustained growth moving forward. U.S. equity markets are flirting with record highs with corporate earnings still healthy on balance. The Federal Reserve has signaled an openness and willingness to cut rates and has clearly shifted monetary policy to a more accommodative stance. We have seen pockets of weakness in economic data, but balance data releases still seem to indicate continued, albeit slower, growth. Finally, concern over global trade and the impact to the global economy has the potential to be transitory in nature if the United States and China can work toward a resolution. While we would carry a modest duration to provide ballast when and where rates fall we would be sensitive to duration much outside of four to five years and would be especially sensitive to longer duration holdings of 10 years or more. The market is currently aggressively pricing in sustained accommodation by the Federal Reserve. The Fed Funds probability of a rate cut at the July 31, 2019 FOMC (Federal Open Market Committee) meeting currently sits at 100%. Fed fund futures are currently pricing a 1.58% Fed funds rate by the 12/11/2019 meeting which implies three FOMC cuts by year-end 2019. That seems an aggressive path for a Federal Reserve that is signaling the next move is likely a cut but does not seem to support such an aggressive path for the remainder of the year. Both the removal of transitory concerns over global trade and a market that could be too aggressive in pricing in Fed action would likely lead to higher rates. We would be cautious on duration given the current interest rate backdrop with a 10-year trading in the 2% range. This stance is bolstered by the fact there is little to no term premium or compensation for extending duration given the shape of the yield curve.


Take Comfort in Credit


Both the U.S. Investment Grade corporate market, up 8.77% YTD (year to date) as of 6/19/2019 and U.S. High Yield market, up 9.35% YTD as of 6/19/2019 have had quite the year. Two tailwinds have driven performance in the credit markets this year: credit spread tightening off December 2018 weakness and lower interest rates. Credit spreads in U.S. High Yield started the year at 537 bps (basis points) and as of the close on 6/19/2019 sat at 384 bps. This is an interesting observation in and of itself as high yield spreads can be a leading indicator of economic weakness and tightening spreads would support a narrative that the economy is still on firm footing. U.S. Investment Grade credit spreads have tightened over 30 bps YTD from 157 bps to start the year to 122 bps, as of 6/19/2019. While it might be lofty to expect U.S. credit markets to repeat the strong 1st half of 2019 performance, we would continue to be comfortable with exposure and it should not come as a surprise if U.S. corporate markets remain the best of the bunch through year end. Current credit cycle metrics seem to support this notion with easing financial conditions, lower interest rates, easier access to capital, corporate earnings that continue to support free cash flows and corporate default rates that are well under long-run averages. In addition, while credit spreads have tightened this year they are still well-off cycle lows set in 2018. The investment grade markets, currently at 122 bps, sit 38 bps above the 84 bps cycle low set on 2/1/2018 where high yield, currently at 384 bps is still 81 bps above the 303 bps cycle low for high yield set on 10/03/2018. We would not necessarily expect credit spreads to return to their lows, but on the flip side with little to no change in the underlying financial metrics of the issuer base they don’t seem stretched either. Finally, both U.S. Investment Grade and U.S. High Yield markets offer some of the higher coupons rates available in U.S. fixed income markets. This makes them less sensitive to interest rate than the balance of U.S. markets and provide high current cash flows for reinvestment. Given the current

macro-economic backdrop we would continue to be comfortable with exposure to credit risk over interest rate risk. However, pockets of weakness do exist in some sectors such as oil field services and retail, and investors looking at lower rated credits would likely benefit from professional assistance in credit selection.


Avoid Treasuries, Consider Municipals


Investors seeking the capital preservation that comes via an investment in safe-haven assets now find themselves at a crossroads midway through 2019 with a U.S. 10-year Treasury back into sub-2% territory. “Flight to safety” or safe-haven assets generally reside in the high-grade areas of the fixed income such as U.S. Treasuries/government-related and U.S. Municipals. These asset classes tend to be the biggest beneficiaries when investors seek safety during periods of equity market turbulence. Much like the U.S. corporate markets, U.S. Treasuries (+5.01% YTD as of 6/19/2019) and U.S. Municipals (+4.89% YTD as of 6/19/2019) have both had a great start to the year, benefitting primarily from the move lower in rates. However, one might want to consider that the last drawdown (7/8/2016 – 3/25/2019) in the U.S. Treasury market was over 800 days. U.S. Treasuries are easily the most exposed U.S. fixed income asset class to potential price erosion where interest rates move up. Sub-3% coupon rates across the curve (2.875% 30-year Treasury) along with historically high duration leaves the asset class lacking for investors seeking capital preservation much less where capital preservation and income are required. For investors in higher tax brackets we would consider U.S. Municipals a more attractive late cycle safe haven. While U.S. Municipals do not provide quite the ballast available in U.S. Treasuries/government-related, we would consider them the “best of the rest” and they do offer the potential for a combination of capital preservation, yield and income not available in any other comparable U.S. high grade fixed income asset class including treasuries in our opinion. Yields, on an after-tax basis, are comparable with lower grade areas of the Investment Grade corporate market and the availability of 5% coupons significantly outpaces coupon rates in other comparable areas of fixed income. Supply-and-demand dynamics continue to look favorable in supporting prices and state and local government financials are in the best condition since the Great Recession. Historically, municipals also lag the broader economy as most tax receipts are collected in arrears. Finally, recent relative underperformance versus treasuries have pushed up municipal relative value measures such as municipal-to-Treasury ratios making municipals even more attractive as an alternative to Treasuries for capital preservation and income. We would give preference to municipals over Treasuries and over even high-grade corporates for clients who carry significant tax liabilities looking for capital preservation and income.


Conclusion:


It bears reminding fixed income investors that regardless of the prevailing interest rate environment, regardless of the asset class and regardless of the future direction of monetary policy, the most important action to take is to stay invested, in our opinion. Even within the most economically-sensitive areas of the markets such as High Yield, time in the market is the number one driver of long-term total return. The income component of total return (i.e. coupon interest) dominates the price component (i.e. movement in price due to interest rates) and, in all but the most interest rate sensitive areas of the market such as Treasuries, we believe staying invested cannot be overstated.


 


CRN: 2019-0603-7462R  


An investment in Municipal Bonds is subject to numerous risks, including higher interest rates, economic recession, deterioration of the municipal bond market, possible downgrades, changes to the tax status of the bonds and defaults of interest and/or principal. A bond’s call price could be less than the price the trust paid for the bond. Bonds typically fall in value when interest rates rise and rise in value when interest rates fall. Bond insurance covers interest and principal payments when due and does not insure or guarantee the value of any bond in any way.


This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

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