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AAM Viewpoints - Odd Thoughts on Random Markets


As we approach the holiday season, it seems one could give thanks that the state of financial markets, especially those here in the US, seem to be in a much better place than at this point last year. The road has been a bit rough with trade tensions, summer doldrums, global weakness and a few rate cuts thrown into the mix. Likely few would have predicted at this point last year, December of 2018, as a precursor to a stellar year for the US equity markets.1 Few would have predicted US Investment Grade Corporates2 as the best performing US fixed income class alongside US High Yield which posted a double digit recovery from a December to remember in 2018.3 And given the strength in equities and high yield, few would have likely predicted US Municipals continuing their run as the market’s late cycle safe haven darling4 with strong year for US Treasuries5 to boot. That is quite the eclectic group of asset class returns and illustrates the oddity of the current market backdrop where generally negatively correlated assets classes generate positive total returns in lock step. This isn’t necessarily surprising given the underlying dynamics of good, but not great, global economic data, supporting equities and high yield, along with global central bank intervention pressuring interest rates to the downside, which has benefitted high grade fixed income. While maybe not surprising, it likely continues to be a fixture of markets heading into 2020 and leads one to some odd thoughts on random markets.

Can the US Avoid Negative Interest Rates? 

Where US rates are at historical lows, the balance of developed market sovereigns look even worse with over 12 trillion in negative yielding sovereign debt. While one can imagine hedge funds having a field day front running central banks, the notion of negative yielding debt as a long-term hold boggles the mind and most certainly does not represent healthy financial markets. As such, it is understandable there is some concern over the consequences and what this might portend for global markets and further concern it might bleed across the pond to the US. One need only compare, the Greek 10 Year benchmark at 1.40% or the Italian 10 Year at 1.24%, to the US 10 Year Treasury of 1.82% to see the mispricing of credit risk at work. In normally functioning markets, devoid of central bank intervention, this dynamic would make no sense. One would be remiss not to acknowledge the potential pain involved in an unwinding of negative yields across the globe.

The notional amount of negative debt in October of 2018 stood just shy of 5.75 trillion which leaves a lot of room to the downside from the current level of 12.325 trillion. We have written in the past on our concern over global sovereign markets and that concern extends to some extent to the US Treasury market. On 6/30/2008 the Bloomberg Barclay’s US Treasury Index carried a yield-to-worst of 3.38% and an Option Adjusted Duration of 5.73 years or 65 basis points of yield per unit of duration. As of the close 11/15/2019 the Bloomberg Barclay’s US Treasury Index carried a paltry yield-to-worst of 1.77% and the duration has extended almost a year to 6.60 years. This equates to 27 bps (basis points) of yield per unit of duration or less than half of pre-crisis levels. Over the same time frame the average coupon of the BBG Barclay’s US Treasury Index has been cut in half moving from 4.75% on 6/30/2008 to 2.36% as of the close on 11/15/2019. While we would tread cautiously with the US Treasury market, we do not see negative rates and the problems they entail in the US anytime soon. The US economy has shown resiliency in the face of untold headwinds over the last bull market and that is reflected in US interest rates. Lost in the era of central bank intervention, is the notion that negative rates portend serious concerns over future growth and the potential for future recession. The bond market is typically a good predictor of future growth prospects and positive interest rates in the US should give solace that the US looks to be on firmer footing than the balance of developed economies. A move to negative yields in the US would likely spook markets as it would exacerbate concerns over global growth and would be indicative that the world’s strongest economy to date was weakening. We do not see negative rates coming to the US in 2020 as some economists suggest and for good reason.

Will Low Rates Continue to Instigate Risk Taking?

A defining hallmark of the post credit crisis (2008) investment landscape has been persistently low global interest rates. The last 10+ years have been defined by the conundrum of little to no meaningful inflation pressures coupled with moderate global growth. This has led to extremely accommodative monetary policy, the expansion of the US Federal Reserve balance sheet and monetary stimulus across developed markets of epic proportions. The result has been historically low rates around the world illustrated by the United States 10 Year. The US 10 Year has had an average yield of 2.46% since 6/31/2008 which is less than half the long run average of 6.11% (12/31/1950-11/15/2019). This likely continues to be a staple of this economic cycle and possibly cycles to come. There are a host of academic rationales for low rates such as secular stagnation, deflationary trends created by globalization and interdependency of global economies. In addition, there are structural factors such as US baby boomer demographics and negative yielding global sovereign debt coupled with economic realities such as low inflation and moderate global growth. All support the idea of “lower for longer” and it likely continues to be a consideration in 2020. While recent events might bias rates to the upside in the near term, with the Federal Reserve stepping to the sidelines, the broader implication for investors is the hunt for yield likely continues. With traditional safety and income asset classes, such as US Treasuries, struggling to outpace even modest levels of inflation, the last 10+ years have also been defined by a hunt for yield as traditional income investors look to equities and add credit and duration risk in fixed income to satisfy income needs easily achievable in higher grade fixed income in cycles past. Low rates instigate risk taking. While we advocate looking to alternatives for income generation, we also advocate intelligent risk taking from a credit and interest rate perspective. Investors should understand these risks and this likely heightens the need for active professional management even in the realm of bonds heading into 2020. This risk taking has been reflected in the insatiable appetite for lower credit quality and longer duration holdings over the current cycle and it bears a reminder that there is no such thing as a free lunch in financial markets.

Can Credit Shine for Another Year?

After a rough December 2018, corporate credit has rebounded and not looked back for the duration of 2019. The US credit landscape does lend itself to some consternation, as an era of cheap money and low interest rates has led to increasing corporate leverage levels. Half of the issuers in the US Investment Grade corporate market now reside in BBB territory with the aggregate rating of all outstanding US investment grade debt hanging on by a thread to a single A rating at A3/A-. 2019 was another record year for BBB issuance and as of now it does not look like the trend will abate any time soon. Many have expressed concern, but to date profitability of US corporations has supported leverage and credit metrics and this could continue through the balance of 2020. While the market does seem to be expressing some concern with lower rated CCC paper lagging both High Yield and Investment Grade markets year-to-date, if you can deal with the sensitivity to equities and heightened volatility in BBB debt it remains an attractive source of income. The higher coupons help offset some of the potential interest rate volatility and there remains some value from a credit spread standpoint. Without a significant shift in investor sentiment, a weakening in economic data, or an unforeseen market event that leads to credit spreads blowing out, a potential leverage related reckoning in the corporate bond market is likely kicked down the road for another year. That is not to say that we would blindly allocate to lower rate corporate credits as one must also consider the compensation. The appetite for yield and low interest rates have led to narrower credit spreads or less compensation for credit risk than in time periods past. While we are comfortable with credit exposure, we would still demand adequate compensation in the form of additional yield relative to higher grade credits. Where this additional yield or compensation for credit risk was not available, we would continue to opt for higher quality.

As a Portfolio Manager, I would be negligent in not pointing out that current market dynamics lend themselves to consider active professional management. While the current market environment could be called mundane relative to this point in time last year, potential risks become a bit heightened as the market digests higher valuations. The environment looks healthy on balance but the backdrop of good but not great economic data, low rates and the added wild card of central banks is not likely to go anywhere anytime soon. While return above inflation is certainly paramount, the real value added in professional management of fixed income, in our opinion, is achieving these returns without taking on many of undue risk that abound in today’s market.

 

  1. S&P 500 +24.46% YTD on price change basis as of 11/19/19
  2. Bloomberg Barclays US IG Corporate Index +13.68% YTD as of 11/19/19
  3. Bloomberg Barclays US High Yield +11.70% YTD as of 11/19/19
  4. Bloomberg Barclays Municipal Bond Index +6.79% YTD as of 11/19/19
  5. Bloomberg Barclays US Treasury Index +7.27% YTD as of 11/19/19
  6. Bloomberg Barclays Taxable Municipal Bond Index +11.50% YTD as of 11/19/19

 

CRN: 2019-1104-7783R


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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