As we entered 2018, fixed income investors were primarily focused on the Federal Reserve and what a normalizing monetary policy environment would mean for fixed income returns. As we exit 2018 and look ahead to 2019, all eyes continue to be on the Fed, but for very different reasons.
For much of 2018, financial markets enjoyed a strong domestic and global economic backdrop, robust corporate revenue and earnings growth, and solid market performance from investment sectors ranging from stocks to high yield corporate bonds. This environment allowed the Federal Reserve to continue the monetary policy normalization process it began in late 2016 by raising the Fed Funds Rate a total of four times.
The environment has now changed.
Late in 2018 investors suddenly began to price-in a more downbeat outlook. Estimates for economic growth, earnings growth and inflation have all declined, yet the Fed expects to continue raising the Fed Funds rate another two times during 2019. The market is pricing-in no additional rate hikes. As such, all eyes remain on the Fed, but unlike 2018, when investors were fixated on how the near certain rate hikes would play out, this time they are waiting to see if the Fed will raise rates at all.
Rates: A regular topic of conversation in 2018 was the flattening of the yield curve. Short-term rates tend to be tied to Fed action, while long-term rates are typically correlated to economic growth and inflation. With estimates for inflation and future economic growth subdued, long-term rates, such as 10-year and 30-year yields, remained stable throughout 2018 after a sharp rise in Q1. Short-term rates moved higher with the Fed, but because short-term bonds have less sensitivity to rate increases than long-term bonds, the price impact on returns was limited. This dynamic, coupled with interest income generation, allowed bond returns to be positive, despite the Fed’s rate increases.
Munis: Tax-free municipals led all investment grade sectors in 2018 and are positioned to perform well again in 2019. A strong technical backdrop was the main driver for muni returns, as supply fell by more than 20% year/year due the elimination of advanced refunding transactions. This year, the expectation is for technicals to remain supportive. Broadly, fundamental credit quality has strengthened over the last several years as the improving economy and strong financial market environment has improved the financial position of many municipalities. The issues around underfunded pension and healthcare liabilities remain acute, however, and must be analyzed thoroughly when making municipal investments.
Related: The Fed Hike
Corporates: Volatility in risk markets spilled over into the investment grade corporate market during the year, causing corporates to underperform most investment grade sectors. The additional yield on corporate bonds compared to risk-free assets like U.S. Treasuries, a metric known as credit spread, increased as investors began to price-in a riskier environment. Elevated debt levels across much of corporate America, as well as rising borrowing costs as outstanding debt comes due, are two areas of investor concern. While yields in the corporate space have increased, they do not yet offer enough value to create a compelling risk/reward tradeoff in our minds. As such, we are maintaining what has been a very conservative allocation to the sector.
Overall: Moving forward, 2019 brings a new level of uncertainty for investors. Monetary policy has tightened and the U.S. economy is set to continue growing. But this growth is expected to proceed at a slower rate, and both trade and geopolitical tensions to remain high. We believe that financial market volatility is likely to continue into next year, and have positioned our portfolios for it, with a high percentage of AA and AAA rated bonds held across our strategies. At some point in 2019 it is possible that more attractive entry points to take risk in investment grade bonds will present themselves, but we are not there yet. In the meantime, we will continue to let our portfolios perform as investment grade bond portfolios are meant to, especially in markets such as these: with stability.
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