Conditions Favor Better Fixed Income Returns in 2019
Muted but positive U.S. and global growth improves 2019 outlook
Volatility has created opportunities in certain sectors
Pause by Fed, mild inflation would aid fixed income returns
Fixed income returns were challenged in 2018 as rates rose in response to a combination of central bank tightening and strong economic growth spurred by fiscal stimulus. The bellwether 10-year Treasury yield began the year around 2.4%, peaked at 3.24%, and finished below 2.7% (see first chart). After tightening initially, credit spreads widened steadily after February on growth concerns, political turmoil, and monetary tightening. A less accommodative Federal Reserve raised rates four times and reduced its balance sheet by over $300 billion. While a headwind to longer rates, a tighter stance rewarded our liquidity management strategies as cash returned over 1.5%, and the curve flattened, playing into our core strategy of upgrading credit exposure, owning floating rate securities and taxable municipals, and establishing a maturity barbell.
With recession risk low in 2019 but deceleration in both U.S. and global economic growth already in motion, our previously unpopular call of a Fed pause in 2019 has become the consensus. This and softening inflation suggests that fixed income returns in 2019 should improve. We expect longer rates to be range-bound, no more than two additional Fed hikes, and further credit volatility. Security and sector selection will be increasingly important as manufacturing decelerates, volatility in the energy sector persists, and public pensions come under increasing scrutiny.
Fourth quarter volatility in risk assets improved valuations and made us more constructive on specific opportunities such as senior bank loans and their collateralized loan obligation (CLO) cousins. Domestic high yield, while cheaper, has not yet reached an entry point (see second chart). We also see value in specific maturities and issuers within the diverse emerging market debt space, including local currency exposure. These opportunities will likely lead fixed income returns in 2019 and serve as a valuable diversifier to other risk assets.
Overall we see a better year for fixed income, led by select opportunities and short-term liquidity management. Risks to our outlook include the pace of global economic deceleration, central bank surprises, and the political environment.