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Fixed income investors ask: Where to from here?

ED GOARD, CFA 06-Feb-2019

For much of 2018, investors were bracing for negative absolute returns from their fixed income portfolio given the likelihood of higher interest rates and continued monetary policy tightening. Yet as volatility spiked in the fourth quarter and bond investors pushed back forcefully against the Fed’s forecast by driving yields lower, many fixed income indices posted positive returns for the year. That’s the good news.

But where to from here? Or rather, is a recession truly imminent as some pundits are warning? That’s the real question dogging many investors.

For clues, it might help to consider how we ended 2018. A plethora of factors contributed to a dramatic shift in sentiment late in the year. Some investors have been wondering if the Fed would be too vigilant for too long. Fed Chairman Powell made comments in early October suggesting monetary policy was a “long way from neutral” despite the steady rate increases implemented throughout 2018. These incited fears of a Fed policy error and the increasing likelihood of a recession. Subsequently, the Fed did reduce its 2019 outlook for rate increases from three to two moves, though nothing is certain and the Fed remains committed to staying flexible depending on the data.

Compounding matters has been a tenuous U.S./China trade relationship, an apparent slowing of global growth, and political chaos in Washington and the EU given the uncertainty surrounding Brexit negotiations. Despite some more recent positive news—including a 90-day trade truce with China, an OPEC agreement to cut oil production and a softer tone from Fed chair Powell—credit spreads remain relatively wide and the front end of the yield curve inverted.

If that weren’t enough, fixed income investors are also wondering if cash will be a viable competing asset class looking out into 2019. Not long-ago investors earned virtually nothing on cash balances, yet today they can earn in the 2-to-2.5% range with little duration or credit risk. This could be attractive to risk-averse investors if volatility remains elevated or even increases. For perspective, 3-month Treasury bills now have a higher yield than the dividend yield on the S&P 500 Index.

Ultimately, we expect economic growth to slow back towards 2% in 2019 as the marginal benefits from fiscal stimulus (tax reform) and deregulation fade. Trade uncertainty is also likely to slow business investment, while tighter financial conditions resulting from volatile equity markets and higher interest rates could further impact sentiment and spending. With that said, we do not expect to see a recession in the U.S. in 2019, but we do see rising risks for 2020 if the Fed continues to raise rates on its current path and if there is not a positive resolution to the U.S.– China trade relationship soon.

For INCORE, we believe an up in quality bias is prudent for the coming year. Yield curve positioning and duration continue to be a critical focus and will be opportunistically managed based upon our proprietary trading signals, as well as our assessment of the Fed’s communications and actions.