The great debate
ED GOARD, CFA 25-Aug-2019
Insanity, or savvy pre-emptive action. That seems to be great debate with regard to the Federal Reserve’s recent decision to push interest rates 25 basis points lower at its last Federal Open Market Committee (FOMC). So what’s behind the rancor?
The chief threat to the current economic run seems to center around trade turmoil, which many believe is already acting as a drag on economic growth, both globally and domestically. Although it seemed progress was being made in the U.S. – China trade spat, flashbacks to elevated volatility rematerialized recently. The growing possibility of supply chain disruptions and the economic impact of higher costs has roiled markets. Also troubling were separate threats of heavy tariffs on Mexican goods, as well as uncertainties surrounding the appointment of a new U.K. Prime Minister, which further complicates Brexit negotiations with European leaders. And finally, let’s not forget the Italian fiscal situation, sudden political changes in Argentina, and renewed U.S.–Iranian tension over its nuclear program. All these global undercurrents have weighed heavily on markets. The FOMC (and other global central banks) took notice and lowered the federal funds rate at the end of July.
While the domestic economy turned in enviable metrics early in the year growing at an annualized rate of 3.1% during the first quarter, growth in the second quarter seems to have slowed to an estimated 2.1%. Consumption looks to have strengthened, led by elevated consumer sentiment and increased spending. All the while, the impressive job-creation streak continues unabated, with unemployment hovering near record lows at 3.7% and with solid payroll and wage growth. Given these robust statistics, it’s no surprise why some pundits were questioning the need for this “insurance” rate cut. It’s our belief that the federal reserve never would have gotten rates to 2.5% in the first place if it weren’t for the fiscal stimulus of tax cuts. With the marginal effects of the stimulus having abated, the inverted yield curve is signaling over-tightening of monetary policy, and the Federal Reserve will now be forced to move quickly back to 1.50% in our view.
Questioning the merits of a rate cut might make for spirited debate, but it’s largely irrelevant. More important is how investors may wish to tilt fixed income portfolios (within their respective strategies). Given the current economic backdrop and the fact that more easing may be on the way in this era of elevated trade tensions, here are three actions worth considering:
- In total return strategies, the significant shift lower in rates and flatter yield curve argues for a reduced allocation to high-yield corporate bonds. While domestic fundamentals appear strong, we are somewhat cautious with only one-third of our allowable maximum exposure.
- For low-duration strategies, an overweight allocation to fixed rate corporate bonds and securitized sectors (namely agency mortgage-backed, asset-backed, and commercial mortgage backed securities) could continue to provide a tailwind. Floating rate securities are likely to underperform in the coming rate-cutting cycle.
- For municipal strategies, a focus on quality, coupled with an underweight position on the one-to-five-year part of the curve, may boost performance if the municipal curve continues to follow the Treasury curve flatter.
The U.S. economy has shown resilience in the face of slower global growth, and we expect that to continue if the Federal Reserve lowers rates appropriately. Geopolitical risks and prolonged trade uncertainties could impact this view, and it seems with the most recent Fed action that global central banks stand ready to act (both with lower rates and larger balance sheets) to support a more robust global growth environment. Of course, investors need to stay alert as the situation is dynamic, and suggestions for fixed income repositioning could change abruptly. After all, remember “the pivot.”