Quarterly Market Summary
Noting downside risks to its economic outlook, the Federal Open Market Committee (FOMC) transitioned to a more dovish policy outlook, increasing the odds of an imminent cut in the fed funds rate.
The willingness of global central banks to provide further accommodation has led to a strong rally in both risky and risk-free assets.
Global manufacturing surveys deteriorated, reflective of softer economic growth and continued concerns over the state of global trading relationships.
Credit spreads, which had widened throughout May on macroeconomic growth concerns, rallied sharply in June in response to the dovish messaging from central banks, bringing spreads close to year-to-date lows.
Maintaining a benchmark-like duration stance across strategies.
Overweight Financials and select BBB Industrials; focused in maturities less than 5 years. Remaining underweight non-corporate credit.
Remain overweight, particularly in short- duration portfolios.
Asset-Backed Securities and Agency Mortgage-Backed Securities provide favorable risk/return characteristics.
Market technicals were favorable for credit in the quarter, with robust inflows into investment-grade funds and relatively modest new supply from issuers.
The rapid decline in U.S. Treasury yields and corresponding spike in interest rate volatility has negatively impacted mortgage- backed security fundamentals. However, improved valuations provide favorable relative value compared to credit.
Second Quarter Sector Review
The unambiguously dovish tone from the Federal Reserve in the second quarter set the stage for a continued rally in both risky and risk-free assets. U.S. Treasury yields moved sharply lower, as expectations for “patience” from the Fed at the beginning of the quarter evolved to reflect an imminent reduction in the policy rate, likely at the July meeting. This considerable move lower in Treasury rates provided impressive returns for fixed income investors for the second consecutive quarter. The Bloomberg Barclays Aggregate Index produced a total return of 308 basis points (bps) during the quarter, bringing the year-to- date return of the index to 6.11%.
Bloomberg Barclays Aggregate Bond Index
Option-Adjusted Spread (OAS)
Non-Corporate Investment Grade
U.S. Mortgage Backed Securities
CMBS: Erisa Eligible
U.S. Corporate High Yield
Source: Bloomberg Index Services Limited
See Important Disclosures at the end of this document for additional information.
U.S. Credit produced a positive 91 bps of excess return during the period, as the option-adjusted spread (OAS) of the Bloomberg Barclays U.S. Aggregate Credit Index tightened by 4 bps. High yield returns lagged investment grade in the quarter after significantly outperforming in the first quarter. Nonetheless, total returns for the Bloomberg Barclays U.S. Corporate High Yield index through the first six months of 2019 stood at a lofty 9.94%. Structured products underperformed credit sectors, as excess returns for Agency Mortgage-Backed (MBS) and Asset-Backed Securities (ABS) were negative 39 bps and positive 11bps, respectively.
The robust returns in fixed income markets reflected investor confidence that global central banks will follow through on the well-telegraphed pivot towards more accommodative policy. Despite concerns over slowing global growth and volatile trade negotiations, more dovish rhetoric from both the Fed and the European Central Bank provided a tailwind to risk assets. This leaves markets at somewhat of an inflection point to start the third quarter, as Treasury markets now imply two to three cuts over the remainder of this calendar year. The overall move in interest rates has been dramatic, with 3- to 7-year Treasury yields now roughly 130 bps lower from the highs of last November. Importantly, the negative slope of the yield curve between the 3-month Treasury bill and the 10-year Treasury note has persisted, which can be harbinger of a looming recession.
Risk assets are richly valued in our view, given the mixed outlook on earnings growth and the potential for a resurfacing of volatility in the second half of 2019. We believe tempered enthusiasm is warranted, as forward return expectations have moderated given the lower level of yields and spreads across the maturity and quality spectrum.
Monetary Policy: Marveled by the Fed’s Endgame
By mid-May, escalating trade tension with both China and Mexico, combined with weaker economic data, led Treasury rates lower, as the market dramatically re-priced expectations for a lower policy rate. At its June 19 meeting, the FOMC responded by carefully signaling a strong bias to lowering rates in order to sustain economic growth. The Committee highlighted concerns about slowing business investment and softening inflation measures. A generally more constructive view of trade talks following the G-20 Summit and the rebound in June payrolls alleviated some pressure on the Fed to move aggressively in the near term. However, the market is forecasting a near-certain 25 bps cut at the July meeting and as many as two additional reductions by the end of the year.
The Fed’s response to the tightening of financial conditions in fourth quarter 2018 was to end its predisposition towards additional rate hikes and pivot to a patient approach to further adjustments in the policy rate. In our view, the deterioration in market sentiment late in the fourth quarter indicates the Fed may have moved beyond neutral with the December rate hike. Recently, weakening manufacturing surveys, both domestic and international, and rising dis-inflationary pressures have increasingly concerned FOMC members. While most indicators would suggest the domestic economy remains on reasonably sound footing, forward guidance from the Fed would suggest we will be entering an easing cycle early in third quarter, with reductions in the policy rate and stabilization of the balance sheet.
Outlook – Central Banks Have the Yellow Jersey
While monetary policy always serves as a primary influencer of financial conditions and sentiment, the substantial moves in global markets over the last several months puts even more focus on central banks to manage expectations. Given risks to the global economy and myriad geopolitical tensions, we are predisposed to maintain more defensive portfolio positioning. A more placid environment, in which yields stabilize and fundamentals improve, could support a further advance in risk assets. Given the binary outcome of these two scenarios, we are attentive to the likelihood for increased volatility, particularly as rhetoric intensifies entering the 2020 election cycle. The lack of compensation investors currently receive for taking incremental credit risk should reward a portfolio construction process focused on risk-optimization across sector, quality, and key rate durations. We are evaluating opportunities to enhance portfolio yield and move up in quality across our strategies.
Technical factors are likely to continue to be a meaningful driver of valuations and liquidity. The credit supply/demand balance has been skewed, with robust inflows from investors occurring simultaneously with diminished new supply from investment grade issuers (relative to the pace of prior years). This has aided spread compression in both primary and secondary markets, as investors search for incremental sources of yield in a lower interest rate environment.
Alternatively in MBS, technical factors have somewhat deteriorated, as the steep drop in U.S. Treasury yields has pushed refinancing activity higher. This environment has weighed on MBS valuations and has resulted in their returns lagging those seen in credit. We have used this opportunity to increase allocations to the sector across strategies, as relative valuations have become more compelling. Coupled with our expectations that MBS will perform favorably to credit in a flight-to-quality scenario, we view it as an attractive way to manage the risk/reward balance in clients’ portfolios.
The Bloomberg Barclays U.S. Credit Index measures the investment grade, US dollar-denominated, fixed-rate, taxable corporate and government related bond markets
The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based flagship benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market.
The Bloomberg Barclays U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt. Canadian and SEC-registered global bonds of issuers in non-emerging countries are included. The index includes both corporate and non-corporate sectors.
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