Quarterly Market Summary
The Federal Open Market Committee (FOMC) proceeded with two 25 basis point (bp) reductions in the policy rate during the quarter in an effort to support the economy amid slowing global growth and trade uncertainties.
The willingness of global central banks to provide further monetary policy accommodation has led to a strong rally in risk-free rates and relative stability in risk markets.
U.S. manufacturing surveys were notably weaker, indicating a contraction in the sector and raising the odds that economic growth will continue to slow.
Strong investor demand for investment-grade Credit was sufficient to absorb a surge in new-issue supply during the month of September; credit spreads were little changed during the quarter overall.
The rapid decline in U.S. Treasury yields and corresponding spike in interest rate volatility highlighted mortgage-backed security convexity risk; however, we believe improved valuations provide favorable opportunities to increase allocations.
Maintaining a benchmark-like duration stance across strategies, with a modest underweight to the front end of the curve.
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.
Modestly reduced overweights in Asset-Backed Securities and increased Agency Mortgage- Backed Security allocation to neutral in Aggregate strategies.
Third Quarter Sector Review
The third quarter was characterized by fears of decelerating growth both domestically and abroad, rising geopolitical threats, and concerns that U.S. – China trade negotiations were again deteriorating. The Federal Reserve responded to the market environment by initiating two 25 bp cuts in the policy rate at both the July and September FOMC meetings. U.S. Treasury yields continued to move sharply lower during the quarter, particularly in August and early September, as markets increasingly expected the Federal Reserve would have no choice but to respond with additional accommodation in future months. This considerable move lower in Treasuries generated impressive returns for fixed income investors.
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 Barclays
See Important Disclosures at the end of this document for additional information.
The Bloomberg Barclays Aggregate Index produced a total return of 2.27% during the quarter, bringing its year-to-date return to 8.52%. U.S. Credit produced only 8 bps of excess return during the period, as the option-adjusted spread (OAS) of the Bloomberg Barclays U.S. Aggregate Credit Index was unchanged for the quarter. High yield was resilient, as a third quarter return of 1.33% pushed the year-to-date total return for the Bloomberg Barclays U.S. Corporate High Yield Index to 11.41%. Structured products generated positive, albeit more modest, excess returns.
Central banks translated dovish rhetoric over the first half of 2019 into action in the third quarter, as both the European Central Bank (ECB) and the FOMC lowered policy rates. Regarding their respective balance sheets, the ECB recommenced open-ended asset purchases, while the Fed ceased the quantitative tightening it began in fourth quarter 2017. Accommodative policy has pressured global interest rates lower and the total market value of negative yielding global debt surged to record levels. While the rally faded in September and yields backed-off recent lows, both forward markets and the slope of yield curves suggest anticipation of additional policy accommodation.
Despite myriad geopolitical risks, financial conditions are supported by the market’s faith in ongoing central bank support. This dynamic has helped stabilize credit spreads, as they remained generally range-bound during the last two quarters. Interest rate volatility spiked in August, as the ICE BofAML MOVE Index jumped. The pace of decline in U.S. rates pushed the duration of the Bloomberg Barclays Fixed-Rate Mortgage-Backed Securities sector down by a year in August, as prepayment risk escalated, leading to negative excess returns for the month.
Monetary Policy: Funds Rate Lower, Balance Sheet Higher, but Don’t Call it Quantitative Easing
While policy rate cuts were well-telegraphed, both FOMC meetings highlighted the growing divergence of opinions among board members. The two dissenters at the July meeting remained opposed to additional accommodation in September, and on the other side of the argument, a dissenter at the June meeting resurfaced in favor of more aggressive easing. Notably, the September “dot- plot” of participant forecasts of the appropriate policy rate in 2020 show a relatively even split of members expecting a future rate above or below the current target.
While the labor market continues to paint a favorable picture of economic prospects, business investment looks increasingly vulnerable, as surveys indicate the manufacturing sector is in contraction. U.S. trade discussions with China remain a wildcard, and the lingering uncertainty is weighing on business confidence. As a counterbalance, Fed easing and declining rates should support improvement in housing activity and continue to boost consumers’ contribution to overall GDP growth. To date, markets have seemed to view the Fed’s response as largely sufficient to offset the negative impacts of trade uncertainty. However, the risks of economic harm from continued U.S. – China sparring remain elevated, as a resolution proves elusive. These factors have helped lead current markets to price-in a likely additional 25 bp cut in the policy rate at the next FOMC meeting on October 30.
Another issue the Fed had to contend with late in the third quarter was surprising volatility in short-term funding markets. Overnight repurchase agreement (repo) rates spiked in mid-September due to a confluence of factors, including an increase in U.S. Treasury issuance, reduced Fed balance-sheet holdings, bank regulatory and liquidity constraints, and corporate tax payments. While this episode highlighted a temporary imbalance in short-term funding markets, the dislocation had minimal impact more broadly. The Fed responded with a series of open-market repo operations, which quickly eased stresses across the money market sector. Chairman Powell recently indicated the FOMC will be announcing a more permanent program to help alleviate the liquidity strain related to the level of bank reserves.
Outlook – Glass Half Full in Credit
Healthy risk appetites and generally rising equity markets have kept equity and credit spread volatility largely contained. However, the same can’t be said for rates markets. The president’s August 1 announcement of additional tariffs on Chinese goods followed on the heels of the Fed’s July 31 meeting, kicking off a dramatic rally in global rates. U.S. 10-year Treasury yields plummeted by more than 50 bps and approached historic lows, while 30-year Treasuries broke through 2% briefly for the first time ever. While these are significant and unexpected developments, we have anticipated the possibility of increased volatility, which has led us towards neutral duration positioning in client portfolios versus their respective benchmarks. Interest rate volatility is likely to remain elevated and increasingly difficult to predict given the competing forces driving U.S. Treasury markets.
This steep drop in Treasury yields led to a fairly significant re-pricing in the agency MBS market, as expectations for mortgage prepayments surged. Valuations improved to multi-year highs, presenting us an opportunity to add to the sector and return to a benchmark-like position after having been underweight for some time. Given the favorable long-term attributes of the sector and rich valuations in high-quality Credit, we will continue to look for attractive opportunities in MBS.
As previously discussed, credit spreads were relatively stable in the quarter despite periodic pullbacks in risk appetites and a surge in supply during September. Investors have continued to pour money into investment-grade fixed income products, which continues to provide technical support for the market. Corporate issuers capitalized on this opportunity to lock-in historically low coupons on debt offerings, as we discussed in a recent market commentary, leading September to be one of the most active months on record. Given this backdrop, we opportunistically participated in some new-issue deals, but have largely left portfolio allocations to Credit unchanged. We remain modestly overweight Credit relative to benchmarks across our strategies, with our continued bias to overweight short-duration Credit and maintain underweight positions further out the curve. We believe this is a prudent way to defensively structure portfolios while still providing a yield advantage versus benchmarks.
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.
The ICE BofAML MOVE Index is a yield curve weighted index of the normalized implied volatility on 1-month Treasury options which are weighted on the 2-, 5-, 10-, and 30-year contracts.
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