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Related Insight

Quarterly Perspectives 4Q19

Quarterly Market Summary
  • The Federal Open Market Committee (FOMC) reduced the fed funds rate by 25 basis points (bps) at its October meeting, but left the policy rate unchanged at its December meeting. The FOMC believes its current policy is appropriate and has no expectations for further action in 2020 based on its economic estimates.

  • The U.S. Treasury (UST) yield curve steepened during the fourth quarter, as short-term rates moved lower in response to the FOMC’s third rate cut for 2019, while longer-dated rates moved higher, as global growth concerns dissipated.

  • Trade tensions de-escalated in the fourth quarter, leading to easing financial conditions, a lessening of recession fears, and a rally in riskier assets.

  • Credit markets closed 2019 on a strong note with further spread compression, capping off a year with the highest level of excess returns for investment grade credit since 2012.

  • Current valuations in structured products look attractive relative to credit, particularly in mortgage-backed securities (MBS), where we have raised targeted allocations across strategies.

 

Duration Positioning
Neutral
Maintaining a benchmark-like duration stance across strategies, with a modest underweight to the front end of the curve.
Credit Sector
Neutral
Overweight Financials and select BBB Industrials; focused in maturities less than 5 years. Remaining underweight non-Corporate credit.
Structured Product
Overweight
Modestly reduced overweights in Asset-Backed Securities and increased Agency Mortgage- Backed Security allocation to neutral in Aggregate strategies.
Fourth Quarter Sector Review

Positive developments in both fiscal and monetary policy provided strong tailwinds for financial markets during the fourth quarter. A de-escalation in trade negotiation rhetoric from both the U.S. and China aided risk appetites, while a cautious Federal Reserve provided additional accommodation with a third consecutive rate cut in October. Coupled with a continuation of positive consumer-related economic data (labor market and confidence surveys), these developments set the stage for equities to sustain record-high valuations, while investment-grade and high-yield credit spreads approached post-crisis lows.

Bloomberg Barclays Aggregate Bond Index
Option-Adjusted Spread (OAS)
Excess Returns
Sector
(bps)
3 Months
YTD
U.S. Agency
10.00
0.09
0.54
U.S. Credit
Industrial
Utility
Financial Institutions
Non-Corporate Investment Grade
90.00
99.00
97.00
80.00
72.00
2.21
2.62
2.13
2.11
1.09
6.20
7.28
4.74
6.23
3.31
U.S. Mortgage Backed Securities
39.00
0.62
0.61
Asset-Backed Securities
44.00
(0.03)
0.71
CMBS: Erisa Eligible
72.00
0.06
1.81
U.S. Corporate High Yield
336.00
2.51
9.34

Source: Bloomberg Barclays
See Important Disclosures at the end of this document for additional information.

The UST yield curve steepened during the fourth quarter after inverting in late summer, largely as a result of short-term yields moving sharply lower in response to the successive Fed rate cuts and longer-term yields moving higher as the late-summer flight to quality reversed. The Bloomberg Barclays Aggregate Index produced a total return of 0.18% during the quarter, bringing its year-to-date return to 8.72%. U.S. Credit produced 221 bps of excess return during the period, as the option-adjusted spread (OAS) of the Bloomberg Barclays U.S. Aggregate Credit Index compressed by 19 bps during the quarter. High-yield markets rallied as well, as a fourth quarter return of 2.61% pushed the year-to-date total return for the Bloomberg Barclays U.S. Corporate High Yield Index to 14.32%. Structured products were mixed, as the Mortgage-Backed sector produced it’s best quarter of excess returns during 2019, while the Asset-Backed sector was slightly negative.
 
The robust returns across fixed income markets in 2019 were a sharp departure from the previous year, as financial markets took great comfort from the aggressive response by the Federal Reserve with its pivot to more accommodative policy. Additionally, many economic and geopolitical uncertainties and potential risks that had lingered throughout much of the year were at least temporarily calmed in investors eyes during the latter stages of the fourth quarter. As a result, the yield-to-maturity on many fixed income indices moved back to near post-crisis lows.
Monetary Policy: Active 2019 for the Fed, Projections for a Calmer 2020
The Fed’s “mid-cycle adjustment” appears complete now that we are one meeting removed from the third consecutive cut in the fed funds rate. The December FOMC meeting statement struck a balanced tone, as the Fed acknowledged that uncertainties had somewhat subsided. However, Chairman Powell noted that for the FOMC to consider future rate hikes, inflation would have to move materially higher on a sustained basis. For the time being, that appears to be a tall order, as most of the Fed’s preferred inflation measures continue to undershoot their long-term objectives. Markets are generally aligned with the Fed’s expectations, as fed fund futures markets currently price in modest odds of a policy adjustment over the next couple of quarters. This is particularly noticeable in the recent steepening of the yield curve, which had previously been flattening since late 2016 after the Fed re-initiated its policy tightening campaign. This flattening ultimately led to an inversion of the yield curve, as market participants grew concerned that the Fed had been too aggressive given a bevy of other domestic and international challenges. The UST curve slope, as measured by the spread between the 10-year Treasury note and 3-month Treasury bill, closed the year almost 90 bps higher from the lows of the late summer months.
 
As we discussed last quarter, the Fed had to expand its focus beyond policy rate decisions to also include the stability of short-term funding markets, which experienced significant volatility during September. The Fed waged an aggressive response, which combined open-market repurchase operations (both overnight and term) with the initiation of UST bill purchases at a pace of $60 billion per month. These measures were particularly helpful as markets navigated through the quarter/year-end when funding pressures have a tendency to develop. Notably, the Fed’s programs were underutilized this quarter with just over $400 billion in liquidity provided through open market operations and bill purchases. Ultimately, it appears likely the Fed’s balance sheet holdings will remain elevated given the apparent efficacy in supporting financial market stability.
 

10-Year U.S. Treasury Note – 3-Month U.S. Treasury Bill Spread

Source: FactSet

Federal Reserve Total Assets ($ in billions)

        Source: FactSet

Patience Warranted as Markets Increasingly Priced for Perfection
Faced with slowing global economic growth, the U.S. economy responded favorably to the Fed’s actions during 2019. In our view, the Fed’s apparent willingness to intervene as-needed to provide stability in funding markets has helped boost investor confidence. Additionally, the de-escalation of trade tensions between the U.S. and China appeared to alleviate concerns that the uncertainty would weaken business investment and tip the U.S. and other global economies closer towards recession. While details remain scant, progress on U.S.-China trade negotiations should at least temporarily alleviate pressure on the global economic outlook.
In our view, credit markets reflect this optimism, as spreads have fully reversed the widening seen in 2018 and are testing the post-crisis tight levels last observed in early 2018. When adjusted for duration, yield, and quality, we would argue valuations are expensive relative to historical levels.
Indeed, we believe valuations leave little margin for error and offer little compensation for risk taking by credit investors. Therefore, we continue to maintain benchmark-like allocations in credit exposure, with a defensive bias in our security selection process, emphasizing shorter-duration (seven years or less) portions of the market. We maintain a modest overweight to BBB-rated issuers. With generally low dispersion on spreads across much of the credit market, we expect security selection will be paramount to performance in 2020.

The fundamental backdrop for corporate issuers has stabilized over the year, as earnings generally exceeded expectations, and some large issuers improved their leverage profiles in response to concerns that manifested during the late-2018 selloff. Equally important, market technicals for corporate debt remain quite healthy, as global demand remains robust, while new-issue supply has been modestly lower than the previous couple of years. The early read on activity in 2020 suggests investor demand is exceeding supply, as recent deals have been well oversubscribed with pricing at the high end of guidance. This has been particularly helpful for low-quality, high-yield energy issuers, where a strong rally in December has helped marginal issuers extend their capital structures and tender for shorter-dated maturities.

Strong investor demand and low risk premiums across much of the credit sector favor our preference to overweight structured products. We believe MBS in particular is an attractive alternative to credit; valuations improved in late summer 2019, as interest rate volatility reached an apex. As we discussed in one of our recent commentaries, “The Case for Structured Securities,” we believe the inclusion of structured securities in client accounts can improve portfolios’ risk-adjusted return characteristics. We have opportunistically added to our MBS positions during the fourth quarter, increasing our overweights across strategies.

Bloomberg Barclays U.S. Aggregate Credit Index* Average Option-Adjusted Spread (bps)

Source: Bloomberg Barclays
See Important Disclosures at the end of this document for additional information.

Despite the generally favorable set of circumstances that drove fourth quarter returns, we remain cognizant of how quickly market dynamics can change. The rapid escalation in tensions between the U.S. and Iran is a perfect illustration of how suddenly these events can occur and the difficulty in assessing possible resolutions and the attendant market implications. With narrowing risk premia and low overall yields, our disciplined, risk-focused portfolio construction process will increasingly emphasize more defensive portfolio allocations.
Indexes
The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and nonagency).

The Bloomberg Barclays U.S. Aggregate Corporate Index represents the total return measure of the corporates portion of the Barclays U.S. Aggregate Index.

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.
BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.
This publication is for informational purposes only. Information contained herein is believed to be accurate, but has not been verified and cannot be guaranteed. Opinions represented are not intended as an offer or solicitation with respect to the purchase or sale of any security and are subject to change without notice. Statements in this material should not be considered investment advice or a forecast or guarantee of future results. To the extent specific securities are referenced herein, they have been selected by the author on an objective basis to illustrate the views expressed in the commentary. Such references do not include all material information about such securities, including risks, and are not intended to be recommendations to take any action with respect to such securities. The securities identified do not represent all of the securities purchased, sold or recommended and it should not be assumed that any listed securities were or will prove to be profitable. Past performance is no guarantee of future results.

PNC Capital Advisors, LLC claims compliance with the Global Investment Performance Standards (GIPS®). To receive a list of composite descriptions of PNC Capital Advisors, LLC and/or a presentation that complies with the GIPS® standards, please send an email to Compliance at [email protected].


PNC Capital Advisors, LLC is an SEC-registered investment adviser, offering an array of investment strategies. PNC Capital Advisors, LLC is a wholly owned subsidiary of PNC Bank N.A. and an indirect subsidiary of The PNC Financial Services Group, Inc. PNC Capital Advisor’s strategies and the investment risks and advisory fees associated with each strategy can be found within Part 2A of the firm’s Form ADV, which is available at https://pnccapitaladvisors.com.

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INVESTMENTS: NOT FDIC INSURED – NO BANK GUARANTEE – MAY LOSE VALUE

Insight Blotter

Still on Track: SOFR In, LIBOR Out

We provide an update to the team’s previous commentary regarding the phase out the London Interbank Offered Rate (LIBOR) in favor of its heir presumptive, the Secured Overnight Financing Rate (SOFR).

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