Fixed Income: This time next year...
With so much going in the markets, we decided to delay our 2019 outlook slightly, in order to meet with as many analysts and strategists as possible and ensure we had time to sensibly comprehend the recent turmoil. Recapping 2018 has not been an enjoyable exercise, but an important one if we are to move ahead with the right lessons and expectations for the coming year.
Going into 2018 we certainly felt that we did not like the vast majority of fixed income markets, but we also felt there would be pockets of safety that could result in reasonable, and certainly not negative returns. Our outlook was for the Federal Reserve to hike three times in 2018 (it looks like it could be four), and for Treasury yields to grind higher with 10-year USTs finishing the year at 2.75%. As it turns out they are at 2.88% currently and rallying strongly, though they did go as high as 3.25% in October. German Bunds continue to amaze us. We were right with our end of QE call and no hike from the European Central Bank, but we thought Bund yields would have moved 50bp higher in a year like this. The demand for a euro risk off asset has been high this year with the events in Italy in particular but also the weak performance of the German economy was noteworthy. Still, we find it hard to reconcile fundamentals with a yield of just 0.25% on the 10-year.
After such a benign 2017 for credit, 2018 was a year when ‘normal’ volatility returned to markets, initially driven by a modest reflation theme in the US, but then by a series of geopolitical concerns around the world, from Argentina, Turkey, Italy, and of course here in the UK, to name just a few. Combine this with an aggressive trade war and the beginning of quantitative tightening, and investors started to flee risk assets. The consequence in fixed income was materially wider credit spreads, though we noted that outflows in Europe in particular were often funded by managers selling their easiest to sell assets. This put pressure on shorter dated bonds meaning low duration funds, which would normally be a safe haven in such a market, also experienced a particularly tough year. All told this has been the most challenging year for fixed income investors since the global financial crisis. Of the credit sectors we have historically favoured, only ABS and CLOs (pools of loan products) managed to produce positive returns. Short dated government bonds did too, as did our preferred rates market of Australia, but these were a few bright spots in a year that repriced large parts of fixed income.
So as Gark Kirk, Eoin Walsh, Chris Bowie, Ben Hayward, Felipe Villaroel and myself sat down last week, our opening comment was that at least yields were materially higher as we enter the new year, which should make our lives considerably easier if volatility is to continue.
Starting with the US, we expect fundamentals to remain supportive, but we also see a gradual slowdown, which combined with the Fed getting to a neutral stance would mean the central bank pausing its rate hikes in order to attempt a soft landing. Consensus among the team was that a pause is likely after a June hike, which would take the Fed Funds upper bound to 3.00%. It is unlikely there will be any further hikes in 2019, with March or June 2020 being our estimate for when they resume, if in fact they are able to. We believe that once the Fed pauses we will already have an inverted yield curve between two and 10 years, and a consequence of that in our view is US banks will start tightening their lending. The impact of this normally is the end of the cycle, but we do know that this cycle is different and we must question conventional wisdom. We remain open to the cycle surviving, just as it did when the Fed paused in 1995, but we do think the market will at least start pricing this in by H2 2019. Hence our overall outlook is the most cautious we have had since the crisis. The Fed could just pull this off with the tools that it has available, in particular its dot plots, and detailed forward guidance could result in hawkish pausing rather than dovish tightening. Once the Fed gets to neutral, it will really want to see the impact of 11 rate hikes, but the market has shown us already in the last two months that it fears a more serious slowdown in 2019. Chairman Powell will need to have learned from his recent errors and be at his polished best in 2019.
Moving back to how we see things playing out in 2019, the inverted curve means our forecast for 10-year US Treasury yields is lower than most. We see them about where they are now at year-end, but we think we see them back up over 3% in the first quarter and then possibly as low as 2.50% by the time the Fed pauses and the fear kicks in. Timing is going to be important in government bond markets in the year ahead.
This call also means US credit spreads are likely to be volatile again, probably peaking in Q3 with markets dislocating from fundamentals as they start pricing in a 2020 recession that may not arrive. Depending on data, this period may well present the best opportunity in bond markets over the whole 2018/2019 period. We feel that after the aggressive recent sell off, spreads globally are attractive going in to 2019, and hopefully the continued supporting fundamentals will give them a chance to rally in the early months of 2019, though we would likely use this opportunity to fade the rally and become more cautious ahead of a possible Fed pause. By year-end, spreads will most likely be wider than where we began the year. Given the more expensive valuations in the US going into 2019, and its relative proximity to the end of cycle worry that we have, we see US credit spreads as the global underperformer in 2019.
We expect the US default rate to remain very low, although a small pick-up in defaults towards 3% or just above is likely given the anticipated tightening. The ratio of upgrades to downgrades, which was at its post-crisis best in 2018, is likely to be much more like neutral in 2019. Fundamentally this is still not a bad place to be, but then 2019 will be less about fundamentals.
Moving closer to home in Europe, most of us thought the ECB would put through its first hike in the autumn, but all of us see the refinancing rate at -0.20% or lower by year-end. Having been so wrong on 10-year Bunds in 2018, you might skip our forecast for 2019, but we unanimously see them higher in 2019, though still underpinned by both the ECB’s stock of existing holdings and the US recession worries mentioned above. Our median forecast is 0.65% by the end of 2019.
European credit spreads will take their lead from the US, but it is worth noting that the big technical fear we had last year – the ECB’s influence on euro credit – has been reflected in pricing and credit spreads are now wider than where they were before Draghi announced his corporate purchase programmes. Credit spreads are materially higher than they were at the beginning of 2018, and they are materially higher than in the US too. This should lead to Europe outperforming the US in 2019. The euro default rate is the lowest in the world, and despite rising slightly towards 2.5% it should remain the lowest in 2019. The very strong upgrade versus downgrade picture that we had in 2018 will abate in 2019, but still we see more upgrades than downgrades for euro credit.
The UK was always going to be the hardest prediction for us given the level of uncertainty here. A good Brexit is impossible, no Brexit is possible again, and some type of fairly bad deal is perhaps the most likely. However, this is only half the story. The one that needs mentioning is what we have come to call the Corbyn premium. Should there be a general election, and should Labour win that, we will face a set of circumstances here in the UK that our financial markets are quite likely to panic about. Gilts remain the sterling risk off asset and they have shown those characteristics since the vote to leave the EU, but should there be a Labour government we are just unconvinced this will remain the case. Fortunately there are other risk off assets that can be swapped to sterling if needed. Our base forecast in the UK is that Gilt yields creep higher towards 1.75% in a catch up with the US, as the Bank of England manages to put through one more base rate hike. As far as sterling credit is concerned, it will start the year with a hefty Brexit premium and is the cheapest of the three markets we have discussed. Some sort of resolution to Brexit, even if that is a poorish exit deal, would result in that premium narrowing. Consequently sterling credit is the most likely to outperform in 2019 even if spreads have a global bias to widen, though we are wary of the Corbyn risk that lurks in the background.
Moving on to a few of the most popular sectors now. Starting with one of our old favourites, bank subordinated debt. Much as we like bank fundamentals, we are acutely aware that banks will lead the way on volatility and will fare amongst the worst heading into a recession (even a recession that does not materialise). For the first time since the CoCo (AT1) sector launched in 2013 there are quite a lot of bonds to be refinanced in 2019 as banks call their inaugural issues. Some of these shorter dated bonds have been sold by managers this year to finance outflows, as mentioned above, and consequently these may prove to be some of the best sources of risk to be found in fixed income in 2019 as redemption locks in the return. However, longer dated securities should be avoided in 2019, especially after the Fed pause while the market decides how heavily to price in a 2020 recession. There is also the chance to see how the banks wish to treat their CoCo investors. Santander would be our top pick for a bank that does not call its bonds at first call date. Longer term this will hurt them, but they have told markets that they will only call if it is in their best interest. All other AT1 bonds we expect will be called in 2019.
Both loans and ABS fared amongst the best classes in 2018, loans in particular, but with our view of the world as well as the scrutiny from regulators into loans and loan pricing, it is hard to see loans as a top performer in 2019, particularly in the US. For investors looking for floating rate product, we think ABS offers a much safer play, even if spreads are likely to be modestly wider by year-end.
Lastly on sectors we discussed emerging markets, which was at or near the centre of most of the geopolitical risks that triggered this year’s market turbulence. Spreads in parts of EM widened considerably in 2018 and yields now look quite attractive. They will not be immune from the market decoupling from fundamentals view that we have for H2, but a Fed pause might be a catalyst for a period of dollar weakness, which we believe is what will trigger investors return to EM. So on a relative basis EM debt could be one of the better sectors in 2019.
Touching on ratings briefly, we think continuing to increase credit quality makes more sense than ever in 2019, and we were really surprised at just how well CCC rated dollar bonds performed in 2018. Yield and lowish duration is a powerful tool sometimes.
So in summary, the opening level of yields going in to 2019 is a big positive, and markets may well focus on fundamentals early in the year giving investors a chance to get off to a good start. The table below shows the magnitude of these moves. Note each index yield is in its own currency so please do not compare across indices for relative yield, but the spread tells a more honest tale.
However, we feel the Fed pausing is inevitable and that could trigger conditions not unlike those we have been experiencing for the last month or so, as the yield curve inverts and end of cycle worries take over. We think the result will be slightly wider credit spreads by the end of the year, with periods of volatility just like in 2018. US Treasuries and Aussie government bonds are our preferred rates markets in which to seek protection. We think sterling credit outperforms euro, which in turn outperforms dollar credit.
Witnessing in detail exactly how markets behaved in 2018 gives us more confidence in how to play 2019, and we feel reasonable positive returns can once again be had. We will be keeping portfolios ultra-short and not worrying about reinvestment; buying 2019 maturity bonds will give investors more certainty of return on these holdings. 2020 maturities work too, and could provide an anchor for performance. Yield and pull to par look to be our best friends for 2019.
The significant back up in US Treasury yields across the curve means we also have plenty of basis points available for protection in 2019 if we need it. The Fed has done a good job bringing these yields higher for exactly this purpose.
So our base case is 2019 will be tough, but probably not as tricky as 2018 as long as you approach it with the right amount of caution.
That just leaves me to thank everyone for all their support and questions this year, and we really hope you find our outlook useful.