The bond market is embarking on another year of Federal Reserve watching. After raising rates four times in 2018, the Fed is currently projecting just two moves this year.
Many economists are calling for slower economic growth, but it's not clear whether it will slow enough to derail Fed tightening. The U.S. still faces risks ranging from trade tensions to possible inflation, which suggests markets will remain volatile in 2019.
With rates likely to continue rising, albeit more slowly, what's a bond investor to do?
Warren Pierson of Baird doesn't expect a recession and sees heavy issuance by the U.S. Treasury keeping upward pressure on interest rates; he is optimistic about investment-grade credit. Bill Martin of Nuveen likes investment-grade U.S. credit and emerging-market debt at current valuations, but warns that it's time to be selective.
(More: Bob Doll's 2019 predictions)
Donald Ellenberger of Federated Investors argues that the market has overpriced the risk of a recession; he sees the possibility that credit spreads tighten and fixed income rallies, led by high-yield and emerging-market debt. Rick Rieder of BlackRock says the slowing economy combined with a pause in Fed tightening will give long Treasuries a boost. And David Hammer of Pimco suggests investors consider municipal bonds, noting that nearly all of the new issuance since the financial crisis has been Treasuries or corporate bonds, while the size of the muni market has been at about the same size for the last decade.
Bold prediction for 2019: Look for higher-quality municipal bonds with maturities of 20 years or longer to outperform short-term maturities in the first half of 2019, and the potential for a pause in the Federal Reserve's rate-hiking cycle.
Pimco expects U.S. growth to slow in 2019 and market volatility to increase, though the probability of a near-term recession remains low. In this environment, municipal bonds may offer investors a late-cycle refuge with attractive, tax-efficient income. However, credit selection will become more critical as economies cool.
We offer municipal bond investors five thoughts heading into the new year.
1. For U.S. taxpayers, federal tax-exempt municipals have typically outperformed other fixed-income asset classes late in the economic cycle. Correlations to riskier assets tend to be low. The tax-exempt Bloomberg Barclays Municipal Bond Index has roughly a quarter the correlation to the S&P 500 of the taxable Bloomberg Barclays US Credit Index.
2. Find better value in longer-term maturities. Corporate tax reform made munis less attractive for U.S. banks and insurance companies, which has reduced demand for bonds maturing in 20 years or longer. Fear of interest-rate risk and an active Fed has increased demand for ultra-short-term munis.
As a result of these factors, we believe longer-term munis, with their much higher yields, are attractive.
3. Lower supply provides a long-term tailwind. U.S. fixed-income markets have grown by more than $11 trillion since the financial crisis. Nearly all of the new supply has been in U.S. Treasuries and taxable corporate bonds. The tax-exempt muni market is about the same size it was a decade ago.
Retiring baby boomers in the U.S. are expected to increase the need for high-quality, tax-efficient income streams in the coming years.
4. Avoid bond issuers that are most exposed to a decline in economic activity, and those with a large unfunded pension obligation.
At Pimco, we have a preference for issuers with secure revenue streams that should not be impacted by unpredictable political outcomes, that are less reliant on continued economic growth and do not compete with other essential governmental services.
Puerto Rico opportunities
5. Puerto Rico's emergence from bankruptcy means $20 billion to $40 billion in newly restructured Puerto Rico debt is expected to enter the municipal market in 2019.
Depending on the structure of the new debt, opportunities could come in direct obligations with improved protections for bondholders, or in other non-Puerto Rico, higher-quality bonds that are sold into the market to pay for these purchases.
Bold prediction for 2019: While volatility is likely to remain high, the biggest risk investors may have in their bond portfolios is that they don't have enough risk heading into 2019.
2018 was a mostly forgettable year for fixed income — and for most asset classes, for that matter. Midterm elections, Fed rate hikes, an escalating trade war, rising and then plunging oil prices, Italian budget talks, Brexit, a relentlessly flattening U.S. yield curve, a 10% correction in the S&P 500, the Mueller investigation, competition from T-bills and money funds for the first time in a decade, and downshifting overseas growth wreaked havoc all over. And looming above all this was the Federal Reserve's steady reversal of its unprecedented monetary stimulus.
So where is the bond market heading in 2019? There are two competing theories. One is that economic growth will decelerate dramatically, possibly into recession, as the Fed overtightens, intellectual property rights prove too intractable to resolve the U.S.-China trade dispute, and the sugar high from tax cuts dissipates. In this scenario, stocks nosedive, credit spreads widen significantly and 10-year Treasury yields tank — good for very high-quality bonds, not so for all others.
The second theory: While growth slows from 2018's robust pace, it stabilizes around 2%, buttressed by the lack of any obvious imbalances in the economy and a still-strong consumer (who makes up 70% of GDP). China and the U.S. strike an accord. Determined not to repeat past central bank mistakes, the Fed eases off the brakes, in part because inflation remains relatively benign. And in Washington, a Democratic House and Trump's White House find common ground to pass a stimulative infrastructure bill. Under this scenario, stocks rally, credit spreads tighten, 10-year Treasury yields are back up to 3.25%, and most fixed-income sectors have a good year, led by riskier high-yield and emerging-market bonds.
Which scenario wins out? My money's on the more optimistic version two. Value has been created in 2018, the market has overpriced recession risk and the Fed isn't stupid.
Bold prediction for 2019: A yield curve inversion does not precipitate a recession, but rather the U.S. economy continues its gradual trajectory of moderate growth. Accordingly, the stock and bond markets generate modest positive returns despite a slight increase in interest rates.
2018 was a year of transition for the bond market, as the long-anticipated increase in yields finally marked or confirmed the end of the Great Bull Market for Bonds. The market's struggle to stage an appropriate sequel to this epic drama can explain a good deal of the volatility that characterized 2018. While space prevents a deeper examination into the complexities of the fixed-income markets for 2018 and 2019, a couple of scripts came forward that captivated investors looking for the next big play.
First, the swift rise in yields early in the year (the 10-year Treasury rose quickly from 2.40% to 2.95% in the first six weeks of 2018) looked like the perfect first scene of "The Great Bear Market for Bonds," and investors braced for a long, steep and fearsome increase in interest rates. But alas, the swift rise quickly subsided, and the 10-year yield spent the rest of the year trading in a relatively tight band around 3% (peaking at 3.24% in mid-November but slipping back below 2.90% in early December).
Second, as the Fed continued to normalize short-term interest rates (i.e., raise them away from the zero floor) and flattened the yield curve, the ominous path to an imminent inversion and inevitable recession gripped bond audiences with fear and pushed investment-grade credit spreads wider. The uncertain fate of the burgeoning number of BBB-rated credits in the coming recession weighed heavily on investment-grade spreads, which are currently 46 basis points wider on the year.
We expect continued yet modest upward pressure on interest rates in 2019 as the market digests ongoing heavy Treasury issuance. We look for further flattening of the yield curve as the Fed cautiously nudges the funds rate up to its neutral target. We are optimistic on investment-grade credit and do not see signs of an imminent recession; the U.S. consumer is in good shape, the banking sector strong and economic momentum solid. While more dramatic (even cataclysmic) screenplays are captivating the headlines and making many investors nervous, we believe a more mundane and benign theme of continuation of gradual moves is more likely to characterize 2019.
Bold prediction for 2019: After years of rising interest rates, 2019 will witness an end to that process, as rates stabilize in a broad range around current levels, becoming a positive contributor to portfolios' forward Sharpe ratios. The Federal Reserve pauses its rate-hiking cycle in the year's first half in response to a slowing economy.
The story of 2019 is one in which balanced portfolios containing high-quality income streams will see significantly better returns than they did in 2018, as the global economy slows and policymakers follow suit.
Profound shifts in the economic landscape over recent months will give the Federal Reserve reason to pause from its current rate-hiking path to survey the scene. A year ago, global liquidity was growing at its fastest pace ever, developed markets' real policy rates were negative, China was enjoying the tail end of a multiyear credit explosion and the U.S. was set to unleash powerful fiscal stimulus. Today, global liquidity is in steady decline, U.S. real policy rates are the highest in almost a decade, China is endeavoring to delever, and U.S. fiscal stimulus is set to abate. Thus, we have likely witnessed peak economic growth and peak inflation for this cycle, and while we do not foresee a recession in 2019, we do anticipate further economic slowing. If 2018 was the "year of adjustment" for policy, 2019 could well be the "year of taking stock."
The implications of a slowing economy coupled with a pause in the Fed's hiking cycle have direct and tangible investment implications, chief of which is that the long end of the Treasury curve once again becomes a viable hedge to a portfolio of risky securities. In 2018, long Treasuries posted a negative return, causing balanced portfolios of stocks and bonds to experience their only year of underperformance versus cash in at least half a century, outside of outright recessions. This regime shift in risky versus risk-free correlation that we expect in 2019 cannot be understated: It means a portfolio of high-quality European and Japanese assets swapped back to U.S. dollars, agency mortgage-backed securities, and modest allocations to select emerging markets and credit could work well in the year ahead, if generously hedged with U.S. duration.
As growth and inflation normalize from lofty levels, so too will financial asset correlations. Having followed markets for more than three decades, the phrase "history doesn't repeat itself, but it often rhymes" will ring true in 2019.
Bold prediction for 2019: Emerging-market debt is historically attractive from a relative value perspective. Potential U.S. dollar weakness in 2019, caused by a more dovish Fed, could provide a tailwind for emerging-market debt, representing a potential opportunity for investors.
The economic backdrop in 2018 was mostly favorable for investors, who benefitted from solid earnings growth, historically low, albeit rising inflation, and tailwinds created by the 2017 Tax Cuts and Jobs Act. While we don't expect a recession in any major economy in 2019, we do expect a slower growth environment coupled with rising rates and more volatility.
We are facing several risks — rising inflation, rising interest rates, slower earnings growth and trade tensions — and believe fixed-income markets offer a range of opportunities. But 2019 may prove to be a balancing act: The key, in our opinion, is to stay actively invested and well diversified. Overall, we suggest our clients strike a balance between optimism and being defensive: Approach markets cautiously but still remain invested. We think increased selectivity, with a focus on quality and valuation, will yield the best results.
While returns in many fixed-income markets were negative in 2018, we think the global economy should continue to expand and credit markets should remain supported into 2019, as there is room to run in this economic cycle. The Fed has been slowly but steadily raising short-term interest rates for three years. The Fed's updated forecasts will likely signal a more gradual approach reflecting heightened risks to the outlook for 2019.
Although we've been positioning more defensively, we retain a constructive view toward markets and think investment-grade U.S. credit markets and emerging-market debt look compelling at current valuations. Against a backdrop of slow but stable global growth, we think recent U.S. dollar strength will be challenged as the U.S. economy slows and the Fed nears the last rate hike. This should provide more support to emerging-market currencies and the sector more broadly.
Geopolitical risks centered on trade tensions, Brexit and a harder-than-anticipated landing in China may generate volatility. Notwithstanding those risks, we see opportunities in select, higher-yielding emerging sovereign credit markets, and higher-volatility local markets where current spreads more than compensate for the fundamental risks.