Fixed Income Market Outlook

July 2018 - Fixed Income Market Outlook

Jul 31, 2018

Highlights

  • Recent bouts of volatility may represent “canaries in the coal mine,” or early warning signals that changes to global liquidity and monetary policy frameworks are likely to result in more persistent and troubling market gyrations.
  • Decelerating global liquidity is also coming alongside a tremendous increase in U.S. Treasury issuance, which together can lead to a crowding-out effect for risk assets; investors would do well to maintain a cautious approach.
  • Finally, as we have been arguing for months, in this evolving market environment we think a barbelled portfolio approach with less risky front-end assets for carry and some equity convexity for upside potential makes good sense.

From the standpoint of asset class return patterns, 2018 is turning out very differently than 2017, at least through mid-year. Indeed, 2017 exhibited a remarkably strong risk-on impulse across virtually all asset class types, and that was alongside historically low levels of market volatility. That dynamic continued into late-January of this year, with the exception of interest-rate sensitive investments, which were hurt by rising rates early in the year. Then, in late-January and early-February we saw a spike up in market volatility and a drop in risk asset prices surrounding the unwind of popular volatility trades, and in fact since that point we have witnessed a series of instances of unsettled markets impacting a variety of asset classes. These latest episodes have underscored to us that the recent bouts of market volatility and more troubled asset class performance are not the result of purely idiosyncratic factors, specific to the asset types in question, but rather stem from a single common source: namely, the deceleration of global liquidity growth and the transition from central-bank derived liquidity to more organic (but less predictable) forms.

Therefore, in a sense, the bouts of volatility we have seen so far this year represent “canaries in the coal mine,” or early warning signals that changes to global liquidity and monetary policy frameworks are likely to result in more persistent market gyrations and the occasional unwind of crowded trades. Of course, there is also a possibility that a more severe market disturbance, or economic recession, could result from waning liquidity levels, but that’s not our base case over the next year. What we do expect to see, however, is an increase in the divergence between different regional rates of economic growth, inflation, debt levels, and monetary policy, such that the hope of global synchronization that began the year fades away by the end of it. Finally, we will examine what we have referred to elsewhere as the “story of the year” for 2018, or the fact that increased yields at the front-end of the U.S. yield curve today represent – for the first time in years – a genuine alternative to some risk asset exposures, at least on a risk-adjusted basis. That fact is beginning to alter many investors’ capital allocation calculus.

In this kind of an environment, to use a metaphor from the chess world, we think it makes sense to use our “investment pawns” both for defense and to help in the positioning of more valuable pieces, such that a more aggressive strike can be made in the future, as opportunities arise. Without doubt, we believe that the docile investment landscape of last year, which saw strong asset class performance across the board that could be captured effectively through beta exposure, and low volatility, is probably behind us, and today a flexible and opportunistic stance should be more advantageous. Drawing on our chess metaphor even further, although the chess board has 64 squares, most effective play takes place in the core 16 squares at the center of the board. Likewise, we think it makes sense to focus today on a core set of investment themes and corresponding assets that in our estimation are likely to dominate the market state of play in the months and years to come. And as we have already intimated, we would place the concept of liquidity right at the center of investment game play today.

Rick Rieder
Managing Director, Chief Investment Officer of Global Fixed Income