FIXED INCOME MARKET OUTLOOK

Nine key investment themes for 2019

Jul 31, 2018

The transition of the calendar year invites both reflection over the 12 months past and the temptation to prognosticate regarding the course of the year ahead. While this has long been a fascination particularly popular in the financial world, we were especially struck this year by the wholesale changes often anticipated merely because January turns the page on December. The most important investment themes are often secular, and even cyclical drivers can adhere to forces that are quite agnostic to our traditional calendar. With that in mind, here are the nine themes we believe will have the most important influence on markets and investing in 2019; some with their impact felt well beyond this year.

 


1. 2019’s investment regime will likely be influenced early on by two major factors coming from policy circles.

While predicting the course of markets for the year ahead is always a nearly impossible task, it is likely to be particularly challenging this year, since markets are likely to remain volatile and their path will largely be determined by critical decisions made by policy makers. Those decisions include: the evolution of rate and liquidity policy by the Federal Reserve, and potential trade and spending agreements reached (or not) in Washington. We think that 2019 will play out with the Fed relenting on its tightening path and pausing its rate hiking (and perhaps even adjusting its balance sheet tightening), as it responds to tighter financial conditions, tighter liquidity and weakening in the interest-rate sensitive parts of the domestic economy. On top of that the Fed also will be watchful of the slowing we’re witnessing in the global economy. Simultaneously, the decisions emanating out of Washington on such critical issues as U.S./China trade policy, fiscal spending, immigration reform, and broader political risk will likely continue to drive risk and risk-free rates over the coming weeks and months.

In some respects, getting the path of these market events right this year may be even more important than being perfectly accurate on the destination for 2019, particularly given the extremely volatile nature of asset-prices on a daily and weekly basis. But since timing markets can be extraordinarily difficult, we prefer to lay out the signposts that investors should look toward as market regimes change. For instance, with the Fed ultimately pausing its hiking cycle, we have reason to expect the U.S. dollar to discontinue the strength witnessed in 2018, and once it becomes obvious that the Fed is planning to halt rate hikes, then we would expect a material and persistent weakening trend to take over with the dollar. As the Fed adjusts to an environment that does not require many (if any) further rate hikes, risk assets should take comfort, with interest rates remaining relatively stable, and ultimately with a yield curve that steepens out as the central bank pins the front-end of the curve to levels that are not higher than today’s, and ultimately are potentially lower.

For several months now we have argued that the Fed would be unlikely to hike policy rates as many times as indicated in its Summary of Economic Projections (the “dot-plot”), but a few months back we began to suggest that a pause in the rate hiking cycle would likely take place in early 2019. The reason, we contended, was that global financial liquidity was becoming too restrictive and was injuring the more interest-rate sensitive segments of the economy, to say nothing of the financial markets. That fact was brought to high relief by the extraordinary market volatility and some deteriorating economic data in late 2018.

In early January, we’ve seen some preliminary evidence that the Fed is coming closer to this view. On January 3, Federal Reserve Bank of Dallas President Kaplan argued that his “own view is that we should not take any further action on interest rates until these issues [global growth decelerating, some areas of economic weakening, and tighter financial conditions] are resolved…”. Further, the next day Chairman Powell discussed monetary policy with his two predecessor Chairs and suggested that it was clear that there was a tension between economic data and financial market concerns. With that in mind, Powell said policy was not on a pre-set course, and that “we will be prepared to adjust policy” to meet the goals of the dual mandate, and that they will be “patient.” While it may be too early to tell, it appears as if the conceptual groundwork for a policy rate pause was being laid down early this year.

2. Reduced global liquidity raises left tail risk potential and market volatility.

The resurgent growth in developed market economies witnessed in recent years has partly been a function of the incredible liquidity DM central banks provided over that time. Today, however, we are seeing a more rapid deceleration in global liquidity than many anticipated, resulting from multiple sources. In the U.S., this takes the form of “triple-barreled tightening,” which is comprised of: higher policy rate levels, Fed balance sheet reduction, and an unprecedented amount of U.S. Treasury issuance, which appropriately can be thought of as a type of tightening of financial conditions, as it can draw capital away from more productive private-sector purposes. This liquidity dynamic can hold a much greater impact on economic and financial conditions than is typically represented in many media sources, which tend to focus on more surface events. Yet, in our view it is not solely the incremental change in the price of money that is really influencing asset supply and demand, but also the quantity of money. Thus, any proactive reduction in the total global liquidity pool runs the risk of having a deleterious impact on a very broad set of global economies and markets, as we saw in 2018.

Indeed, as our proxy of global liquidity has approached contraction territory, economic growth has slowed across much of the globe, many countries’ foreign exchange reserves have dwindled and aggregate financial market capitalization has declined (see Figure 1). Quantitative easing by the ECB has ended and the Bank of Japan has tempered its buying. As described above, in the U.S. we find ourselves in an unusual situation in which the Fed and markets are beginning to recognize the need for a pause in rate hiking and we may even see the central bank put a halt to the unwinding of its balance sheet holdings.

Figure 1: As goes global liquidity, so too can go economies and markets

As goes global liquidity, so too can go economies and markets

Source: Bloomberg, data as of December 31, 2018

3. Return potential will be there, but with lower upside and overshoots to the downside, along with potentially elevated volatility.

Last year was historically challenging for financial asset performance. In 2019, however, we think market prices should stabilize, and may witness tangible bouts of upside and higher risk-tolerance at times. Still, the re-rating of U.S. and global growth to lower levels, and possible risks from further Fed tightening, are likely to keep markets volatile and could place something of a cap on upside potential. A risk to bond market price potential is the record Treasury issuance that has to get priced in 2019, ultimately drawing investor dollars from other assets. Further, another “issuance” risk is that not a single U.S. high yield bond was issued in the month of December 2018, so when the market re-opens in January, investors will be demanding elevated premiums. When the Fed ultimately pauses this year, return generation potential will be much more robust.

4. Investing in carry, higher in the capital stack, may make sense.

We believe that today’s markets are well-suited for carry strategies to succeed. The powerful growth of broad-based financial market liquidity in the post-crisis years flattered the price-return component of most asset classes, and simultaneously suppressed yields and spreads, which muted the attractiveness of the income component, or the “carry”, of total return coming in to 2018. However, yields repriced in Q4 2018 such that income (or coupon, perhaps the most vital component for bond market total return) is now attractive again (see Figure 2). We think the use of a broader historical lens engenders a renewed appreciation for the income component of total return, which over long-periods of time is incredibly valuable and potentially is grossly underestimated today.

Figure 2: Income component of bond market total return is vital

Income component of bond market total return is vital

5. In 2019, investors should re-think their hedging toolkit.

Heading into 2018, the U.S. dollar was our favored hedge, as duration was not an effective ballast to risk in a rising rate environment; but we think that relationship reverses in 2019, as correlations have recently shifted meaningfully (see Figure 3). Thus, while the USD can stay bid for the time being, the dollar has minimal upside. Rather, we believe the next significant currency move will be USD’s weakening in the face of a Fed rate-hiking pause.

Figure 3: Equity/bond correlations have shifted of late

Equity/bond correlations have shifted of late

Sources: Bloomberg, BlackRock, data as of December 8, 2018

At the same time, according to Bloomberg equity/bond correlation data, as of January 11, 2019, U.S. risk-free rates can now serve as a more effective hedge to risk again; but while we have this handy implement back in our toolbox, heightened volatility in markets will amplify the importance of capturing big market moves and removing hedges when they have performed. And for the first time in a few years, with real rates now at reasonable levels and inflation risk muted, we think longer-end interest rates work well in a portfolio context and can be a very constructive hedge to risk assets, as seen at the end of 2018. Also, longer-dated municipal bonds can provide attractive tax-advantaged yield today, and can likely provide an implicit duration hedge for portfolios as well.

6. The paradox of portfolio construction: Higher yields than in recent years can allow for return with reduced risk.

We think the move higher in U.S. Treasury rates has commensurately provided much more attractive return and income opportunities on a forward-looking horizon. Also, because currency markets tend to reflect interest rate differentials, and because foreign rate markets have not matched the move higher in U.S. rates (some have declined, maintain negative rates), most FX (foreign exchange) markets are pricing in significant appreciation against the dollar, allowing for positive-yielding FX hedging opportunities. Buying assets and locking in FX hedges in such regions may significantly enhance carry while reducing volatility. That’s recently made front-end Japanese yen rates and front-end euro investment-grade credit attractive when factoring in the additional yield gained through FX hedging.

7. 2018’s global growth dispersion will likely give way to growth convergence in 2019…at lower levels.

As U.S. fiscal stimulus tailwinds fade in 2019, and as the negative confidence shock from lower financial asset prices works its way into confidence and consumption measures, U.S. growth is likely to decelerate somewhat in 2019. That in turn should end up weighing on an already slowing global growth backdrop, ultimately setting the stage for renewed global monetary stimulus as the cycle turns. We could well see fiscal stimulus out of Europe, Japan, and China that improves the global growth outlook, and as mentioned earlier, the trade disputes being resolved in a productive manner will likely have significant implications for sentiment in both corporate spending and investment, as well as for financial market sentiment.

8. Emerging markets may bring positive performance to portfolios again.

Aided by an ultimately weaker USD over the course of the year and stable-to-lower developed market sovereign yields, and coupled with the meaningful repricing of risk in 2018, emerging markets debt can be a positive performer in 2019. We would look to selectively add exposure on any weakness that may come early in the year. For example, local currency sovereign bonds in countries like Brazil or Indonesia have re-priced by 150-200 basis points from first quarter 2018 levels, according to Bloomberg data, as of January 11, 2019. While growth is moving to a lower trajectory, regional EM economic volatility should not be so great that it offsets the positives of a weaker USD and stable Treasury yields.

9. Keep in mind the longer-term negative structural factors (debt, demographics and deficits).

Not all investment risks are matters of the news of the day, and in fact we would argue that more attention needs to be paid to longer-term structural forces that greatly influence economies and markets. As a result, we have talked for years about demographics and technological disruption weighing heavily on the potential for inflation to rise excessively, even in an economy operating at full capacity. The dearth of inflation today, however, makes the world’s debt load all the more burdensome. Further, deficits, like those we are seeing debated in Europe, can be briefly stimulative to an economy, but ultimately only grow the debt in the face of demographic headwinds in these areas. In the end, it is the demographic, debt and deficit picture in regions like Europe and Japan that suggest to us that their central banks will be unlikely to be able to “normalize” monetary policy anytime in the foreseeable future. Therefore, investors with longer-term asset allocations to these regions of the world must keep this in mind and should proceed cautiously.

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