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BOND MARKET INSIGHTS

Five “wild cards” for fixed income in 2020

Jeffrey Rosenberg |Jan 27, 2020

2020 investment returns will likely come down to a few “wild cards” on these five key issues. We look at how the outcome of these issues could upend the current market consensus.

Sr. Portfolio Manager Jeff Rosenberg discusses the key events in 2020 and what scenarios may upend the market’s current expectations.

  • Transcript

    Jeff Rosenberg: Our 2020 outlook again looks at five of the key “wild cards” that might upend consensus outlooks for market returns. Consensus views see modest yet positive returns from stocks and bonds as trade optimism rises and recession fears ebb.

    When we look back at last year, it was certainly the Fed and its policy pivot that turned out to be the greatest wild card. They led global monetary policy from an environment of tightening to loosening. Critically, that loosening of monetary policy helped to offset the trade and recession fears that were driving losses in the fourth quarter of 2018. When we look forward to 2020, policy is being replaced by politics – the first of our five wild cards. Trade, monetary policy, valuations and vulnerabilities round out the rest of our wild cards.

    We turn first to politics which means foremost, the outlook for the U.S. Presidential election. We go back to other elections both here in the U.S. and globally, and we have had a really hard time predicting election outcomes. And even if the outcome could be predicted, there are difficulties predicting the market response to that outcome. Betting markets and market expectations are currently looking in the U.S. for a divided government outcome and a Trump win. That highlights we could see a lot of surprises. Either a united government on one side or the other, a new president, and we will expect significant policy shifts from that outcomes with great market impact.

    On trade, the start of the year news has been all positive. We’ve had the signing of the “phase one” deal between the U.S. and China, the passage of USMCA for North America, and an apparent détente in future trade conflict with Europe.   Will it last? What happens after the election? Trade risk has declined, and markets are optimistic, but we could see it turn quickly.

    On monetary policy, in the U.S., clearly with the Fed saying policy is “appropriate” this is an expectation that they are on hold—we see that globally as well. Even so, what we look forward from the Fed is a greater likelihood of supportive policy in response to its need. from the Fed than its move to preemptive tightening that we saw a couple of years ago.

    Critically this shift in the Fed’s outlook is an aspect that is supportive of the diversifying benefits of safe-haven bonds in broadly diversifying portfolio.

    Finally, turning to our last two wild cards on evaluations and vulnerabilities, when we look at valuations in fixed income, they appear stretched to start the year. That lowers our return expectations as yields are low and spreads have less room to compress. This also presents a vulnerability as we have less cushion in spread from potential shocks. 

    Vulnerabilities are inherently impossible to predict, but we do see some late cycle areas raising some concern. Rising credit risks, for example, in the form of an increase in net credit downgrades in the high yield market, is typically associated with widening spreads. Yet at the end of 2019, we saw the opposite—weaker credit conditions and tightening of credit spreads. Certainly, the outlook for less concern around recession means less risk of rising default risk and a fundamental support for the credit market. But outperformance again of the weakest credits to start the year, reminds us that the potential risk for investor reach for yield behavior are still with us.

    These five wildcards highlight the outlook for market returns, but our systematic investment process is equally focused on alpha. That is extracting returns, not focused on the direction of markets, but out of idiosyncratic opportunities that arise from “dispersion.” Dispersion within and across markets.

    For example, in our micro—that is in equity and credit strategies—we highlight the relationship that dispersion tends to rise and fall with market risks. And currently market risk is falling, yet we see dispersion and hence opportunities for alpha returns, appears rising in the universe of levered companies in which we invest. That rise in dispersion may reflect some of those unique characteristics of rising downgrades even as spreads are tightening. That may reflect a market of greater winners and losers in a late credit cycle environment. You can find all of this and more in our piece “Five Wild Cards for Fixed Income in 2020” at blackrock.com/sfi.

Bond market highlights

  • In 2019, possibly the most impactful “wild card” in markets came in the form of monetary policy, when the Federal Reserve reversed course from a steady pace of rate hikes to a series of rate cuts.
  • This year, early signs point to politics being the major issue that determines investment returns. For investors, political uncertainty is one of the most difficult risks to measure because the outcome, as well as the market reaction, can be very hard to predict.
  • Following a strong 2019 that saw U.S. equity markets rise 20-30% and fixed income returns top 8-15%, 2020 consensus return expectations have settled towards long run averages of ~5% for stocks, and coupon-like returns of ~2% for safe bonds and ~5-6% for riskier bonds.

We now take a closer look at what issues could upend these market expectations.

The five “wild cards” for fixed income in 2020

  1. Politics – The biggest “wild card" of 2020—the U.S. presidential election. The outcome of the U.S. election likely influences all other issues because whoever wins the race is likely to have significant impacts to policy, trade deal negotiations, and geopolitics for 2021 and beyond. This uncertainty may lead to large surprises – in either direction.
  1. Trade – The U.S. election likely keeps this can kicked down the road until after the result, but the market may be overconfident if it assumes the “phase one” deal means that this risk is completely dormant until November. The positive news on trade fuels our optimism to start the year, but there may be a surprise to the downside if trade uncertainty reemerges in the run up to the election or after.
  2. Monetary Policy – Both monetary policy and financial conditions eased in 2019 reversing the recession fears for 2020. U.S. monetary policy looks skewed to the accommodative side when faced with any downside shock, further supporting economic growth and market returns.
  3. Valuations – A weaker margin outlook for stocks, and low starting yields and tight spreads for bonds present a return challenge in the absence of policy fueled price gains. Absent any expansion in valuations, expect lower base case returns.
  4. Vulnerabilities – An absence of monetary policy tailwinds may expose unseen vulnerabilities in financial markets. An unexpected shock could reset the current global growth and inflation expectations and force global central banks to make hard decisions when they are already testing the limits of their tools.

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Jeffrey Rosenberg
Sr. Portfolio Manager, Systematic Fixed Income
Jeffrey Rosenberg, CFA, Managing Director, leads active and factor investments for mutual funds, institutional portfolios and ETFs within BlackRock's Systematic Fixed ...
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