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BOND MARKET INSIGHTS

What Lies Beneath…

Jeffrey Rosenberg |Oct 15, 2019

We look beneath the surface of debt and equity markets, which until recently have been resilient in the face of rising recession risks.

Bond market highlights

  • Underneath the misleading calm surface of the markets we see several examples of late cycle, recessionary risks highlighting the vulnerability of the current expansion.
  • The tension in macroeconomics contrasts a strong US consumer outlook to a rapidly eroding manufacturing sentiment. In the context of a slowing global outlook, whether the global policy response will be enough to forestall a recession and the uncertainty of trade and political developments heighten the sense of uncertainty.
  • Beneath the surface of overall market measures and predating their more recent increase, rising dispersion in credit spreads, concentration in quality measures of equity performance, and the equity factor reversal in momentum stocks all appear consistent with late economic cycle investor crowding.
  • In a portfolio context we highlight a further late cycle vulnerability: zero (and low) rates have forced a tradeoff between choosing income or diversification in fixed income portfolios. Higher levels of income come with a latent “springing equity” risk, “springing” precisely when investors can least tolerate it – during equity drawdowns. A more defensive approach to ballast increases in importance as recession risks rise.

A surface level view

The collapse in survey-based measures of future manufacturing activity alongside declines in non-manufacturing sentiment further ratcheted up recession fears reflected in the falling bond yields. But while falling yields and a flattening yield curve appear to reflect a heighted level of recession fears, credit and equity market overall valuations appear to reflect a more sanguine view. Looking beneath the surface though helps to explain this seeming disconnect: a preference for quality while maintaining risky asset exposure for yield (in the case of credit markets) and upside (in the case of equity markets).

Macro divergence – strength in consumer, weakness in producer

A strong US consumer contrasts a rapidly eroding manufacturing outlook. The September employment report’s continued strength did little to change this narrative. The chart below highlights a key measure of sentiment fueling the dichotomy: the fall in the ISM US Manufacturing PMI survey. Despite these survey indications from the production side of the economy, strong labor markets have supported real income gains and consumption, holding up the overall economy (though at a slower pace than last year).

This raises the question of whether the global policy response will be enough to forestall a recession. At the same time, the lack of clarity around trade and political developments heighten the sense of uncertainty. The European Central Bank (ECB) and Emerging Market central banks have moved to restart accommodation through asset purchases and rate cuts. The Bank of Japan (BOJ) is expected to follow suit later this year. And of course, the Federal Reserve reversed course and cut rates in July and September with market expectations vacillating between one or two more cuts this year.

Notable, however, has been China’s more tepid response to the third recession risk episode of this expansion. With a potential debt crisis partly resulting from its past excesses in providing short term stimulus, China has been more restrained in its policy response relative to the stimulus that followed earlier bouts of global slowdowns. Trade negotiations and domestic political considerations further cloud the outlook and add to the sense of investor uncertainty. The upshot is a clear rise in recessionary probabilities.

Recession risks from trade and manufacturing vs. China policy response

Recession risks from trade and manufacturing vs. China policy response

Source: Bloomberg, Citi, as of 9/30/19.

Beneath the calm… a focus
on quality

In markets, that uncertainty reflects only recently in overall levels of rising volatility. Yet predating this more recent increase – and beneath the surface of the aggregate market measures - rising dispersion in credit spreads, concentration in quality measures of equity performance, and the equity factor reversal in momentum stocks all appear consistent with late economic cycle crowding by investors into balance sheet measures of quality.

To illustrate, the figure below highlights the equity and credit market outperformance of quality companies. In both measures we use balance sheet metrics rather than the typical earnings focused metrics of “quality” companies. And while we see general performance correspondence between debt and equity markets, the equity measures are even stronger, reaching post crisis highs. For equities that may reflect a degree of investor crowding into defensive and winning positions.

Quality measures in both stocks and credit outperforming

Quality measures in both stocks and credit outperforming

Source: Bloomberg Barclays, Citi, as of 9/30/19.

For credit, the concentration of outperformance in higher quality names reflects the confluence of recession risk coupled with continued need for yield. Recession fears motivate investors to have less exposure to the economic cycle. Yet the current state of rate policy, which is preemptively pushing rates lower, motivates investors to “reach for yield”. That need for yield appears to be keeping the overall level of spreads contained even as the quality measures of spread differential reach new highs. This is not typical of the credit market, where generally overall spread levels and the degree of quality differential move together.

The consequences of reaching
for yield

With these signs of rising recession risk clear, we pivot to some portfolio construction consequences for investors. The long-standing dilemma for asset allocation and portfolio construction is that prolonged periods of zero and negative interest rates result in decreased availability of income from investors’ fixed income allocations.

In eras prior to the financial crisis, positive real global yields coupled with higher inflation risk premia led to levels of nominal interest rates on safe assets that both offered attractive real and inflation risk compensation. At the same time, these safe assets promised diversification from equity risk as their prices reliably rose in periods of equity declines.

Post-crisis, the collapse in both real and inflation risk premia posed a dilemma for investors: whether and by how much to allocate away from safe government bonds in pursuit of higher income and face the consequences of greater risk in overall portfolios for doing so.

Read more about the consequences of reaching for yield in this late-cycle environment in our latest systematic fixed income commentary.

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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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