Fear Trade Wavering
February 2019
On the heels of December, which saw investors flock to safety and throw capital into all manner of high quality fixed income instruments, January proved to be a welcome reprieve for riskier credits as high yield corporate bonds rallied alongside stocks. The Bloomberg Barclays U.S. Corporate High Yield Index returned 4.5% during the month after a 2.1% drop in December and a 4.5% decline over the course of the 4th quarter of 2018. One word characterized the fourth quarter - fear. Fear surrounding a potential FOMC policy misstep, fear tied to political uncertainty and dysfunction in D.C. and abroad, and fear over a lack of progress on the U.S./China trade front. In short, there was no “one thing” driving the risk-off sentiment that engulfed markets, it was multiple things.
Early on in ‘19 we’ve received some clarity on issues that eluded us late last year. Investors at least believe they have more clarity on FOMC policy, while U.S./China trade relations remain a complex subject, with the two sides appearing either closer to a resolution or “miles and miles” away from one as Commerce Secretary Wilbur Ross described it, depending upon what day of the week it is, who’s talking, and the news outlet reporting - at least the two sides remain engaged with dialogue ongoing. Given recent economic data releases out of China and fragile market sentiment here in the U.S., both sides appear to need a win. China sent a trade representative to the U.S. the last week of January, and a meeting between President Trump and China’s President Xi Jinping is rumored for mid-February. Our expectation remains that a half-deal will materialize prior to the March 1 deadline, while structural issues, i.e. the theft of intellectual property by Chinese firms, will take longer to hash out. The thawing of frosty trade relations would be a decidedly positive outcome for stocks and corporate bonds.
The bright spot in the Treasury rally is that investors allocated across a portfolio of both stocks and investment-grade bonds have likely experienced desired diversification benefits as prices of Treasury bonds have rallied as stocks have sold off - a much more palatable outcome relative to February when both stocks and Treasury bonds pulled back in unison. The downside of the recent rally in long-dated Treasuries is that expected return should now be lowered as the yield to worst on the Bloomberg Barclays U.S. Treasury Index has dropped to just 2.6%. Treasury bonds continue to have a place in a broadly diversified portfolio, but the recent downdraft in yields on lowered growth expectations may be set up to reverse course as the pendulum of investor expectations shifts back toward economic slowdown and away from recession. A trade deal with China would undoubtedly expedite this process.
The Bloomberg Barclays U.S. Treasury Index rose 2.5% from October through December amid the ebb and flow of news on the aforementioned issues/topics. We believe the rally in long-term Treasury yields is likely overdone given our expectation that U.S. GDP growth will be in the 2.5% area for full-year 2019. The 10-year U.S. Treasury bond carried a yield of just 2.63% at the end of January – just 8 basis points above the yield on 1-year Treasury paper. Duration was your friend in the risk-off environment that materialized in 4Q, and exposure to long-dated Treasuries remains a good diversification tool, but there’s little “value” in the 5 to 10-year portion of the curve at present. There remains significant demand for long-dated assets from pensions and insurance companies, among others, but foreign buyers appear poised to potentially scale back purchases as select countries attempt to reduce exposure to the U.S. dollar and dollar-denominated assets. We expect the 10-year yield to move higher over the coming quarters as the FOMC pauses, recession fears take a back seat, and inflation gradually rises, likely leading to at least one hike in the Fed funds rate in the back-half of ’19.
Source: AAII, Bloomberg, Factset
