This article was originally published on September 26, 2018. It has been updated to reflect a revised position on duration following a sharp rise in U.S. bond yields.
The U.S. Federal Reserve raised rates again this week — the fourth hike in as many quarters. It came as no shock to professional investors, as the thriving job market and rising inflation prompt the central bank to stay the course on tightening credit. The national unemployment rate has been at or below 4% since April and, over the past few months, the year-over-year Consumer Price Index has been edging up to near 3% for the first time since 2012.
The federal funds target rate is now 25 basis points higher, in a range of 2% to 2.25%. Through the end of 2019, our rates team expects two to three additional rate hikes — roughly in-line with the 2.6 priced into bond markets. Both, however, are fewer than the four increases through 2019 that the Fed currently projects.
Earlier this year, U.S. equities were riled by volatility after a long period of calm. This was partially blamed on the market waking up to the fact that the Fed this time around was intent on reining in monetary policy.
As the central bank continues to soak up money supply, unforeseen knock-on effects could spur fresh bouts of volatility. And that doesn’t even take into account other risks keeping investors up at night, such as messy trade disputes and turmoil in some emerging markets possibly injecting pain into other economies.
These types of concerns led Capital Group’s fixed income Portfolio Strategy Group (PSG) to a view that lofty valuations across several bond sectors warrant prudence. In its fall forum, the group made a few key recommendations on portfolio positioning for our managers:
- Be cautious on credit. Debt levels are high and the U.S. economic recovery is in the late stages. That combination makes some corporate bonds look too expensive.
- Mortgage-backed securities are looking a little better. The group had been cautious on the mortgage sector for some time, but compared with overpriced corporate bonds they look more attractive.
- We still like TIPS. Inflation is up, but we don’t think it has peaked. As consumer prices continue to rise, so too should the value of Treasury Inflation-Protected Securities.
- Expect a steeper Treasury yield curve. The curve recently had flattened. Under some scenarios, especially in an environment where volatility returns and growth sputters, this trend could change.
What is PSG?
Capital Group’s Portfolio Strategy Group (PSG) forum is a two-day event, taking place a few times a year, which gathers the entire fixed income group across the globe for an in-depth discussion of the macroeconomic environment and fixed income markets. Our proprietary fundamental research is the foundation of the discussions and the basis of any resulting recommendation for our investment professionals. Portfolio managers consider the group’s recommendations to inform investing within their individual portfolio strategies. The following is a recap of views that emerged from the recent meeting in early September.
PSG’s positioning primarily informs core fixed income portfolios. Core portfolios aim to provide diversification from equities, capital preservation and income while striving to generate returns in excess of the Bloomberg Barclays U.S. Aggregate Index. The goal is to efficiently express their thematic views and avoid stacking risks. That means all positions should not perform well, or poorly, in a single environment.
Outlook and positioning
When 2018 began it looked like all was right in the world. It was known as a “Goldilocks” economy. Fast-forwarding to now, global growth no longer looks quite so synchronized. The U.S. economy appears to be expanding at a decent clip, but prospects look dimmer in Europe, China and emerging markets. This divergence is leading to differing monetary policy paths too. As we saw this week, the Fed is continuing to tighten and that’s beginning to hamper global lending. This partly explains why emerging markets assets have hit a soft patch.
Other potential shocks also loom. Both public and private debt growth in the post-crisis period have ballooned, making financial markets more susceptible to damage when shocks hit. It’s hard to tell how the political winds will shape trade tiffs, so potential implications remain murky. Still, the volatility we saw earlier in the year serves as a sobering reminder: Domestic political agendas such as trade tariffs threaten turbulence for markets.
When it comes to the U.S. economy, growth may remain positive but weaken to more modest levels. Nevertheless, the economy and markets look vulnerable amid continued Fed tightening and late-cycle imbalances such as elevated debt levels. History also provides a not-so-gentle reminder that the last two recessions were spawned not by shifts in the underlying economy, but by shocks in financial markets.
As the U.S. economy has boomed, corporations have flourished. But as growth begins to wane over the next few years, profit margins will likely get squeezed. Meanwhile, corporate bond values still are hovering near their most expensive level in a decade. Pair that with reasonably solid fundamentals, and determining the value of these bonds becomes a challenge. A scenario in which growth sags, but doesn’t fall into the red, also is quite likely and could keep asset markets on firm footing.
Putting all that together makes us cautious on credit, so we are positioned with less exposure than the index. Having lower exposure to corporate bonds means we also will earn less interest income if the economy keeps roaring. We compensate for this possibility through other exposures.
Duration had been reduced slightly in the September PSG meeting. However, duration was increased back to neutral relative to the index in October. This adjustment follows a sharp rise in U.S. bond yields and reflects greater uncertainty about the likely path of Fed rate moves in 2019 and beyond. For those not fluent in bond investor jargon, duration is a measure of interest rate risk exposure. We think of our interest rate exposure as a combination of duration and yield curve risk.
We continue to find the five-year part of the U.S. Treasury yield curve the most attractive. This yield curve plots the yield that investors demand at different maturity dates. The yield curve currently is relatively flat, which indicates investors are demanding a relatively small premium for bonds with longer term maturities.
Since the curve is now so flat, a variety of economic scenarios could lead the curve to steepen from here. That steepening could occur with long-term rates rising more than short-term rates, or short-term rates falling more than long-term rates. The PSG continues to recommend that managers position for a steeper yield curve, which should provide protection in an environment of increased market volatility.
As an economic cycle progresses towards the end of its expansionary period, you can expect to see a few trends. One is that the unemployment rate dips very low as lots of new jobs bubble up. Competition for workers tends to result in rising wage growth, which in turn leads to expectations for higher inflation. Indeed, we’ve seen inflation tick up in recent quarters and consumer prices look likely to rise further.
This trend has led the TIPS breakeven rate, the inflation rate at which TIPS returns equal nominal Treasury returns, to increase. However, breakeven increases have lagged the rise in actual inflation. As a result, we find TIPS attractive. Under several scenarios, TIPS also are likely to fare better than U.S. corporate bonds, and may also serve as a hedge to our yield curve positioning.
Spreads for mortgage-backed securities (MBS) to Treasuries, the differences between how much these securities yield, are narrow but stable. Although that indicates MBS are somewhat expensive, the risks facing the mortgage sector look potentially less impactful than the risks facing corporate credit.
In our view, mortgage-backed securities offer a lower volatility way to increase portfolio yield and returns in an environment of positive, but slower, economic growth. As a result, we have moved from recommending less exposure to U.S. mortgage-backed securities than the index to a neutral position.
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