Bonds: Total Market
FINSUM is at the Inside ETFs conference in Hollywood, FL this week, and we wanted to bring you a little live coverage. Yesterday, there was a major session at the event discussing the outlook for fixed income. The consensus was that even though the Fed has paused, there is now way to tell when rates may rise again. Further, while China’s economy looks weak right now, that could turn around rapidly in the event of a trade deal with the US. Finally, all of the five panelists discussing fixed income said the ”liquidity mismatch” between ETFs and fixed income instruments is overblown and that there is not nearly as much to worry about as some think.
FINSUM: Fixed income’s outlook is murky right now. On the one hand, the Fed has paused, but on the other, rates could start rising anytime. On balance, we do think the risk-reward is slightly in favor of a shorter-duration long position.
Active funds have been much maligned in the press over the last couple of years. The rise of passive investing has drawn the value of active investing into question, and the media has focused lot of attention on large groups of underperforming funds. That said, active funds, at least in fixed income, are winning right now. In every period from one to ten-years, actively managed bond funds have outperformed ETFs. Such funds are less constrained in their ability to seek out safe high yields, whether that be in junk bonds or emerging markets.
FINSUM: In many ways this makes sense, as there are many more bonds than there are equities, which means that there is likely more alpha to be generated through an unconstrained approach.
The Fed is facing a herculean task, argues the Wall Street Journal. That task is to keep inflation at its target, while also steering a moderation in growth. In other words, how does the Fed keep inflation in check without causing a recession? One way to consider this challenge is to think about how the Fed may approach it: “focus more on the domestic economy and keep nudging interest rates higher to combat inflationary concerns, or pay greater attention to stresses abroad and in the markets, and hold rates steady or even nudge them lower”, says the WSJ.
FINSUM: We think this is not as hard as rumored. Our view is that the Fed should freeze rate hikes and broadcast that a long-term freeze is the plan. That should put the economy (and markets) on solid footing, and keep things from getting too out of hand.
If that headline sounds like relief to your ears, read further. While there are no clear signs out of the Fed yet (other than increasingly dovish talk), new data is showing that the Fed may cut rates in 2019. The forward spread shows that traders are anticipating a rate cut at the beginning of the year. Two-year Treasuries have seen their yields slip below one-years’. This is the first time this has happened since 2008. According to a market strategist at Pimco, “This is a crystal ball, it’s telling you about the future and what the market thinks of the Fed and what it will do with its policy rate”.
FINSUM: We don’t think the Fed will cut in the first quarter unless something more drastic happens, but we are quite sure they won’t hike.
The market has been very worried about a potential bond market meltdown. Both investment grade and high yield debt have seen major losses lately as fears have mounted about high corporate debt heading into a possible recession and downturn in earnings. One of the big worries is that there will be a surge in BBB (the lowest rung of investment grade) debt that falls into junk status. However, Bank of America is more sanguine, arguing that growth is solid and companies have actually been issuing much less debt, and will continue to do so. Their view is that companies are in a much sounder financial position than before the last crisis.
FINSUM: The debt gorge that happened over the last several years is inevitably going to have consequences, and we think BAML is way too relaxed about the risks.
Where to put one’s money in 2019? That is the difficult question every investor must face at the moment. For a long time “TINA”, or “there is no alternative”, was the mantra which kept guiding capital into stocks alongside miniscule yields. Now with rates and yields rising and stocks having seen big losses, where should investors turn? The reality is that bonds seem likely to outperform stocks next year, at least according to JP Morgan. The bank thinks EM debt is likely to have a good year as once the Fed stops tightening the Dollar will likely weaken, giving a boost to EM assets.
FINSUM: In our view, a lot of damage has already been done to stocks and there are now some very interesting buys. Furthermore, short-term debt has seen yields rise high enough that you can get decent returns without a lot of interest rate risk.