Year-End Fixed Income Survey 2019

Throughout the year, we ask leading bond and currency managers to consider valuations, expectations and outlooks for the coming months.

In this latest survey, we asked 52 managers for their feedback. Interest rate managers absorbed two interest rate cuts by the U.S. Federal Reserve (Fed) in Q3 and even expect two more to come – broadly in line with what the market is currently pricing in. Meanwhile, credit managers are tilting towards being more cautious amid shifting fears of a global slowdown to a potential U.S. recession.  

On one hand, we have a Fed looking to make precautionary adjustments, and on the other we have credit managers now fearing that perhaps those adjustments aren’t enough. There is also an expectation of a modest widening in credit spreads. That is why in this survey we explore: are markets on the same page as the Fed on its mid–cycle adjustment approach?

Mid–cycle adjustment?

    Over the course of the year, we experienced the ramifications of a complex trade war between the U.S. and China, Brexit uncertainties and moderating global economic data – notably with weakening manufacturing PMIs1. However, inflation has remained relatively steady. This backdrop became the battlefield with which central banks in developed economies had to contend. The Fed is trying to address this backdrop by employing a mid–cycle adjustment approach, which uses precautionary interest rate cuts to ensure the safety and soundness of the nation’s markets. Recall that the historical threshold of the mid–cycle adjustment during the last cycles (1995/1998) was a reduction of 75 basis points (bps), and if the Fed cut rates in October, this limit will be reached.

    How concerned are markets?

    Views from interest rate managers

    • Managers’ weighted average expectation is of two more Fed interest rate cuts in the next 12 months (one of them being in Q4). None of the managers expect a hike in the next 12 months and only a small fraction of managers expects there to be a hike in the 12 months beyond that.
    • Meanwhile, 70% of managers also believe that we have seen the peak in the Fed Funds Rate2 this cycle.
    • They also indicated modest to no real concerns regarding inflation for the next 12 months. However, it’s worth mentioning the upward trajectory of wage inflation which may have meaningfully impacted core inflation numbers — potentially forcing the Fed to tighten, rather than ease monetary policy. 68% of the managers further increased their conviction in the steepening of the yield curve. It was only a year ago that 59% of managers expected a flatter yield curve. A steeper curve makes sense given their range–bound expectations for the U.S. 10–year Treasury yield and the expectation for two more Fed interest rate cuts.

    Views from credit managers

    • Within the Global Leveraged Credit space, managers shifted their outlook for spreads in the next 12 months from range bound in Q2 to a moderate widening of 10 to 30 bps in Q3. Most also believed business fundamentals were modestly deteriorating – the most since the survey started (Q3 68% versus Q2 12%). They also added that a U.S. recession, rather than a slowdown in global growth, was their biggest fear.
    • In the Global Investment Grade Credit segment, managers also expect widening credit spreads, but on a more moderate scale. It is also worth noting that 58% managers thought that credit spreads do not compensate investors for risks – the highest yet for the survey. However, 40% of managers additionally thought that leverage of BBB–level rated companies3 in the index will decrease – which is also the most since the survey started. With BBBs becoming such a substantial percentage of Investment Grade indices, the trajectory of fundamentals is topical at the moment.
    • There was a modestly bullish tone when it came to securitised assets, with managers adding a bit more risk than in the last quarter. Credit Risk Transfer remains the most favoured sector, but BBB collateralized loan obligations (CLOs) have jumped up materially. Managers also preferred to be long commercial mortgage–backed securities.

    Risk across the globe

    Europe and UK

    • Since the last survey, managers continued to be less optimistic on Europe (including the UK). In Credit, Europe had previously been more popular, but the U.S. has maintained its lead in both corporate high yield and investment–grade credit.
    • Currency or foreign exchange (FX) managers have also retained a weakened view on the euro — expressing concerns about the recovery of the European economy.
    • For the British pound, the view from FX managers is that Brexit uncertainty remains the driver for the currency, but with a lower probability of a hard Brexit, optimism returned with the sterling trading close to £1.28.

    Emerging markets and Japan

    • More than half of hard currency Emerging Market Debt (EMD) managers expect spread tightening, while a large majority of those expect it to be modest. Ukraine is now the most favoured country, with the Philippines remaining the least favourite. The biggest shift however was in Argentina, with almost 40% overweight preference in Q1 to a mere 6% in Q3.
    • Local currency EMD rates continue to be viewed as cheap, despite all–time lows in the GBI–EM Local Currency Index4 yield. This is largely driven by expectations for lower inflation. The managers’ weighted total return expectations dropped down to 5.3% — the lowest since the survey started – likely accounting for the lowest yield recorded in the index.
    • FX managers remain neutral on the Japanese yen compared to the previous survey — holding the currency as either a value or risk–averse position.

    Conclusion

    From this survey, credit managers are showing some signs of caution and may not be fully convinced by the trajectory of the Fed’s accommodative stance. We believe they understand that with tight spreads, future performance is predicated on the Fed being accommodative. Could this be challenged if the survey’s lack of concern around inflation proves to be incorrect? while inflation expectations are muted, factors such as momentum in wage inflation could push inflation higher — which may place the Fed in a more challenging situation with structural pressures to keep the dovish tone. With very little room for error, we find it interesting that although the interest rate managers are sold on an accommodative Fed, credit managers are exhibiting some vigilance.  

     

    Watch out for our 2019 Fixed Income Survey report: Deep dive, coming soon.

     

    Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.

1Purchasing Managers' Index, which shows the prevailing direction of economic terms in a sector.

2Federal Funds Rate, the benchmark interest rate that banks charge each other for overnight loans. It is often viewed as a signal of the health of the economy.

3Long–term corporate credit ratings are generally defined by agencies such as Standard & Poors and Fitch. The scales generally go from very low–risk triple A (AAA) at the top to very high–risk and default "D" at the bottom.

4Government Bond Index–Emerging Markets Local Currency Index.