U.S. Fixed Income

Live your best life

Our 2020 fixed income outlook: Near term, the environment is reasonable, but markets living their best life in 2020 may be expensive longer term.
December 2019

Living your best life, if we understand the parlance of our times, is to say live in the moment. This seems like a reasonable strategy for short-term enjoyment, but a fairly mediocre life plan.

That approach appears a reasonable analog for 2020 as we examine markets, policy and the economy. Near term, the environment is reasonable, but markets living their best life in 2020 may be expensive longer term.

The G.O.A.T.

Well that was fast. In case you were worried about rising interest rates in 2018 and worried that rising rates would carry over into the new year, that fear was allayed quickly in 2019. Treasuries once again proved their mettle—serving as the diversifier in the volatile fourth quarter of 2018 and still delivering strong returns in 2019 even while equities rallied sharply. This performance reinforced what we have long believed, the utility of traditional fixed income as a structural, strategic component of asset allocations.

Live your best life - The markets living their best life cartoon

Pics or it didn’t happen

It seems like a distant memory, but a year ago in December 2018 the Fed issued its fourth rate hike of the year. The Fed was still discussing the Fed Funds rate being below neutral and lowered their expectations of rates hikes in 2019 from 3 to 2. Since that time the Fed has done a 540⁰ (yes, it feels like they did a full 360⁰ before doing a 180⁰.)

Fed funds rate target range 2015–2019

Live your best life - Fed funds rate target range 2015-2019

Source: Federal Reserve

The Fed garbled communication for most of 2019, triggering a negative feedback loop where the Fed led the market to expect rate cuts, which it then took as market signaling for rate cuts. By the end of 2019, the optimist in us wants to believe that the Fed has found its sea legs and messaging will be more consistent going forward.

You do you Fed, you do you

If we observed a hypothetical landscape with equity markets returning north of 20%, unemployment near 50-year lows and inflation and growth just shy of long-run trend, what would you project as Fed policy? Our projection would have been for fairly neutral policy—but the Fed in 2019 chose to ease significantly.

The Fed has indicated that they are now on pause in terms of rate cuts and that the additions to the balance sheet do not constitute another round of quantitative easing. While we agree regarding the balance sheet—buying T-bills is categorically different than mortgage pools or long Treasuries—we are more dubious regarding the pause.

The recent Fed has shown a bias towards easing—particularly when expected by the market. And the market has a voracious appetite for liquidity, which the recent cuts have provided.

Side hustle

With the notable exception of the Fed’s bumble with overnight repos, which saw rates soar briefly, liquidity is back big time. As we often observe, Fed policies take time to ripple through to Main Street, but are felt instantly on Wall Street. What is being felt rapidly now though is the combination of the Fed’s (again) growing balance sheet, declining short- and long-term rates and the investor appetite for yield wherever they can find it. In this regard, the Fed’s policy has been a success in improving financial conditions. This bodes well near-term for both the economy and financial markets, though we maintain our concerns about what the Fed has paid in optionality for this short-term fix, a topic we explored more fully in Did the Fed just go Minority Report?

2020 Outlook Summary

Duration/government securities

  • Converged duration to benchmarks during the year with the expectation to stay neutral in the current environment given unpredictable balance of factors that could push rates higher or lower from today’s levels; underweight government securities relative to non-governmental securities, deriving duration from other sectors
  • Moved term-structure to more neutral positioning relative to prior periods as Fed concluded tightening cycle, reinitiated policy easing and now claims to be on hold; reduced floating rate exposure in portfolios


  • Overweight corporates and securitized products; fundamentals and policy provide a supportive backdrop for non-governmental securities and demand remains strong, but spread compression and current valuations have created potential vulnerability to volatility
  • Look for opportunities for sector and quality rotation as markets contemplate fears of political change, ebbs and flows in trade negotiations, and global and U.S. growth concerns which could impact valuations differentially

Bloomberg United States Financial Conditions Index

Live your best life - Bloomberg United States Financial Conditions Index

Source: Bloomberg

This access to capital can be seen in the resurgence of corporate debt issuance. We had been pleased that one of the outcomes of the 2018 increase in rates was an organic deleveraging in the corporate sector as corporate profits improved and issuance declined as rates rose. 2019 started with a similar downward trend in issuance, which we hoped would continue this theme and year-to-date investment grade corporate issuance has been 2% below the 2018 level (itself a big decline from 2017 levels). Alas, the lure of cheap money is too strong, and after an initial decline in issuance, there has been a rebound post-Fed cuts. On its own, issuance is not a bad thing and despite headlines focused on share buy-backs to support equity prices, we observe reasonable cap-ex and focus on balance sheet optimization versus straight leverage increases. Recent projections are for a decrease in issuance in 2020, which we would welcome, but we will also monitor this metric closely if rates remain where they are.

Investment grade corporate issuance by quarter 2017–2019

Live your best life - Investment grade corporate issuance by quarter 2017-2019

*Q4 2019 as of 12/10/2019. Source: Bloomberg

Even with the trend of globalization stalled or reversing in economic, geopolitical and trade terms, financial markets are deeply intertwined. We got a healthy reminder of this interconnectedness in 2019 as the global decline in rates, including a significant increase in negative yielding debt helped pull U.S. rates lower. In 2018, it appeared U.S. growth had sufficiently differentiated itself from the rest of the developed world to reach escape velocity from the gravity that is the European and Japanese morass. In 2019, as the U.S. growth trajectory slowed, the U.S. rate market was pulled towards the vortex. In 2020, we do not expect the U.S. to fully converge to the slower global developed rates, but nor will it break away to the positive as it did in 2018. The result, we expect, is that global rates will continue to impact the U.S. market. With respect to former Speaker of the House Tip O’Neil’s observation, while all politics is local, all monetary policy is global.

The struggle is real

As we consider policy risk in investing, elections are a logical locus for attention. Polarization of political views in the U.S. has raised the profile of the upcoming elections. We recall every recent election being referred to as “the most important election of our lifetimes” and we expect to hear that again in this cycle. For a long time, American politics was said to be played between the 40 yard lines—a football reference to indicate that while differences existed between the parties, the U.S. was fundamentally a centrist and moderate country. Outliers to this centrism, even if elected, faced a deliberately byzantine system of checks and balances at the local, state and federal level.

There is no doubt that elections have consequences—for example: tax policy after the 2016 election. However, the truly major policy changes such as the Affordable Care Act have traditionally needed significant majorities to achieve. Policy-driven volatility then has largely been about expectations and policy changes on the margin, excepting the rare circumstance of a senate supermajority. While President Trump’s prolific tweeting has become (in)famous, it is easy to forget that when Hillary Clinton was assumed to be the next president, her tweets on pharmaceuticals roiled that sector of the market.

Expectations for pharmaceuticals were more favorable with a Trump victory—but the results have been mixed as the sector has performed essentially in line with other IG credit, but outperforming within high yield. Similarly, Republicans are nearly universally thought of as more friendly to the energy sector, but since Trump’s election high yield energy has underperformed broader high yield by nearly 800 basis points on an annualized basis.

One could argue the counterfactual, which is to say “it would have been worse” with the other candidate. This may well be true in some cases, but this distorts the original argument that many prognosticators make; to illustrate with the energy sector, Trump being more favorable to energy than Clinton or his next Democrat opponent is not the same as saying one should take an overweight exposure to energy.

Similarly, there has been much consternation from market pundits regarding a potential Warren presidency. While it is “known” that Warren will be bad for financials, what would happen if there were a negative market environment? In that case, wouldn’t generally more defensive assets such as financials be favorable exposure? We could then see financials as one of the better performing sectors despite a candidate viewed as less favorable for the sector.

Spilling the tea

The prospective policy chatter that we are most focused on is not the differences in healthcare, environment or tax policy, though those could have profound implications if implemented as described by some of the Democratic candidates. Our interest has been piqued by discussion of ending the senate filibuster, which allowed the minority party to stall or block legislation. If indeed senate rules are changed to eliminate the filibuster it would allow more sweeping legislation to be passed with a simple majority (or even 50 votes plus the Vice Presidential tie-breaker). This change would be significant in that it would remove what has historically been one of the moderating factors in the legislative process. Even in the case where the Senate had a majority to pass a bill it may have pulled the bill more centrist to avoid the potential of the opposing party filibustering it. With that incentive removed we could see more extreme legislation, requiring less compromise, being implemented far more rapidly with less consultation with the opposing party. Similarly and equally discouraging, the following presidential election we could see significant legislation undone.

The engines of the economy, be it consumers or corporations, like clarity for future planning. Markets hate uncertainty. Getting rid of the filibuster would increase policy noise and make each election more significant in terms of true economic implications, which should increase the uncertainty premium built into investments.

Sorry not sorry

Sadly our main political prediction for 2020 is that whichever party wins, government deficits will continue. Sorry not sorry, but the only party that cares about government spending is the one out of power. Too often we have seen candidates preach fiscal responsibility, then implement new expenditures. This prediction is most relevant as we consider the constituents of the fixed income market. We expect that Treasuries will continue to grow both in absolute and relative terms as a percent of the U.S. fixed income markets.

Market valuations are cheap today…said no one ever

Returning to near-term markets, our view is that the challenge lies not so much with economic fundamentals or even short-term policy impacts, but rather with valuations. Our view is that economic fundamentals in the U.S., while demonstrating expected slowing, remain relatively more resilient than most had expected though in-line with our predictions. While 2018 was notable for growth above trend, 2019 is on pace to end with the same GDP growth rate 2.3% as the trailing 10 years (this includes the strong 2018.) Projections for next year are for continued moderation of growth, but declining to a modestly below-trend figure (current consensus is for 1.8%) is hardly cause for alarm.

U.S. GDP growth by calendar year vs. 10-year average

Live your best life - US GDP growth by calendar year vs 10-year average

Source: Bloomberg

Similarly, corporate earnings have a tough comparator versus year (2018 saw extraordinary tax reform fueled profit growth), but FactSet projects the full year 2019 measure will be for 0.1% growth in earnings year-over-year. Their projection for next year is just shy of 10% earnings growth, a far cry from broad corporate distress. Through the third quarter, Moody’s default data showed a default rate of only 0.5% for Bs compared to a rate of 0.0% for BBs over the last 12 months. Their forecast for overall high yield defaults is to see an increase from the most recent quarter’s pace of 3.2% to 3.7% by the end of the third quarter of 2020—though this remains somewhat of an energy sector story with that sector having an outsized percent of high yield names trading at distressed levels.

Other measures, from leading economic indicators to consumer confidence and labor market strength demonstrate a slowing but healthy economy. This backdrop is quite reasonable for U.S. fixed income as slow, but positive growth, and reasonable, but below trend, inflation suggests a middle path for rates and support for spreads of non-governmental fixed income assets.

With the Fed ending their normalization of the balance sheet relatively quickly and reverting to their easing bias in 2019 and reflecting their view that sustaining the expansion is their goal, monetary policy too seems supportive in the coming year. Fiscal policy, while unlikely to deliver anything as substantial as tax reform in 2020 is far from restrictive with trillion dollar deficits on the horizon.

The challenge then is in valuations rather than fundamentals. With IG credit spreads ending November at 100 basis points of OAS (option adjusted spread), about 10 basis points inside of the historical median levels of near 110 bps, credit could be described as fairly priced given the supports for the sector, but it would be tough to argue the sector is cheap. Similarly on the high yield front, spreads of around 370 basis points are inside of the historical median level of closer to 470 basis points. Overall, high yield spreads mask what has been an interesting bifurcation between higher quality high yield (BB/B) and lower quality (CCC). Though November, higher quality delivered +840 bps of excess returns vs. Treasuries, while CCC delivered -37 bps. In terms of spreads, while BB/B has seen meaningful compression year to date from 436 bps to 269 bps, CCC spreads have widened from 979 bps to 989 bps. Agency mortgages, which have long been trading inside their historical median levels of around 52 bps, ended November with an OAS of 45 bps. This left them somewhat closer to median levels than recent history, but with the character of the Fed balance sheet continuing to normalize, one component of demand is being reduced.

Thirsty for yield

The demand for yield in a yield-starved developed world remains strong and we view this demand as a further support for non-governmental sectors in the coming year. Demand can be fickle, existing until it no longer does, but for the time being we expect the world’s appetite for yield to remain. In this regard, the U.S. market remains particularly appealing, not just for its higher baseline yields, but its massive size ($23 trillion or 41% of the Bloomberg Barclays Global Aggregate Index), liquidity and relative diversity of fixed income issuers.

Conclusion: Lit or salty

Our concerns of growing intermediate to long-term risk are exemplified by the Fed using some of its policy capacity preemptively, potentially leaving the U.S. open to a larger negative event in the future and simultaneously acclimatizing markets to expect permanent stimulus. This risk can be seen as well with the U.S. running trillion dollar deficits while not in a recession and consideration of eliminating the filibuster to achieve short-run political objectives.

Near term, our views are much more benign as we view those factors elevating intermediate term risk as positive short term (the filibuster elimination notwithstanding.) The most concerning aspect of today’s market is valuations, though we know this can change rather quickly. We view sufficient supports, fundamental, technical, and policy driven for markets to perform well in 2020. Indeed, markets may live their best life in 2020.

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This report contains our opinion as of the date the report was generated. It is for general information purposes only and is not intended to predict or guarantee the future performance of any investment, investment manager, market sector, or the markets generally. We will not update this report or advise you if there is any change in this report or our opinion. The information, ratings, and opinions in this report are based on numerous sources believed to be reliable, such as investment managers, custodians, mutual fund companies, and third-party data and service providers. We do not represent or warrant that the report is accurate or complete.

Keep in mind that as interest rates rise, prices for bonds with fixed interest rates may fall. This may have an adverse effect on a portfolio.

Foreign investing involves special risks due to factors such as increased volatility, currency fluctuation and political uncertainties. High yield bond funds may have higher yields and are subject to greater credit, market and interest rate risk than higher-rated fixed-income securities. Keep in mind that as interest rates rise, prices for bonds with fixed interest rates may fall. This may have an adverse effect on a Fund’s portfolio.

Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index that covers the U.S. investment-grade fixed-rate bond market, including government and credit securities, agency mortgage pass-through securities, asset-backed securities and commercial mortgage-based securities. To qualify for inclusion, a bond or security must have at least one year to final maturity, rated investment grade Baa3 or better, dollar denominated, non convertible, fixed rate and be publicly issued.

The Bloomberg U.S. Financial Conditions Index provides a daily statistical measure of the relative strength of the U.S. money markets, bond markets, and equity markets, and is considered an accurate gauge of the overall conditions in U.S. financial and credit markets.

This presentation may contain targeted returns and forward-looking statements. “Forward-looking statements,” can be identified by the use of forward-looking terminology such as “may”, “should”, “expect”, “anticipate”, “outlook”, “project”, “estimate”, “intend”, “continue” or “believe” or the negatives thereof, or variations thereon, or other comparable terminology. Investors are cautioned not to place undue reliance on such returns and statements, as actual returns and results could differ materially due to various risks and uncertainties. This material does not constitute investment advice. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investment involves risk. Market conditions and trends will fluctuate. The value of an investment as well as income associated with investments may rise or fall. Accordingly, investors may receive back less than originally invested.

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