Cash was king in 2018, but likely won't be in 2019
As 2018 wound to a close, some market writers got to dust off a headline that hasn't been on target for a long time: It was a year when "cash was king." The ICE BofAML 3-mo. U.S. Treasury Index returned 1.87% during 2018, while longer-duration and credit risky fixed-income classes were flat to down for the year. Fixed-income sectors were hurt by the U.S. Federal Reserve's continued hiking of the fed funds target rate, while credit riskier segments of the market like emergingmarket debt and corporate bonds were further affected by widening credit spreads, which reflected concerns over a slowing global economy. But as Exhibit A shows, while cash was king, U.S. municipal bonds, mortgagebacked debt and floating-rate loans also had positive returns. Importantly, the fixed-income losses of 2018 resulted in higher yields for investors, which open up a range of opportunities for 2019 in sectors we believe are likely to outperform cash under various economic scenarios. But before we review those, first we look back at the dynamics that drove the fixed-income market in 2018.
2018: Rate hikes and flattening
At the beginning of 2018, the market (as indicated by fed funds futures) and the Fed were in general agreement with expectations of three to four 25-basispoint (bps) increases in the fed funds target rate in 2018. This was coupled with a slow unwind of quantitative easing (QE), now referred to as quantitative tightening (QT). This presented a strong case for a flattening U.S. yield curve and a tail wind for the U.S. dollar. We suggested investors consider a range of floating-rate and shortduration assets in this environment. This prognosis proved to be correct, as the yield curve did indeed flatten. Most shorter-duration and floatingrate sectors eked out positive returns in 2018, while longer-duration sectors like investment-grade and high-yield debt were in negative territory (Exhibit A). Besides loans, investors have a number of choices in floating-rate assets across the credit-quality spectrum to help position their fixed-income portfolios in a rising or flattening U.S. yield curve environment. For example, municipal floating-rate notes (FRN) are rated AA+, with a yield that adjusts with the Securities Industry and Financial Markets Association (SIFMA) Index, and returned 1.70% in 2018. Floating-rate agency collateralized mortgage obligations (CMOs) are backed by single-family residences, are rated AAA, and returned 2.46% in 2018. Further out the risk spectrum, there are floating-rate collateralized loan obligations (CLOs). These are structured products invested in floating-rate loans, and are offered in different tranches of varying credit quality. For example, a B-rated CLO returned 2.93% in 2018. The yields on CMOs and CLOs both adjust with Libor.1
Considering slower growth
Toward year end, we experienced large bouts of market volatility, as a number of concerns appeared to take hold with investors, including fears of slower future global growth and an out-of-control trade war. Late in 2018, the U.S. yield curve (10-year U.S. Treasury yields minus 2 year U.S. Treasury yields) nearly inverted - an historical leading indicator of recession. Federal funds futures began to reflect speculation that the Fed might pause in its rate hikes and deliver no target fed funds increases in 2019. There's no doubt we face a number of global economic crosscurrents. Exhibit B compares Purchasing Managers' Index (PMI) levels for the U.S., Europe and China over the past year. When the PMI is below 50 the economy is considered to be in a contractionary phase. The U.S. PMI remained at 59.3, while Europe and China have slowed markedly, and both are in or close to contraction. The near inversion of the U.S. yield curve would seem to imply that the U.S. may follow the rest of the world in slower economic growth. That could be true, but even then the indicator is notoriously imprecise in terms of how soon a recession may follow - two years is the average. The U.S. economy could cool, for example, to 2% GDP growth without entering recession. The U.S. economy grew 3.5% in the third quarter and 4.2% in the second quarter, and is on pace for its strongest year of growth since 2004. If trade wars abate and employment remains strong, it's easy to imagine an environment conducive to the Fed continuing some level of QT.
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