Prepare for (Soft) Landing
For 2019, tighter financial conditions and smaller global central bank balance sheets should persistently elevate volatility across fixed income markets. This environment will support demand for higher-quality intermediate and longer-duration assets.
Government Bond Markets*
Shifts in central bank policy portend slightly higher yields and modest inflation.
Global Interest Rates and Inflation
A soft landing in U.S. should produce a steeper yield curve and potentially extend the length of the current business cycle. At the same time, inflationary pressures should remain, but remain modest; the cyclical inflation upward tendency is fading as commodity/oil prices remain under pressure while structural pressures from wage growth and trade policies remain forces that bias inflation upward. The Fed is likely to pause during the first half of 2019 to re-assess the impact of its prior hikes on the real economy; we anticipate one or two Fed interest rate hikes for the year. We expect U.S. long-term rates to remain range-bound in 2019.
We start 2019 with 10-year U.S. Treasury yields slightly below our fair value estimates of 3 – 3.25%. The most recent inversion of part of the curve between the 2-Year and the 5-Year Treasury reflects demand from investors to hedge unanticipated credit volatility and the potential fact that the real rates in the U.S. are too high to deliver a persistent inflation of around 2%.
In Europe, the end of ECB quantitative easing should prompt a repricing of government debt, but with only a limited rise in yield (with the 10-year bund, for example, moving toward 0.75% from current levels near 0.3%). If core inflation stays below 1.5%, a bearish bond market is unlikely to materialize. Still, there are rising uncertainties regarding ECB policy, especially given that Draghi will step down as president in October. European corporate bonds should outperform based on resilient capital spending, which supports growth backed by credit quality and investable liquidity. However, issuer selection remains of the utmost importance. New regulations and tariffs portend idiosyncratic risks, which could impact the banking sector and industrial operating margins, respectively.
As for Italy, we assume the risk of recession due to higher rates and poor domestic funding support should force the populist government to reduce its 2019 public deficit target. This opens the possibility of its buying back Italian bonds into the European Parliament election in May.
With more hikes than cuts expected by emerging markets central banks in 2019, certain markets will potentially see upward pressure on local rates.
Investment Grade Sector*
The outlook for investment grade credit is broadly positive, despite more volatility and idiosyncratic risk.
We are incrementally positive on U.S. agency mortgage-backed securities (MBS) and have moved to a modest overweight for 2019. From a portfolio management perspective, we believe that agency MBS are an attractive asset class due to their spread, liquidity, quality and currently muted prepayment sensitivity. Our call is a reaction to meaningful MBS spread-widening during the fourth quarter of 2018. However, we believe any spread-tightening will be modest as the current flatness of the yield curve has dampened bank buying in the sector.
We are overweight commercial mortgage-backed securities (CMBS) and view these instruments as particularly attractive due to their lower exposure to idiosyncratic risk relative to other credit markets. We view the front end of the yield curve as the most attractive part of this market and have added to our CMBS exposure as spreads moved wider in sympathy with a broader spread-widening trade in the fourth quarter of 2018.
Asset-backed securities (ABS) remain overweight as they provide high-quality short-duration investments that trade off the Libor curve. Swap spreads to Treasuries remain relatively wide, particularly on the front end of the yield curve. ABS credit is further supported by strengthening U.S. consumer balance sheets.
Rounding out securitized assets, mortgage-backed credit (MBS credit) is also overweight. Relative value has largely shifted from the legacy distressed RMBS market to the credit risk transfer (CRT) market, supported by consistent underlying home price appreciation data and housing affordability measures. That said, we have been avoiding recently issued CRT deals, where we are seeing some degradation in the collateral quality and structural quality.
Investment Grade Credit
Investment grade credit performed weakly in the fourth quarter of 2018 for a variety of reasons. While idiosyncratic credit issues (GE, Pacific Gas and Electric) have driven some underperformance, more important systemic issues have surfaced, including monetary policy worries, macro growth concerns and political uncertainty. This backdrop is characteristic of the shift from easy to more restrictive monetary policy.
Overall, we expect the 2019 investment grade credit market to be less forgiving on credit concerns or disappointments. As volatility increases, tactical trading opportunities will become more common. This makes credit research especially valuable for identifying issue-specific alpha-generation opportunities relative to market beta movements.
We are not anticipating the end of the positive credit cycle. Economic growth in the U.S. and Europe should remain sufficient to maintain stable credit quality in aggregate. The cushion has decreased, though, from the relatively robust growth in 2018. Therefore, some credits will be exposed with over-levered balance sheets or business models that are no longer stable.
In aggregate, leverage across industrial sectors remains high and has accounted for the large expansion of the BBB portion of the index. This is the part of the market where we can expect to continue to experience volatility. U.S. banks historically have been comparable to BBB industrials, but they are in a much stronger relative balance sheet position and may provide a preferable source of stability in 2019.
In 2018 corporate investment grade supply declined by approximately 10% year-over-year due to reduced merger activity and the impact of tax-related repatriation. For 2019 we expect supply to decline by a similar percentage. Lower supply levels should help provide technical support for pricing throughout the year.
Interest rates, not credit, are the biggest driver of volatility in the U.S. market for municipal bonds. Recent rate volatility has spurred fund outflows, but if rates continue to stabilize, as we expect, the muni market should firm.
The technical backdrop for municipal debt is favorable as demand should be robust, especially in high-tax states where investors will feel the bite of recent tax regulation that caps state and local tax deductions. Relative to anemic new issuance in 2018, supply should pick up in 2019 with solid local and state tax receipts leading to more political confidence in new money issuance. Build America Bond refundings could potentially further add to tax-exempt supply.
High Yield & Emerging Markets Debt*
A benign default outlook for U.S. and European high-yield should coincide with stabilization in emerging markets.
High Yield Credit and Leveraged Loans
We are constructive on the fundamentals of U.S. high yield credit, which present reasonable leverage and strong interest coverage. In fact, the default outlook remains benign for 2019, with expectations below 2%. New-issue supply in 2019 likely will be similar to 2018, with issuers continuing to express a preference for the loan market. Overall, we think recent spread-widening and higher absolute levels of yield should bring investors back to the U.S. high yield market.
Fundamental strength in European high yield credit is similar to the U.S. market, but there are important differences. European high yield is skewed toward higher-quality credits, with very few triple-C issues and relatively low energy exposure. Against a backdrop of positive fundamentals and low default rates, recent spread-widening has made this asset class attractive for dollar-based investors. Stability in European growth rates may provide a positive catalyst for these securities.
As for bank loans, we expect continued coupon increases during 2019, which should make the asset class attractive relative to other fixed income alternatives. Modestly offsetting this benefit is the aggressive new issuance we had seen throughout 2018. While much has been written about the deterioration of documentation and covenants, we believe many of these concerns are concentrated in lower-rated quality tiers and among smaller, middle-market issuers. We believe current total return expectations look attractive compared to the default risk, which we expect to be below the market average for the next 12 months.
We continue to see attractive relative value in collateralized loan obligation (CLO) debt. CLOs can provide investors with a significant yield pickup relative to comparably rated corporates for floating-rate exposure to an extremely diversified and actively managed portfolio of primarily first-lien senior-secured corporate loans, along with significant credit enhancement against losses in the underlying loan portfolios.
Investment grade CLO debt can provide attractive return on regulatory capital for insurers and banks. We believe CLO AAA spreads at three-month Libor +1.25% (or approximately 4% current yield) generally are cheap relative to BBB rated corporate bonds at 4.8% yield-to-worst given the significant pickup in credit quality. On the non-investment grade side, we believe CLO mezzanine debt should be considered to be a part of high yield investors’ asset allocation mix. At current spreads of thee-month LIBOR +6.75% (or approximately 9.5% current yield) CLO BB debt offers a yield pickup of close to 400 basis points over BB high yield and loans for exposure to the same universe of underlying corporate credits.
Emerging Markets Debt
Despite the continued slowing of China, our base case for emerging markets economic growth is less bearish than the consensus. We expect emerging markets to stabilize, with GDP remaining largely at 2018 levels.
For hard-currency sovereigns, calendar year 2018 is on track to become the third worst in the past 20 years, behind only the 2008 global financial crisis and the 1998 Asian crisis. Yields in emerging markets sovereigns have reached nine-year highs at 7.12%, and spreads at around 400 bps have gone back to the early stages of recovery from the energy-led crisis ending early 2016; in doing so, they have become attractive, in relative terms especially, after allowing for hedging costs for non-U.S. dollar investors. Within hard currency, we are overweight sovereigns relative to corporates based on better fundamentals and relative valuations for the former following pronounced underperformance of hard-currency sovereigns relative to U.S. high yield credits in 2018.
Valuations are looking attractive on the local currency side as well, with real yields at historically high levels near 3% and emerging markets currencies looking undervalued in aggregate following the 2018 correction. At present, we believe that the risk-reward potential is fairly balanced between hard and local currency, but we favor hard currency sovereigns at the margin considering the downside risks. Hard-currency sovereigns and corporates are more sensitive and aligned to generic credit spreads, which creates an end-of-cycle dependency toward the second half of 2019. Hard-currency sovereigns are also more exposed to commodities (oil and gas, predominantly), while hard-currency corporates are vulnerable to bouts of illiquidity. Local-currency issues are more sensitive to equity markets and growth, and tend to react positively to lower energy prices, making the trade-offs quite balanced.
Tariffs and trade policy add significant uncertainty to the outlook for currencies globally.
U.S. dollar: Markets began 2018 expecting the dollar to continue to weaken, in part due to projections that euro zone GDP growth would close in on that of the U.S. This clearly did not play out; instead, the gap between the U.S. and other major economies widened further, feeding a sustained rally in the U.S. dollar. We think 2018 expectations could actually come to pass in 2019, with the rest of the world catching up to the U.S., and the market is not priced for this scenario.
Tighter U.S. financial conditions from flattish equity markets, wider credit spreads and a stronger currency has tamed expectations of Fed hikes. While a softening in the Fed’s stance alone is unlikely to be enough to cause the dollar to weaken, a convergence in global growth would likely pressure the greenback. Moreover, toward the end of 2019 fiscal will fade concurrent with a large increase in U.S. debt issuance, a combination that could further weigh on the dollar.
From a long-term valuation perspective, the USD is overvalued by around 15% on average relative to other G10 currencies. While not insignificant we do not consider this to be overstretched. Broad real effective exchange rate measures suggest the dollar is approximately 3 – 4% off its December 2016 peak.
Euro: While the budget dispute between the EU and Italy is likely to get resolved at some point, Italian growth seems to have stalled, and the longer the dispute lasts, the more tightening financial conditions and borrowing costs are likely to weigh on economic activity. Despite this, we believe that the end of restrictive fiscal policy in Europe is on the horizon. A shift to more stimulative fiscal policy could provide the boost to European growth needed for the euro to recover ground versus the dollar later next year.
The European Parliament elections in May 2019 will inevitably have implications for member countries’ fiscal policies. Support for populist parties in Europe, especially on the far right, has been growing as immigration continues to be a major issue for voters. Meanwhile, recent disappointment in economic data, combined with a sharp correction in energy prices, has triggered a repricing of interest rates expectations, which in turn has kept EUR/USD under pressure. However, the ECB has ended its quantitative easing program and continues to sound confident that domestic demand and improvements in the labor market are likely to keep inflation moving toward its policy target.
Other currencies: Trade wars add significant uncertainty to the outlook for currencies globally. Currently, the market appears to be repositioning for a more constructive political outcome. Evidence of credible progress in the U.S. – China negotiation could support the currencies of open economies generally linked to global growth, such as Australian dollar, New Zealand dollar and South Korean won. Emerging markets currencies are also likely to recover under this scenario. On the other hand, lack of progress and further escalation of a trade war could support another leg higher in the U.S. dollar.
Fixed Income Investment Strategy Committee
About the Members
The Neuberger Berman Fixed Income Investment Strategy Committee consists of 18 of our most senior investment professionals, who meet monthly to share views on their respective sectors to inform the asset allocation decisions made for our multi-sector strategies. The group covers the full range of fixed income, combining deep investment knowledge with an average of 26 years of experience.