We had a chance to see Kathy Jones, SVP and Chief Fixed Income Strategist of Charles Schwab, give a live talk at their San Francisco headquarters earlier this week. Jones’ ability to take an often times underwhelming Fixed Income topic and naturally speak to it with passion and wit was cool to see.
This event that they like to call a “Knowledge Forum”, is regularly put on by Schwab Advisor Services and it’s in an attempt to bring fresh insights and local perspectives to investment professionals.
In this week’s installment, while the Fixed Income market outlook was the broader theme, Jones honed in on a few key updates related to Fed Policy, the duration debate, the credit bubble?, and corporate debt in emerging markets. I did my best to regurgitate my chicken-scratch note-taking. Hope you enjoy.
Since the financial crisis, total assets of major central banks such as the Fed, the BOJ, and the ECB have more than tripled. Will this gravity defiance continue? In short, no. As the aforementioned central banks pull back on quantitative easing, global liquidity will continue to decline. Central banks’ balance sheets are decreasing and it’s the first year Fed assets have not increased in over a decade.
Switching to interest rates, Jones discussed empirically that the low interest rate environment to which we’ve all become “accustomed” since the Great Recession, might have a more lasting effect on the natural rate of interest. In examining the Laubach Williams Natural Rate of Interest, before the 2008 crisis and dating back to the early 90s, the average Fed funds rate hovered at 2.7%. Post-2008 crisis, the average rate has held steady at 0.7% and according to Jones, it is looking more like a “new normal” despite what the Fed may suggest. In that same vain, she expects two additional rate hikes this year, one this month and one in December, but believes the Fed’s two expected rate hikes in 2019 may be hard to realize. Here’s why:
– Real short-term rates have turned positive for the first time in a decade. Coupled with continued balance sheet reduction, monetary policy is much tighter than in recent years and much tighter than in other major countries.
– Long-term inflation expectations remain anchored by a 10-year breakeven rate, which has averaged below 2.3% for the past five years. Moreover, the flattening yield curve is also diminishing inflation expectations.
– Even though market expectations are up, they are still well below the Fed’s median projections and market estimates don’t see the Fed funds rate getting to 3%.
The big question is whether we’re nearing a cyclical peak. According to Jones, in past cycles, 10-year bond yields and the Fed funds rate have peaked around the same level. Relative to that statistic, we continue to navigate into uncharted territories post-2008, as longer-run projections convey that 10-year yields may have already peaked at 3.12%. As such, Jones sees better risk-reward in the short-term to intermediate-term part of the yield curve. She believes 2 to 5-year investment grade corporate bonds possess the most return for every unit of duration risk.
In short, Jones doesn’t expect the bubble to burst just yet. That said, there are valid points to consider on both sides of the argument.
Supporters of a credit bubble: Total debt as a percent of real GDP has surpassed the previous pre-crisis peak and continues to rise. A distinct deterioration in credit ratings exists in investment grade – ten years ago, roughly 25% were rated BBB; today 50% are rated BBB.
Dissenters of a credit bubble: Corporate debt relative to liquid assets is at its lowest level since the 1960s. Cash balances remain high and earnings have been positive. Today, and especially given the scars that likely remain from the financial crisis, corporations possess a strong ability to service and manage their debt.
All things considered, Jones provided the following insights on the various investments within fixed income:
– Year-to-date, floating-rate investments have posted the strongest returns, followed by those with greater risks, and she sees that outperformance continuing for another one or two quarters.
– Jones is neutral on investment grade because pricing isn’t too attractive and average duration has been trending up for years, which means investors in investment grade may be taking on more interest rate risk than they realize.
– As for high-yield, she is neutral to cautious. She reminded us that high-yields always get caught when the business cycle changes. Since that impending change is still on the horizon, coupled with continued strong corporate earnings, it’s not quite the moment to pull back on high-yields.
– Jones sees an opportunity in preferreds because prices are slightly below their 5-year average and she believes it’s a good coupon for a long-term play – long-term because given the duration, there will be increased volatility, so it’s easier to stomach over a longer period.
– For munis, she believes valuations are high at the short end of the muni curve, but low compared to historical averages. Therefore, average duration in the 5-8-year range makes more sense.
Emerging Market Bonds
According to Jones, historically when the Fed tightens, it’s never a good time for emerging markets – as easy money goes away, EM is always most vulnerable. That coupled with declining global liquidity have caused money to flow out of emerging market assets. Trade tensions between the U.S. and China is the third dog in this fight, which has worsened the trend since China is a major trading partner of other EM countries. It also doesn’t help that over the past ten years, EM corporations have sharply increased their U.S. Dollar borrowing by 5.5x, totaling $1.2 Trillion.
Jones closed by reiterating her stance in a recent appearance on Bloomberg TV’s fixed income segment in which she disagreed with her fellow panelists that a 3.1% EM spread over treasuries was a healthy yield to own. She argued that an investor shouldn’t buy EM bonds until they’re receiving at least 400 basis points of yield – commensurate with the relative level of risk of that investment.
Big thanks to the Schwab Advisor Services team for hosting this fixed income chat.
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