The first quarter of 2019 had a sharp reversal from the end of 2018 in both market sentiment and performance. This was guided by successive dovish signals from the Federal Reserve, including March's comments, which took the bond market by surprise and sent yields considerably lower.
The strong, and contrasting, reactions to the Fed's comments over the prior two quarters highlight the continued disconnect between Fed communication and market interpretation. As such, we begin the second quarter with the Treasury yield curve taking a somewhat unusual "S" shape.
U.S. Treasury and municipal yield curves
Sources: Vanguard calculations, using Bloomberg data, U.S. Treasury
Economic outlook and rates
We continue to expect a deceleration in economic growth during 2019 but do not view a U.S. recession as imminent. Economic data in China have weakened, but we expect stabilization toward midyear, prompted by supportive fiscal policy. This is likely to have positive spillover effects on European growth, which has been underwhelming. Trade tensions remain a wild card, with downside risk to the global economy, but progress toward a resolution will support growth.
The U.S. Treasury yield curve inversion warrants discussion. While historically a reliable predictor of tougher economic times, we are not giving full credence just yet to the predictive power of this recent inversion. The reason being the federal funds rate is close to neutral, rather than restrictive. Previous inversions have coincided with tighter monetary policy. Additionally, past inversions that led to recessions have tended to start at the long end and migrate to the short end. This time, the reverse is happening, possibly signaling that the market may expect the Fed to ease relatively soon. We respect this signal, but we need to see persistence in the yield curve’s inverted state to determine its significance. Given the extreme flatness of the yield curve, our preferred strategy is to position for curve steepening, since we believe it could transpire across a number of scenarios.
U.S. agency/U.S. mortgage-backed securities
We entered the year overweight to agency mortgage-backed securities (MBS), given their attractive valuations. This view proved beneficial as the quarter's strong rally pulled MBS spreads tighter. Going forward, we see the picture for MBS as more challenged, and we have reduced our overweight. Interest rates on mortgage loans have fallen in tandem with the recent decline in Treasury yields, resulting in a higher likelihood that mortgage holders will refinance. This increased convexity risk has, and will continue to, hurt valuations. In addition, mortgage supply will pick up following spring home-buying season and as the Fed continues to unwind its MBS positions. We have moved to a neutral posture on MBS, with a focus on securities that offer better prepayment protection.
Break-even inflation (BEI) spreads widened during the first few months of the year largely because of a strong rebound in oil prices and a calming of global risks, but levels are still below the range that persisted for most of 2018. Oil's retracement of more than 30% in the first quarter brings the price of West Texas Intermediate crude oil within the expected range we highlighted late last year. Drivers of inflation overall have been mixed and below the Fed's 2% target, but the Fed is indicating more willingness to let inflation run above this level. The market is in a show-me mode, however, and we think it will take several strong inflation readings with no Fed reaction for investors to raise their longer-term inflation expectations. By the end of the year, we see core inflation muted, but ending close to 2%. Near term, we are taking advantage of opportunities in a seasonal 1-year BEI carry trade and a long position in 30-year BEI because we see it as underpriced.
今年头几个月，盈亏平衡通胀率(BEI)息差扩大，主要原因是油价强劲反弹和全球风险得到缓解，但仍低于2018年大部分时间的水平。今年第一季度油价回调超过30%，使西德克萨斯中质原油(West Texas Intermediate)的价格处于我们去年年底强调的预期区间。通货膨胀的驱动因素有好有坏，低于美联储2%的目标，但美联储表示更愿意让通货膨胀高于这一水平。然而，市场正处于“自我展示”模式，我们认为，在美联储没有做出反应的情况下，投资者需要几次强劲的通胀数据，才能提高他们的长期通胀预期。到今年年底，我们看到核心通货膨胀有所减弱，但接近2%。近期，我们正利用1年期贝南克套息交易的季节性机会，以及30年期贝南克套息交易的多头仓位，因我们认为贝南克价格被低估。
Implications for Vanguard funds:
- Maintain a close-to-neutral duration overall, but positioned for a steeper curve.
- Remain overweight to 30-year BEI and are tactically long in shorter-maturity TIPS.
- Shift to a neutral MBS position, based on less attractive valuations and increased convexity risk.
First-quarter performance across fixed income credit reflects a sharp reversal from the "risk off" tone that pushed spreads significantly wider during the fourth quarter of 2018. This rally was driven by the Fed's pivot to a more dovish posture—pausing interest rate hikes and slowing its balance sheet runoff.
U.S. investment-grade and high-yield corporate valuations richened in the quarter, reaching the 25th percentile of historical spread levels. Given our outlook, today's valuations leave less scope for further price appreciation. A U.S. economy that avoids a recession would provide only moderate upside from today's levels, while the onset of a recession would prompt large underperformance—once again, credit offers an asymmetrical risk/return profile.
Retracement in credit spreads
Source: Bloomberg Barclays, as of March 31, 2019.
That being said, we are comfortable maintaining overall credit-risk exposure near the lower end of our range and still see tactical opportunities in parts of sectors where valuations haven't completely adjusted to the recent rally. Subsector and issuer selection, along with up versus down in quality, are levers we expect to pull to add value in this environment.
A January rally in credit spreads, combined with a March decline in Treasury yields, pushed first-quarter returns in the sector above 5%. Industrial issuers outperformed financials and utilities, driven by a strong rebound in energy prices that bolstered energy-related subsectors. A more accommodative Fed tone, an increase in demand from non-U.S. investors, lower net supply, and a relatively stable fundamental backdrop have helped further support credit sentiment. We used this opportunity to reduce or exit positions in highly levered or less liquid issuers that we view as being vulnerable in a decelerating U.S. economy, and to lean into higher-quality U.S. and non-U.S. banks.
Interestingly, we've seen market participants show more patience with corporate issuers relative to last year. Downward revisions to company guidance and even rating downgrades have been met with less negative price impact. We are encouraged by the more "bondholder friendly" steps several firms have taken to decrease leverage, but we acknowledge that this environment warrants a more selective approach. We view valuations as fair and fundamentals as somewhat stretched, but an overall accommodative environment in the near term presents better relative value in BBBs versus As, with opportunities for security selection across the sector.
Consistent with their lower beta relative to other credit sectors, asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS) followed the quarter's pattern of spread compression, but to a lesser degree. We continue to see a supportive case for ABS from a strong U.S. consumer and for CMBS from stable property valuations and a favorable supply-demand dynamic. With respect to fundamentals, we do not see any major areas of concern. Pockets of delinquencies or borrower defaults will likely be contained, and bondholders should benefit from overcollateralization and our focus on diversification within our securitized exposure. Our positioning reflects a defensive bias—moving up in credit quality through higher-rated auto securities and adding back exposure to higher-quality subsectors, such as credit cards.
Emerging markets (EM) benefited considerably from a pause in U.S. interest rate hikes. This, alongside strong investor demand, supportive country fundamentals, and a lower-than-expected early-year supply, boosted performance across both investment-grade and high-yield EM issuers. After an especially strong start to the year, the rally in EM debt moderated in March. Our portfolios benefited from an overweight to the sector during the quarter, and we still see opportunities going forward, but any further spread tightening will likely require a catalyst and be led by lower-quality EM issuers.
As anticipated, the technical backdrop is becoming more challenging as new supply has picked up meaningfully and credit spreads are at richer levels. We expect a reduction in demand from profit taking and have moved into a neutral position to the sector overall. This is expressed through a tactical overweight in select lower-quality issuers, such as Argentina and Ukraine, offset by overweight positions in high-quality Middle East issuers, such as Qatar. Notably, we are underweighting Turkey amid significant volatility.
The recovery in high-yield corporates throughout the first quarter was swift, marking the strongest start to a calendar year on record. Although high-yield bonds recovered most of their losses from the fourth quarter, current spreads of 390 basis points (bps) remain 90 bps wider than the postcrisis tights of October 2018.
The first-quarter rally has been atypical in that lower-quality high-yield credits have not outperformed. BB-rated bonds have recovered more than twice what they lost during the end of 2018, while CCC-rated bonds have recovered only about 75% of their fourth-quarter losses. We see a few key reasons for this. First, CCCs outperformed meaningfully in the summer of 2018. Second, BBs have benefited from their longer duration and higher liquidity. Third, we believe the downturn in global economic data has caused investors to avoid going too far down in quality. Buying BBs is the easier and more liquid method to benefit from a beta-driven market recovery without adding a large amount of default risk late in the economic cycle. While the down-in-quality underperformance is notable, we don’t view this as an indicator of an imminent recession.
Although the first quarter saw robust issuance, the high-yield technical picture remains strong, supported by meaningful inflows to high-yield bonds ($10.6 billion), which came largely from bank loans ($10.1 billion in outflows). While expected defaults remain low, high-yield valuations have recovered and now leave only moderate upside. We continue to favor the lower relative risk of BBs despite their recent outperformance and are focused on adding value primarily through bottom-up credit selection.
Implications for Vanguard funds:
- Slightly overweight credit exposure overall but hovering near the lower end of our range, based on a positive near-term view and a watchful longer-term outlook.
- Overweight select BBB and BB-rated corporate bonds, avoiding vulnerable names with high leverage and weaker growth prospects.
- Move toward an overall neutral position to EM ahead of a more challenging technical backdrop, but capitalize on tactical opportunities along the credit-quality spectrum.