Asset Class: U.S. Fixed Income

2018 Fixed Income Outlook: Something’s gotta give

sand castle about to be washed away

The strong equity market has yet to produce the proverbial stock tips from taxi drivers, but we’ve gotten quite a few Bitcoin suggestions from all walks of life. People are (supposedly) mortgaging their houses to buy it and headlines are hyping teenage millionaires.

The phenomenon has spawned parody songs like “I Love You Like a Bitcoin Baby!” and parody cryptocurrencies: Dogecoin (who knew a parody could have a market cap above $2 billion!?!?). Whether Bitcoin is a currency, a technology or an investment, what it tells us about the broader investment landscape and valuations across asset classes may be most important.

The Bitcoin brief — digital currency as an analog for markets

Currency? Bitcoin has been around for close to a decade, but it attracted significant attention at the end of 2017 as prices spiked. Originally created in 2009 when many had lost faith in the global financial system, bitcoin and other cryptocurrencies were intended to decentralize financial activity. While decentralization has certain appeals to those lacking faith in the “full faith and credit” of the U.S. government or other paper currency issuers, ultimately the dollar works a reserve currency for the world precisely for the reason of that shared faith. This faith is why Treasuries are the ultimate flight to safety asset whenever North Korea gets frisky or another crisis (even, ironically, the 2011 S&P downgrade of U.S. Treasury ratings) occurs. To date, even the websites or occasional other vendors accepting bitcoin for transactions still price their goods and services in an established currency, making bitcoin function as a conduit; ironically, those transacting in bitcoin in prices set by dollars are making a similar, if unwitting, statement of faith.

Technology? Blockchain may be revolutionary technology as its proponents claim and the appeal of anonymous digital exchange is understandable. However, there are likely limits as success of anonymity could be its own undoing. Regimes such as Venezuela and Russia are considering their own issuance seeking to avoid U.S. sanctions. If cryptocurrency becomes a mechanism for illicit dealing, they could go the way of the bearer bond; before being outlawed in 1982, bearer bonds allowed the investors to literally clip coupons off a bond certificate and the physical holder of the coupons to receive cash at an agent bank. As such, they could function as means of transferring large amounts of value in a less traceable manner and drew scrutiny until they were no longer issued. Interestingly, the other major trend in digital means of exchange, e.g., Venmo, is blurring the lines between being a bank and a social network, where a person’s newsfeed shares the details of their transactions with their network of friends, seemingly the diametric opposite of the more discreet bitcoin.

Investment? The meteoric rise in bitcoin prices parallels a larger trend of asset value increases that has been seen across nearly every major investment category. In 2017, U.S. equity markets hit all-time highs, the U.S. housing market hit its all-time high and credit spreads closed the year at decade long tights. In some ways, the explosion of bitcoin and its brethren is new and unique and in other ways it seems to be intimately tied to the increase in valuations across other asset classes. Investors are looking for alternatives to generate returns, from private equity to private debt to private currency. Bitcoin has no yield, no earnings and has no commodity value, so how did we get here?

2017 recap — how the markets stopped worrying and started to love the economy

2018 fi outlook cartoonAt the outset of the year, we labeled 2017 ‘a year of transition’. In retrospect, the description was more apt than we anticipated. In terms of monetary policy, the U.S. ‘officially’ entered a rate hike cycle, began the balance sheet unwind and met the presumptive new Fed Chair. More broadly, monetary policy, which seemed the dominant force for a decade, gave way to fundamental economic improvement with the tailwind of fiscal policy support. And of course, the new U.S. president took office with all the effects of a new administration in Washington. Despite much justifiable fretting, fears of a continued populist upsurge faded as the year progressed and non-fringe political parties tended to prevail globally. Perhaps most notable, but less discussed, global economic activity surprised materially on the upside for the first time in years, delivering just shy of 4% growth vs. the expected low 3%s.

citi economic surprise 2018 fi outlook medIn the U.S., this economic surprise manifested itself not only in higher-than-expected GDP growth, seemingly ignoring two major hurricanes, but in a variety of other economic data. Unemployment reached its lowest level in a decade, in part due to a surprising rebound in the manufacturing sector. In particular, consumer confidence and business confidence rose dramatically, or as NFIB President and CEO Juanita Duggan put it: “2017 was the most remarkable year in the 45-year history of the NFIB [small business] Optimism Index.”

Among the many 2017 transitions, the Federal Reserve (Fed) chair change will likely be the least impactful, as we do not anticipate that the transition at the Fed from Chair Janet Yellen to Jerome Powell will prove material in terms of policy. In short, we think the baton will be passed smoothly. During his prepared remarks to Congress, presumptive Chairman Powell’s expectations called for interest rates to rise, “somewhat further” and the Fed’s balance sheet to shrink, “gradually.” Sound familiar? The area in which we can foresee modest differences in the leadership views is around deregulation, an oft forgot responsibility of the Fed. In this arena, Powell has perhaps a slightly more laissez-faire view than Chair Yellen. This difference notwithstanding, from a policy standpoint, the consistency across leadership is welcome and much needed.

2s30s curve 2018 fi outlook medBucking the trend, long-term interest rates appeared determined not to transition in 2017. While they fluctuated, the 10-year treasury did not break higher as many had once again called for, ending within three basis points of the end of 2016. The dominant theme, in fact, has been a flattening of the yield curve. We called for a progressive flattening as early as 2014 in our paper “Why Rising Rates Doesn’t Mean Rising Rates,” in which, among other arguments, we suggested that a Fed rate hike cycle should flatten the curve. As the Fed was able, for the first time in the current cycle, to hit three rate hikes in a year, the flattening of the U.S. yield curve became more pronounced. As we enter 2018, some have asked whether continued flattening would lead to an inverted curve, with all the associated negative market signals.

The yield curve steamroller

In brief, our view is that the Fed, which until 2017 had consistently been more accommodative even than its own dovish language, will desperately avoid such a situation. Both from a philosophical perspective and from a lack of desire to rock the boat as the economy appears to have gained momentum, we believe the new Chair and several vacant seats are unlikely to alter the course that Chair Yellen’s Fed charted.

As much as we believe the Fed would like to deliver another three rate hikes in 2018, they will gladly forgo that chance if the curve flattens to the point where an inverted curve is even close to the horizon. This is not to portray the Fed as omnipotent; there is always the potential for the market to “overrule” the Fed and invert the curve, but we see the Powell Fed continuing the Yellen Fed’s acute awareness of market reactions. The Fed has suggested as much, hinting that financial stability is itself a target, one that could put the Fed in the delicate position of continuing their rate hike path predictably with an increasingly flat curve.

us treasury curve 2018 fi outloook medFrom the long end, we see improving economic data, but middling inflation, limiting a decline in rates. At the same time, exogenous factors have continued to weigh down the potential for a near-term sharp increase. Despite rising hedging costs, global yield differentials and diverging monetary policy continues to support U.S. rates. The passive trend, one we highlighted at the outset of 2017 in “Alexa, Invest in Fixed Income,” supports long rates as passive investors purchase Treasuries at nearly double the rate of the average active manager. Finally, recurrent geopolitical uncertainties, from looming tensions with North Korea to occasional flairs of Brexit or other scares, have periodically sprouted to compress rates. While we expect passive to continue as a support and geopolitical surprises are, by their nature, unpredictable, the evolution of monetary policy globally bears monitoring.

Dude, where’s my inflation

Asset prices broadly have risen dramatically since the nadir of the great recession. From financial assets to home prices, the world is becoming more expensive. This is perhaps even more true in healthcare and higher education, yet inflation metrics reflect little of this. While inflation has, in a sense, impacted the prices of everything surrounding an individual, it hasn’t impacted the price of that individual’s time, i.e., their wages for labor. Wages have been slow to grow, despite labor force tightening, i.e., lower unemployment, underemployment and greater workforce participation. Tax reform, which will take effect this year, poses an interesting question. Its architects hope for a stimulative effect, which will drive wages higher. Even if it does not provide this boost, it should lift disposable income. Will recycling of that disposable income push inflation metrics higher and eventually flow into wages?

Some metrics do suggest there is improving or higher wage growth, but to date, it has yet to impact headline metrics. Absent these indicators, it is difficult to foresee a meaningful adjustment higher in Treasury yields, as inflation seems to remain an anchor holding them down.

While Fed rate hikes are often a tool to battle inflation (see Volcker, Paul circa 1979) or preempt it (i.e., more recent rate hike cycles), in the current regime, inflation is seemingly the sole counterargument to further rate hikes in an environment where the Fed is desperate to escape their crisis era policies and growth, employment, consumer confidence and asset prices reflect a far healthier landscape.

unemployment v wage growth 2018 fi outlook medHints of inflation would suggest a revisiting of longer term rates — though they could also remove the current roadblock for the Fed to raise rates more rapidly. Were inflation data to give the Fed that clearance, the Fed could act more rapidly, which could itself be disinflationary.

Outlook — something’s gotta give

With improving economic data, supportive fiscal policy (tax reform complete and an infrastructure package supposedly on the way) and benign monetary policy, 2018 appears healthy for markets of all stripes. Yet, as noted, if inflation remains stubbornly low and other exogenous trends persist, then interest rates are unlikely to shift meaningfully higher.

This poses an interesting dilemma: are we closer to the end of business cycle than to the start of a transition higher in rates? Janet Yellen observed that “it’s a myth that expansions die of old age,” but prior to Trump’s election, the current business cycle appeared to be in senescence. The recent reinvigoration enabled the Fed to step back as it has, but it chose a deliberately slow path. The balance sheet unwind will take years to meaningfully reduce the Fed’s exposure, which raises the question if the Fed is “all in” on the cycle continuing.

Should we experience a hiccup, a pause in the unwind is likely, but what of a full blown recession? Do markets now expect quantitative easing as a response? The end of a business cycle is different than a financial crisis, but are investors prepared to make the distinction if equity markets decline beyond correction territory?

Rates — the odd man out?

At least in the short term, the Fed’s bet of a positive economic horizon appears reasonable. They should be able to continue reducing their balance sheet and increasing the Fed Funds rate. Balancing the various demand factors, rates should close the year higher, but not dramatically so. If this is the case, it is important to restate some of the experience of 2017. At various points, rates had risen meaningfully over the trailing 12 months, yet fixed income returns remained positive if unexciting. With rates currently at a higher starting point than, say, the third quarter of 2016, interest income provides a greater cushion.

Interest rate markets appear to be the odd man out compared to other asset classes. In our view, the stubbornness of interest rates to get onboard with other asset classes represents the bond markets typical — and healthy — skepticism, which serves as a reminder: While asset prices are flying high, multiples are expanding and blockchain technology is providing yet another “asset class” for risk markets, GDP of mid-2%s and core inflation of mid-1%s provide nearly no margin for error when it comes to “policy normalization.”

This is the classic, “half full vs. half empty” debate, whereby risk markets are looking at the next 6 to 12 months as a period of stable to increasing growth, which will see its way through any additional policy normalization. Economic data and financial conditions have been steadily improving along with the Fed’s slow drift towards higher interest rates. On the other hand, the Treasury market remain unconvinced that the next chapter of this expansion is the one in which real wage growth finally accelerates and the much-discussed Phillips curve is fully redeemed. After all, if the neutral rate for Fed Funds has shifted lower, theoretically so too must the neutral unemployment rate. If that is in fact what the Treasury market is telling us, it is a view the Fed does not appear to share. The Fed believes the pedal has been pressed to the metal long enough, and the car is finally going to be dropped in gear. This point of contention is one that will not be resolved until the Fed telegraphs policy is now “normal,” perhaps 12 to 24 months from now.

Conclusions

As we synthesize all these factors, we see a benign environment for traditional fixed income, one no doubt with unforeseen surprises, but one that delivers reasonable returns even if yields drift higher. With changes abounding from fiscal and monetary policy, nimbleness will be at a premium.

In the current market phase of high liquidity, insatiate investor appetite for risk, and ample market demand for new securities and low to negative yields on cash, asset prices have been rising across the board. As such, the risks are asymmetric to price declines, yet few factors are visible catalysts to drive such declines at the moment; on the contrary, there are ample arguments to support current levels of pricing or further improvement. In our view, this is as true of private equity, which saw record capital raises in 2017 (over $450 billion) and dry powder accumulate to over $1 trillion for the first time, as it is of corporate bond spreads at their tightest levels in a decade. While we are therefore cognizant of fixed income valuation levels, we view these investments in the context of a world where nothing appears cheap.

Leaving aside our general view that liquidity is a nearly permanently undervalued risk factor, it is noteworthy that some investors are seeking speculative gains from their cash in form of cryptocurrency. This choice of private currency vs. standard currency is similar to the liquidity trade-offs we are witnessing from equity vs. private equity to traditional fixed income vs. private debt and other non-traditional fixed income alternatives. The promise of returns is tantalizing, but the liquidity give-up, substitution of risk factors and lack of historical testing are less appealing. In periods of market illiquidity, the aphorism “cash is king” invariably resurfaces, though it often lays dormant in intervening periods. We appear to be in such a hibernation period, a healthy reminder that when the liquidity of traditional asset classes is needed vs. less liquid alternatives, it is harder to find.

With secular trends speeding ever faster and fears of obsolescence touching new sectors and businesses, deep research will be as important as ever in investment decisions. While it can be tempting to believe that a new technology, investment approach or cryptocurrency will remake the world and offer us a panacea, more often we find that it is the same boring old fundamentals that guide us best for the long term.

 

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