We are nearly through the first quarter and it’s time to check the market’s pulse. The core of our thesis around heightened volatility in 2019 rests on the view that we are coming off a period of money being priced below its natural rate. The artificial rate environment created capital market distortions and, in many places, poor investment of capital in the economy. The mispricing of money also created unhealthy imbalances in the markets. We believe that the market will continue to contend with imbalances and the re-pricing of risk throughout 2019, but with these ongoing changes will come new valuations and opportunities. We have been focusing on Interest Rates, The Fed, Credit, Curves, CEO/CFO Behavior, Washington and Active Fixed Income.
We started the year asking “What Could Go Right?” and would like to look at “What Has Gone Right?”
As of mid-March, Treasury rates remain within a very tight range. The front-end is pegged to the Fed Funds Rate while the long-end reflects global growth concerns. We continue to expect rate volatility as we enter 3Q and the market contends with conflicting signals: domestic inflation rising but global growth slowing. We think inflation concerns will cause long-end Treasury rates to move higher in yield over time. In the near term rates will play off the growing consensus view of a slowing global economy.
The Fed is clearly communicating that it is watching and listening to the market and that both policy and the economy are in a good place. Chairman Powell has also suggested that the Fed will not only review the communication tools including the “Dot Plot” but are studying the impact of “makeup strategies,” essentially letting inflation rise above the target to “makeup” for past inflation shortfalls. This plays nicely into our view that inflation – via hard data, wages, and expectations – will rise as we enter 3Q. What is now a patient Fed will cause long-end Treasury rates to move higher in yield, similar to 2018. Our view that Powell is an excellent leader, communicator and the right person to lead the Fed is being confirmed. His recent appearance on 60 minutes and his commentary around the Fed’s independence validate our views.
Much like equities, credit spreads have rebounded materially from the December wides, reflecting a more positive outlook. Investment grade spreads are 30 basis points (bps) tighter and high yield spreads are 140 basis points (bps) tighter year-to-date (YTD). Many segments of the credit market have returned to the tights registered prior to the Q4 correction. This obviously raises questions around risk and reward. While we believe that volatility will be with us for most of 2019, the recent respite in vol (note the VIX) is a welcome outcome for credit investors. The relief rally gives investors the opportunity to revisit those investments that caused them the most heartburn in Q4 – bank loans, high yield, private credit, levered strategies. Caution is warranted. We continue to selectively allocate to improving fundamental credit stories.
Curves within both credit and Treasuries remain flat and in some cases inverted as investors move out the curve seeking yield. This has been more pronounced in the first quarter due U.S. Fixed Income offering an attractive yield in a slowing global environment. The inversion between 5-year Treasuries and 2-year Treasuries has raised questions again around future recession risk. With the combined flat curves, there are consequences for both interest rates and fixed income risk assets. Investors will need to consider the drawdown risk associated with limited yield pickup as they move out the curve. Similar to 2018, we believe that the front-end offers some of the most compelling risk adjusted returns. The long end should be monitored closely for opportunities. We remain cautious with a significant allocation to short duration credit.
We continue to watch management team behaviors/actions and their capital allocation decisions. The most recent examples are AT&T and Kraft. They join the list of companies from last year that have turned their focus to de-levering – AB InBev cutting the dividend in half and GE cutting the dividend to one cent. AT&T’s CEO recently noted that there are no plans for future mergers and acquisitions (M&A) and that they have one focus: paying down debt. Kraft on the other hand cut its dividend by $1.1 billion/year, or approximately 36% and has indicated that assets sales could be in the future. We believe management teams will be forced to focus on bondholders and on healthier balance sheets. We continue to expect greater dispersion among credit as the year progresses. There will be some great winners and some significant losers! Security selection – and more importantly – security avoidance, will be key drivers of returns this year.
The longest government shutdown in history ended. The Treasury is taking extraordinary measures to avoid the debt limit (As of March 1, 2019) and The President released his deficit-laden budget proposal (March 11, 2019). Negotiations between China and the US on trade remain ongoing. Event-driven volatility from Washington remains high (although the market’s recent reaction to the headlines has become more muted). We expect the recent calm to fade away.
Our expectations around what could go right have largely played out so far this year. Year-to-date returns in the equity markets look more like annual expectations. The swift recovery in credit is a welcome development for many – especially issuers and those feeing offsides in November and December. Energy prices have moved significantly higher and global risk assets have been some of the best performers. The return environment looks much more challenging going forward. And we believe that volatility will not remain in slumber.
Complacency will NOT be an investor’s friend in this environment; it’s time to know your fixed income manager, know how they invest and how they think about preserving capital.
Let’s talk – Smith Capital Investors
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