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A Goldilocks Economic Backdrop Demands Caution, Not Complacency, From Bond Investors

The economic backdrop for bond investors is a bit of a mixed picture, with continued economic growth, low unemployment and subdued inflation, but also tepid wage growth, growing budget deficits, increasing leverage and a slowing housing market. And that's just in the United States. These are the headwinds and tailwinds that fixed-income managers are navigating as plan sponsors and other institutional investors ask whether now is the time to adjust their allocations both to equities, where valuations are steep, and fixed income. In this round table, Thomas C. Goggins, senior managing director and senior portfolio manager on the global multisector fixed-income team at Manulife Asset Management, Marty Margolis, chief investment officer at PFM Asset Management LLC, and Don Sheridan, a director on the fixed-income research team at Segal Marco Advisors, discuss the trends shaping fixed-income markets, including inflation and the flattening yield curve, opportunities around the globe and risks that investors need to keep an eye on.

Meet the Round Table Participants

THOMAS C. GOGGINS
Senior Managing Director and Senior Portfolio Manager on the Global Multisector Fixed-Income Team
Manulife Asset Management

MARTY MARGOLIS
Chief Investment Officer
PFM Asset Management LLC

DON SHERIDAN
Director on the Fixed-Income Research Team
Segal Marco Advisors

Round Table

P&I: How are today's overall conditions affecting your view of opportunity and risk over the next 18 to 24 months?

Marty Margolis: It's a mixed picture, but it's a little bit of a Goldilocks picture at the moment, and we could start out by putting a couple stakes in the ground that might carry us for the next year, and perhaps for the next two years. The first is that we expect, with continued support from fiscal and monetary policy, a continuation of the basic growth trend we've seen over the last several years. We are anticipating modest growth and modest inflation for the next 12 to 18 months. But after that we are less sure.

Our second stake in the ground is that we expect a couple of Fed tightenings during the balance of this year, with some uncertainty about the Fed next year. Now, rising rates do produce negative returns, and clients are certainly focused on the reality that many long-duration investment accounts have had zero or negative returns over the last 12 or 18 months. But rates are above their floors. There does seem to be some rate stability in the marketplace. There continue to be, in our view, opportunities in sectors that produced incremental returns in the past, and there seems to be a good prospect for what would be, by historic terms, modest but positive returns over the next year or two in fixed-income strategies.

P&I: Thomas, are you seeing similar trends on the global front?

Thomas C. Goggins: Overall it's a very good economic backdrop, with the U.S. economy growing at a 4% rate, Europe seeing its strongest growth in the last 10 years and Asia moving along nicely. At the same time, however, we're seeing a normalization of interest rates, certainly by the Fed, the Bank of Canada and the Bank of England, and we believe the European Central Bank will probably have to address rates sooner rather than later. That generally is a negative environment for owning high-quality bonds, i.e., government bonds.

That likely means eschewing interest rate risk in favor of credit risk. The challenge is that, given current spreads, there are no cheap sectors in global fixed-income markets. We are, however, finding select opportunities at the issuer level and building portfolios that strike a balance between yield, quality, stability and liquidity.

Foreign exchange is probably the area that has been offering the most excitement. Because of tariff and trade discussions, there has been more volatility in FX than, say, interest rates or credit. We believe that's where managers with expertise may be able to add a lot of value for clients.

P&I: Don, how are institutional investors thinking about fixed-income portfolios based on current conditions?

Don Sheridan: A lot of institutional investors are nervous about their equity exposure, given where prices are today. But even while they may be considering rotating out of equity into credit, plan sponsors still have a target actuarial assumption rate to achieve. So the asset allocation decision is becoming more and more nuanced and difficult to model. Rising interest rates are also a concern. A lot of investors are seeking out floating-rate and short-duration type solutions to address that problem within fixed income.

Diversification through global allocations and flexibility with manager mandates are both becoming more pronounced. Where permitted, investors are trying to capitalize on value in areas like currency, where there's volatility that is creating opportunities.

In fixed income, there's asymmetric risk to worry about with the interest rate term structure. Having blanket exposure to Treasuries is clearly not something we encourage, but we also are trying to be very careful with our yield-curve positioning and exposure to spread duration assets to preserve capital and manage contribution to duration. There are more and more conversations taking place around potentially forfeiting liquidity in certain areas, like credit, to benefit from a liquidity premium.

However, at the same time, as rates go up, you do get to reinvest in bonds offering higher cash flows. At a plan level, the broad index should continue to give a correlation benefit relative to other assets in the portfolio and hopefully soon generate positive returns once again, when interest rate directional uncertainty settles down.

P&I: The flattening yield curve has been in the news lately. Are any of you worried about recession, and how are you interpreting the signals?

Marty Margolis: We've been cautious for about the last 12 months, and that means being a bit defensive on duration, and with a preference for the non-Treasury sectors. Credit has had a really good run, but when the business cycle turns down, all credit is not going to be equally treated and equally protected. High yield has had a pretty good run; I would say at some point sooner rather than later, it may be appropriate to lighten up on high yield. It may be appropriate to lighten up on business-cycle-related credits, and it's certainly appropriate to be cautious about leveraged credit, given the very notable increase in corporate leverage.

Now, as to the timing, we're not worried particularly about 2018. Beyond that, things are less clear, and much less certain.

Thomas C. Goggins: First I would say that, in my view, there's too big an obsession with the question of yield-curve inversion. Yes, recessions are often preceded by inversion, but not all inversions are followed by recession. There are a lot of technical factors driving the shape of the curve, and I believe those are not as important as the overall U.S. economic backdrop, which still looks pretty good.

Now, if you think back to mid-2016, at that point the consensus was that the U.S. was in the eighth inning of the credit cycle. But with the recent tax cuts and regulatory changes in Washington, those have extended the U.S. economic cycle, and subsequently the credit cycle, into an extra-inning ballgame, and I believe we have even a little bit further to run outside the U.S.

Don Sheridan: Bond managers have been beating the drum for years that we are in unprecedented territory, largely because of these quantitative easing programs that came out of the global financial crisis. It's tough to pinpoint where we are in the cycle, but what we do see is that spreads in almost all sectors are trading within 15-year medians, and they continue to grind tighter.

So yes, the inverted yield curve is very topical. But we should also note that in the past, recessions have been precipitated by catalysts, not just an inverted curve. In the '70s it was trouble in the energy sector. In the '90s it was currency markets. There was a tech bubble in 2001 and a housing collapse in 2007 to 2008. All were preceded by yield-curve inversion, but the subsequent recession was caused by a catalyst.

Right now we don't see many issues that give us concern. In fact, we see a lot of indications that things aren't so bad. Leverage is ticking up, but interest coverage is as well. In high yield, maturity walls have been pushed back. A huge refinancing wave has helped lessen default risk, which gives investors some comfort.

P&I: So how might that context impact immediate opportunities in fixed income or long-term strategic plans for investors?

Marty Margolis: Returns across the curve and across fixed-income sectors over the past year or so have been more in the red than in the black. With the exception of cash-like portfolios, most bond strategies have had poor or negative returns compared with large, positive returns in equities.

That presents a challenge for investors, who really have to take a deep breath and think about why they want to increase allocations to fixed income.

Going forward, I believe portfolio managers have an expectation that fixed-income sectors for the next period, say over a year or two, can be reasonable. They could be in the range of perhaps 2% to 4%, and returns further out the yield curve from cash can be higher than returns on cash. And if you believe that equity returns are going to be muted over the next couple of years, then fixed income is an OK place to be.

The problem is that investors listen to those arguments and then look at recent returns — which as I said, have been negative in many cases — and it's difficult for them to come to terms with the proposition that a fixed-income allocation will pay off.

Thomas C. Goggins: I would mention two very interesting points here. First, when we started the year out, many market participants would have thought that triple C's would have underperformed double B's, but just the opposite has happened. Second, given the changing nature of fixed income on a global basis, I believe that the flexibility of a multisector approach could be ideally suited to the type of environment we are in right now — with central banks around the globe in various stages of raising rates, countries in different stages of the economic cycle and idiosyncratic opportunities across the credit spectrum.

Don Sheridan: Just to add a bit more perspective on that credit situation, with triple C's having rallied. It is surprising. They have rallied aggressively. But some managers can see the inefficiencies in that market, and the shorter duration of triple C's, and understand the rationale for the rally. Investors who can give managers the flexibility to traffic throughout the quality spectrum, through various instruments, are able to benefit from shorter-term opportunities. So, increasingly, we are encouraging clients to have a diversified blend of credit. In our view, a blended approach may help dampen volatility while capturing a meaningful amount of credit beta that investors may need.

P&I: Inflation and the dollar are two big inputs into a fixed-income investor's outlook and strategy. What are you seeing there?

The dollar continues to strengthen, which is creating some issues for investors when it comes to hedging costs and demand for U.S. Treasury instruments. As the Fed is unwinding its balance sheet, it's looking to private markets to absorb that supply, and that situation will clearly be impactful to pricing on the yield curve.

We believe inflation could rise in the near term, but may be more benign in the long term. At the end of June, the five-year breakeven was approximately 10 basis points higher than the 30-year. We look at signals like that to gauge market sentiment and how it's pricing inflation risk. Understand, however, that the tariff situation could potentially stoke inflation — potentially as much as 1% if the proposed new tariff regime is fully implemented. There are a lot of unknowns when it comes to trade policy that make investors very uncomfortable with long-term allocation and pricing assumptions.

Marty Margolis: The big mystery to me is the absence of sustained wage inflation, and I think most economists have no idea why wage growth has not picked up. It's not through observed increases in productivity. It's just a mystery.

But as long as wage and earnings growth remain modest — in the absence of a huge rise in commodity prices, which we have not seen — inflation will likely remain muted. And as long as inflation is contained, interest rates, at least in developed markets around the globe, are going to remain contained. We have seen a huge difference in rates between sovereign bonds in the U.S. and sovereign bonds in Germany and Japan, for example.

The very low inflation rates globally act as a cap on U.S. interest rates, and that, of course, flows into the currency markets. The strength of the dollar, in turn, has an effect on domestic U.S. investors.

Thomas C. Goggins: We are a little bit out of consensus on the U.S. dollar, which we believe may be in for sustained movement lower. Recent market volatility has pushed out expectations for interest rate hikes by many central banks outside the U.S., which has resulted in U.S. dollar strength in the short term. However, when looking longer term, we believe the fundamentals that have driven U.S. dollar strength over the last several years, namely diverging central bank policies, interest rate and growth differentials relative to the U.S., are now converging. As a result, the broader U.S. dollar uptrend has likely peaked, and as the market refocuses on fundamentals, the dollar has the potential to weaken over the long term.

On inflation, we are vigilant in terms of watching for wage growth, and the lack of it really is a mystery. One possibility is that a decline in U.S. unemployment numbers indicates people coming off the sidelines and into the workforce — potentially a downward pressure on wages. But overall, as fixed-income managers, we want to prepare for higher inflation, because we want to protect the downside. If we give a little bit on the upside, I think most clients would be okay with that, because protecting the downside is so important.

P&I: Do you have any concerns about increasing government deficits and corporate leverage?

Thomas C. Goggins: Leverage is one of the things that concerns us, especially the amount of triple B debt out there on corporate balance sheets. The worry is that mergers and acquisitions in the triple B area, often done for defensive purposes, leads to transactions that are not well thought out. We could see, a few years out, that many of these credits could move from triple B to high yield because they were poorly conceived transactions. That's a very big concern for us from the credit standpoint.

From a U.S. government perspective, certainly the deficit is a concern, but at the end of the day, the U.S. continues to be the reserve currency of choice and, really, the strongest economy out there.

Don Sheridan: I agree with Tom that the triple B situation is a bit concerning. It's north of 40% of the Barclays credit index, has grown tremendously in the last eight years and is now approaching about $3 trillion. On the other hand, while it is one notch removed from high yield, there are a lot of large, solid companies making up a huge component of that issuance — names like AT&T, Verizon, GM and other very large issuers. Those companies boast steady, consistent annual free cashflow to support that debt.

As with any area in spread sectors, everything is trading tight. So one has to be highly selective. If one were making an overweight allocation to triple B's, I would be particularly concerned with yield-curve positioning and the portfolio's duration profile. Long-dated triple B's won't be so easily absorbed in the shorter-dated high-yield universe.

Marty Margolis: Expanding leverage and debt, combined with exposure to the business cycle, have become much more important than they were even six months ago. We haven't markedly changed our allocations, but we have raised our sensitivity around leverage and market-access issues.

If you look at the composition of U.S. credit markets today versus the same point in prior business cycles, there is more leverage. We see, on average, lower credit ratings. There's less room to go down the credit steps before you fall, and the impending growth of Treasury issuance puts forward the possibility of limited market access in the future, or certainly higher costs for borrowers that are not the government. Putting all that together with a business downturn, it can be worrisome. It has led us to put much more focus on our credit decisions, and on our bond-selection decisions.

We recognize that spreads by historic standards are relatively narrow. But even if we wanted to take the risk by adding to credit, I'm not sure that the benefit is there.

P&I: We've talked a lot about risks, now let's talk about the good stuff. Where are you finding opportunity?

Marty Margolis: We are primarily focused on investment-grade sectors, and in that area we think there is still some value in credit, but it's selective. We would be cautious of companies subject to business-cycle factors, as well as companies subject to M&A. We tend to be more comfortable with financial services companies, particularly in banking, for lots of reasons around their financial condition and the improved regulatory framework, at least to-date.

Away from credit, we think asset-backed securities have some value — particularly mortgage-backed securities, again issue-specific, where relative value is growing. We would rather use our risk budget more for interest rate risk embedded in mortgage-backed and agency mortgage-backed issues than for speculative kinds of credit.

In terms of the curve, the place to be is relatively short. The problem is that no part of the curve reflects a market outlook for multiple Fed rate increases over the next 18 months. So investors have to find the least bad shelter in kind of a rough sea, if you will. In other words, I don't see real value in big curve bets these days.

Thomas C. Goggins: We look at opportunities in the context of four major risks — interest rate, credit, FX and liquidity. Given our expectations with major central banks normalizing interest rates, there's just no value in being long duration, so overall all of our portfolios are short duration.

In terms of credit risk, we do not see any cheap sectors, but individually we are finding cheap bonds. However, we have been reducing investment-grade corporates more recently. Our only investment-grade exposure would be floating-rate structures in corporate bonds, or bonds issued by companies that give us the ability to have the greater of fixed or floating rate — again taking advantage of a rising rate environment.

Given the strong domestic backdrop, we have a small allocation to preferreds, just for absolute yield, some selected convertible bonds, given the strength in the equity markets, and a decent allocation to high yield, with a focus on double B and single B issuers.

Today, selectivity is important in global fixed-income markets. In emerging markets especially, that means not lumping all EM into a single basket. For example, we are avoiding Turkey, South Africa and Argentina, while preferring Mexico and Indonesia. In developed markets, such as Europe, that may mean avoiding Greece and Italy while preferring Hungary, Portugal and Ireland. In all three of those latter countries you can pick up positive yield.

And in foreign exchange, we're being more tactical, which we believe offers a lot of return potential over the next year, as we see more volatility as a result of global trade tensions and country-specific political events.

Don Sheridan: We are seeing opportunity away from U.S. core — not abandoning U.S. core, but certainly looking to capitalize at the margin in areas like emerging market debt and private credit. We find those opportunities extremely interesting. Private credit, with its first lien position, or senior-secured-type propositions, we like the net internal rate-of-return projected story there.

As for other sectors, we're pretty neutral across the board. The challenge is to find the right skill set to avoid idiosyncratic risk and to find the right blend of assets, particularly in the below-investment-grade space. Within structured credit, as the consumer spends more, areas of asset-backed securities become more appealing — that is a structural component in a lot of bar-belled portfolios. Other areas, like collateralized loan obligations, present interesting opportunities in structured credit as well.

We continue to advocate for moving away from core at the margin, recognizing that ultimately you want to have a high-quality fixed-income portfolio. We continue to encourage our clients to be thoughtful about their willingness and ability to take risks. Don't become complacent. ■

This sponsored round table is published by the P&I Content Solutions Group, a division of Pensions & Investments. The content was not written by the editors of the newspaper, Pensions & Investments, and does not represent the views of the publication, or its parent company, Crain Communications.