Investment Insights

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2020 Fixed Income Outlook: 

Staying positive amid the negative

By Jim Cielinski/Janus Henderson Investors

Negative rates and weak economic data paint a challenging backdrop, but there is room to be positive within Fixed Income, an asset class that can tolerate mundane conditions.

Incongruous Highs and Lows

The latter half of 2019 was full of contradictions. U.S. equities hit record highs with labor markets in robust health, yet many purchasing manager indices were in contraction territory and the Chinese economy grew at its slowest pace in 27 years. Worryingly, the U.S. yield curve inverted, with the 2s10s spread turning negative in August – historically, a harbinger of recession.

The inversion has correctly signaled a fragile global economy. Yet it also reflects why the Federal Reserve (Fed) has been swift to act, rapidly cutting rates to reverse the (overly aggressive) tightening in 2018. Central banks worldwide have mirrored the U.S. pivot: In 3Q19, 56 out of 62 rate moves were cuts, whereas in 3Q18, 27 out of 31 adjustments were hikes.

The Trade Smokescreen

We believe economic weakness in 2019 was a lagged response to earlier monetary tightening in the world’s two largest economies – the U.S. and China. With both now firmly in easing mode, we would look for some recovery. The trade war raised costs, reconfigured investment flows and exacerbated the global slowdown but did not cause it. If trade is resolved, but weak growth persists – indicating that the global slowdown is more structural than originally envisaged – expect credit spreads to widen and government bonds to rally.

The market’s consensual calm could be disturbed if the unemployment shoe drops. Consumption has been pivotal in protecting the U.S. economy in contrast with weakness in export-driven Germany. The latter’s sensitivity to fragile global growth means the European Central Bank (ECB) is expected to stay highly accommodative. New ECB president Christine Lagarde’s stark defense of negative rates suggests no departure from her predecessor’s policies. This should anchor eurozone sovereign yields around the zero bound. We expect Lagarde to repeat calls for more fiscal stimulus to assist the bank’s monetary policy; low government debt burdens in Northern Europe at a time of political angst will make these calls increasingly difficult to ignore.

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Elsewhere, policy effectiveness is struggling in China. Regional bank failures have led to tighter credit conditions, dampening the impact of policy easing. Emerging market debt – so closely linked to China’s fortunes – could become more attractive if the transmission mechanism of looser policy can gain traction.

Wage growth appears to be peaking and forward rates suggest inflation will be contained in most developed markets. We believe consensus is correct, and central bankers will continue to undershoot inflation targets. The Fed will likely make one or two additional cuts in 2020, which should bring the real rate more firmly into negative territory.

With the Fed cutting, the yield curve should steepen, offering potentially welcome news for bank margins. For insurers and pension schemes, for which the nominal level of sovereign bond yields is important, the search for yield will continue, driving investors further down the credit spectrum and out in duration, building up risk in the system. 

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Active Management

The decline in rates brought forward gains in 2019, but risk-free rates measured in mere basis points in many developed markets (and negative in Europe) present a meager foundation on which to build returns. A more active investment approach will be required to identify markets where real yields persist and where central bank policy rates are expected to head lower. We are not predicting a global recession in 2020, but that does not preclude individual sector recessions (i.e., energy in 2015), and sufficiently avoiding associated spread widening will be key. 

Where we preach particular caution is toward valuations. The market is scarcely distinguishing between BBB and BB issuers in terms of cost of capital, creating little incentive for companies to retain investment-grade metrics. With both investment-grade and high-yield credit spreads encroaching on the tightest levels of the cycle, there is also little cushion should markets be hit by a shock – which may be likely in a U.S. presidential election year. 

A Focus on Fundamentals

Dispersion should remain a feature, and avoiding losses will be critical as disruption continues. The defaults in 2019, such as travel company Thomas Cook, were symptomatic of how technology and shifting consumption patterns are reshaping the world. Lending to companies that will be around tomorrow requires investors to be on the right side of change. In our view, that means monitoring both traditional metrics and what matters to future investors and consumers, including environmental, social and governance factors.

While the low real yield environment lessens default risk, we see diminishing gains from refinancing, particularly in Europe. Corporate borrowers must increasingly rely on cash flow over financial engineering to support their debt. In the U.S., the return on equity remains below the cost of equity capital, and this will continue to encourage share buybacks over capital expenditure. Bond investors will need to monitor whether proceeds from borrowing are being used for bondholder-friendly purposes or are worsening the balance sheet. 

No Repeat Offenders

The search for yield will force investors to look across the entire range of Fixed Income, and could result in increased interest in asset- and mortgage-backed securities. True, excessive mortgage debt was behind the Global Financial Crisis, but it is atypical for a sector to reoffend so soon. Unlike corporate credit, the debt build-up in this cycle has not been in U.S. mortgage credit.

The global economy is at a critical juncture, and investors should keep an eye on key signposts. Labor markets and incomes will be important corroborating indicators of recession while geopolitics and sentiment shifts will likely produce market disruption. Even at low yields, developed market sovereign bonds should continue to offer diversification to Equities, although more credit-sensitive areas would be vulnerable in an equity correction. A low-yielding world might reduce nominal returns, but it will not eliminate opportunities, except for those that refuse to adapt to the new framework.

The opinions and views expressed are as of the date published and are subject to change without notice. They are for information purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation to buy, sell or hold any security, investment strategy or market sector.

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