Fixed Income Outlook for 4Q 2019

by Luís Casanova (41197) and Tomás Tavares (23927)

SUMMARY

All in all, central banks have eased less than was originally expect by the markets over
the last few months. This, combined with the fact that recent economic indicators
underperformed, has led to a rally in rates. This effect was more felt in Europe and Asia.
The U.S. has generally outperformed expectations, as shown in the graph below.

OUTLOOK
The ever-present concern regarding possibly increasing trade tensions dominates the
market sentiment. Governments are reticent to ameliorate the situation using fiscal
tools, thereby leaving central banks to handle a possible recession by using their rate
setting mechanisms. Central bank rates could go really low, possibly even 0% in the U.S.
and negative in many European countries.

The above referenced trade war has resulted in a global downturn in manufacturing and
trade. Expecting that the U.S. and China won’t find a compromise that would eliminate
the tariffs, we turned our attention to what impact could this situation have on the
consumer and service industries. As for the former, since unemployment is, and has
been, very low, wages have been trending upwards, and consumer confidence is high.
Due to this factors, a further cut in rates could improve the consumer balance sheet.

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Already, mortgage refinancing in the U.S. and the surge in asset prices have been
generating a wealth effect across savers, but we worry that the growing impact of tariffs
may cause companies to cut their labour forces to shed expenses.

Central banks’ monetary policy should diminish the downside of the trade wars, but it
can’t, by itself, stop a recession. In our view, because we are late in the economic cycle,
fiscal stimulus should be the preferred method of staving off a recession. Because of the
high deficits and debt-to-GDP ratios observed in many European countries, fiscal
stimulus is not appealing to its governments. When it comes to the U.S., political
divisions are plentiful, and being seen collaborating with the other side, even to the
betterment of the economy, can end a politician’s career.

How far can monetary policy go?

We are of the opinion that central banks will have no choice increase money supply until
governments decide to expand. Both the ECB and the Fed could, presumably, keep
expanding their balance sheets into the trillions per year. As it stands, we believe that
inflation is not as impeding a problem as a recession and for that reason central banks
shouldn’t refrain from increasing liquidity because of inflationary fears.

RISKS
We are of the opinion that the biggest risk are trade tensions between the U.S. and
China. They could escalate in the coming months and threaten to slow down growth in
both countries and extend to Europe and South America. Tangentially related is the fact
that the U.S. could extend those tariffs to Europe further compounding the effects
described above.

The other major concern is a slow reaction by central banks in case the economy does
slow down. They could think that fiscal policy could be a better solution to solve growth
issues and decline to decrease rates.

A third concern is, as usual, Brexit. Recently, the Supreme Court dealt a blow to the PM
Boris Johnson by declaring his suspension of Parliament unlawful. It’s still unclear how
this affect the markets in the near future, for this reason we advise to stay away from
UK rates.

YIELDS RECOMMENDATIONS
When we talk precisely about rates, either, U.S government bonds and U.S agency
mortgages, we think they should be underweight in your portfolio. This is explained by
the market expectations of Fed being excessive, turning treasury valuations prudent,
particularly in shorter maturities. Falling rates have impelled mortgage prepayments
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and shortened asset maturity. Higher-coupon mortgages have been particularly hit.
With this, it’s recommended the latter for long-term asset allocation purposes of the
high-coupon mortgages. On the other hand, U.S municipal bonds are outperforming.
That is due to benign supply dynamics, seasonal demand and broadly improved
fundamental making treasuries rally. In addition, the tax renovation has also made
municipal bonds tax-free more attractive.

Analysing the credits such as U.S investment grade, high yield and securitized assets all
transmit good performance. Investment-grade credit is still a key component of income
correlated with easier monetary policies that may extend the economic expansion.
Observing the high yield and according with the monetary policy there is a favourable
backdrop to take advantage off. In specific, BB-rated bonds are ideal since they offer not
only attractive income, as also, lower vulnerability to risks associated with decelerating
economic growth. Securities like residential and commercial mortgage backed securities
(RMBS and CMBS), collateralized loan obligations (CLOs) and whole loans, as well as
asset-backed securities (ABS) are also assets to take in account for their attractive yields
and income potential.

Likewise, Emerging market Bonds have also income potential, sustained by the growing
global economy that have stimulated local rates to rally, despite rising geopolitical risks.
There are opportunities in Latin America and in countries not directly exposed to U.S.-
China trade tensions. Moreover, Asia fixed income is also outrunning induced by the
currency stability and steady growth in China. The outcome goes in a way to move up in
quality across credit, while maintaining long credit risk contained.

Source: Blackrock Investment Institute

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References:

https://www.blackrock.com/us/individual/insights/blackrock-investment-institute

https://www.gsam.com/content/gsam/us/en/institutions/strategies/explore-by-asset-
class/fixed-income.html

https://www.gsam.com/content/dam/gsam/pdfs/common/en/public/articles/global-fixed-
income/gfi-weekly.pdf?sa=n&rd=n

https://am.jpmorgan.com/us/en/asset-management/gim/adv/insights/portfolio-
insights/global-fixed-income-views

https://www.thecapitalideas.com/category/fixed-income

https://blogs.cfainstitute.org/investor/2019/05/07/bond-compass-the-fixed-income-outlook/

https://www.rbcgam.com/en/ca/article/global-fixed-income-markets-fall-2019/detail