Fixed Income Outlook

Reassessing the Economy and The Fed

In the fourth quarter, the outlook for the economy and the Fed changed.

Growing trade tensions between the U.S. and China as well as uncertainty over the Brexit issue clouded the outlook for global growth. The narrative changed from “the U.S. will bring the global economy up” to “the global economy will drag the US down.” Interest rate sensitive sectors of the U.S. economy, such as housing and autos, began to slow as the result of interest rate hikes that began in December of 2015. The market grew concerned that the Fed was not responding to the changing economic environment and would raise short term interest rates too far and further damage the slowing economy.

The result of the changing outlook in the fourth quarter hit the markets hard. Credit spreads widened in both the investment grade and high yield bond markets as stocks declined. The yield of the 10-year U.S. Treasury Note dropped from over 3.00% to 2.68% as safe haven buying from the risk markets flooded into riskless US Treasuries.

Fed Chair Powell’s comments at the December 19 post-FOMC press conference upset the markets. Powell indicated that the Fed would likely raise short-term interest rates in 2019 by 0.25% or 0.50% and the reduction of the Fed’s balance sheet (that ballooned under quantitative easing during the financial crisis) was on “auto-pilot.” The markets took Powell’s comments as being out of touch. The markets were concerned the Fed would increase short-term interest rates too far and further choke the slowing economy. However, on January 4th at an economic conference Mr. Powell walked back those comments and indicated the Fed was data dependent and did not have a predetermined course for interest rate hikes. Those comments triggered strong rallies in risk assets, both equity and fixed income.

Looking forward, the path of interest rates and the credit markets will depend on how the US economy holds together. Mr. Powell commented on January 10th that he did not foresee a recession in the US in 2019. Barring the US economy entering a recession, we do not expect the yield curve between the 2-year and 10-year Treasuries to invert. Rather, we expect the curve to stay slightly positive. The most likely path for the 10 year U.S. Treasury is to trade in a range similar to 2018, roughly 2.75% to 3.25%.

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Municipal Market Update

The municipal market had a late fourth quarter rally to finish the year on a positive note. Municipal yields peaked in late October on strong economic growth and the expectation that the Federal Reserve would continue on its projected tightening path. However, over the past two months, the market has reset its growth expectations lower. Fears over a global slowdown, increased volatility in the stock market, uncertainty over rate hikes and the government shutdown have created a rally in the Treasury market, pushing yields lower.

November and December proved to be pivotal months for the municipal market. Year-to-date through October 31st the ICE BofAML 1-10 Year AAA-A Municipal Index returned -.19% and the 10-year AAA General Obligation (GO) peaked at 2.73%. Market sentiment began to change in November sparking a rally in the bond markets. The yield on the 10-year AAA GO declined 45 basis points in the last two months of 2018 to finish at 2.28%, while the 5-year AAA GO declined 36 basis points to 1.94%. As a result of declining yields, the BofAML 1-10-year AAA-A index posted a positive fourth quarter return of 1.51% and finished the year up 1.59%.

Several factors that contributed to the firmer municipal market in the fourth quarter could remain in place for 2019. After a lull in new issue supply during the fourth quarter, the new issue calendar is starting to build. While dealers are expecting an increase in new issue supply for 2019, the elimination of municipal refinancing is keeping annual supply levels below historical averages. Investor demand for municipal debt continues to be steady with the recent volatility in the stock market. Municipal bonds remain appealing to many high-net worth investors thanks to their lower volatility and steady tax-free cash flow.

Bonds from states with high state income taxes continue to be in demand as the chance of further tax reform diminishes. Municipal credits remain strong as state tax collections increased the most since 2013. A lower, but positive, GDP forecast along with a more dovish tone from the Fed has been positive for bonds and could provide rate stability in the short-run. If the expansion has more legs than is being priced in the market, rates could push higher. However, we expect the Fed to react quickly if the economic numbers are better than expected.

Investment Grade

Investment grade new-issue supply was fairly active in October and November, but diminished after the Thanksgiving holidays, resulting in a relatively dormant December. 2018 ended with a total of $1.08 trillion in new supply coming to market, about an 11% drop from last year’s record levels. Higher borrowing costs and repatriation of cash from overseas accounted for the drop. Nearly 85% of the decline in corporate new issuance was a result of repatriation of cash from overseas. We do not expect this trend to continue in 2019 due to various political headwinds. In the near-term, the government shutdown and trade disputes may keep downward pressure on issuance in the near-term. Yet, it would be a surprise to see supply stay muted again for a full calendar year.

The fourth quarter saw credit spreads widen to levels not seen in 18 months as tariff concerns and equity volatility weighed heavily on the market. This was further magnified by investment-grade fund outflows that were the highest in two years in late December. December is a time when the market is typically thinly traded and firms are thinly staffed due to the holidays, so any major inflow or outflow of supply can cause spread movements to be magnified. With corporate fundamentals and economic numbers both still looking solid, overall spreads have probably pushed too wide, and near-term tightening in spreads should be seen as trading activity returns to normal.

High Yield

Credit spreads in the high yield sector ended 2018 near their year-to-date “wides” at levels not seen since mid-2016. Along with the volatility in equities, the high yield market has taken its cue from a weakening commodities sector, primarily oil. High yield new supply also saw a rare occurrence as December was the first month in 12 years with zero issuance. According to the Securities Industry and Financial Markets Association, the high yield sector as a whole saw just over $165 billion priced for the year, a significant drop of nearly 40 percent from 2017. Spreads should tighten during the first quarter as high yield bonds continue to show strong fundamentals, including low default rates. However, seeing positive momentum in the equity and oil markets would help to sustain any recovery in the high yield sector in the long-term.

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BBVA Compass is the trade name for Compass Bank, Member FDIC, and a member of the BBVA Group. Securities products are NOT deposits, are NOT FDIC insured, are NOT bank guaranteed, may LOSE value and are NOT insured by any federal government agency.

This material contains forward looking statements and projections. There are no guarantees that these results will be achieved.

Investing involves risk including the potential loss of principal. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary.  Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.

Indexes are unmanaged and investors are not able to invest directly into any index.

International investing involves special risks not present with U.S. investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.

Investments in stocks of small companies involve additional risks. Smaller companies typically have a higher risk of failure, and are not as well established as larger blue-chip companies. Historically, smaller-company stocks have experienced a greater degree of market volatility than the overall market average.

Equity investments tend to be volatile and do not involve the guarantees associated with holding a bond to maturity.

In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.

Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors.

The investor should note that vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.

Municipal bond offerings are subject to availability and change in price. If sold prior to maturity, municipal bonds may be subject to market and interest risk. An issuer may default on payment of the principal or interest of a bond. Bond values will decline as interest rates rise. Depending upon the municipal bond offered, alternative minimum tax and state/local taxes could apply.

The price of commodities is subject to substantial price fluctuations of short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.

Investments in real estate have various risks including possible lack of liquidity and devaluation based on adverse economic and regulatory changes.

Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), BofA Merrill Lynch U.S. Treasuries 1-10 years, BofA Merrill Lynch U.S. Agencies 1-10 years, BofA Merrill Lynch U.S. Corporates 1-10 years A-AAA, BofA Merrill Lynch U.S. Municipals 1-10 years A-AAA, Russell Top 200 Index, Russell 1000 Index, Russell Midcap Index, Russell 2500 Index, Russell 2000 Index, Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).