Mounted-Revenue Outlook Q1 2019

Excerpted from Guggenheim Investments’ First Quarter 2019 Mounted-Revenue Outlook

Our final a number of installments have reiterated a central theme: The Federal Reserve (Fed), in search of to normalize coverage and mood above-trend financial progress, was heading in the right direction to trigger a recession that we projected would start within the first half of 2020. This timing is essential as a result of historical past has proven us that market situations usually deteriorate within the 12 months main as much as a recession. This meant we needed to handle round an overvalued market figuring out that quickly sufficient we'd see dramatic unfold widening and liquidity points.

Within the fourth quarter, this late-cycle drama started to unfold, and threat belongings offered off. After setting peaks in October, equities and credit score sectors started a wild experience down. The selloff intensified in December amid a extreme lack of liquidity. Earlier than the December Federal Open Market Committee (FOMC) press convention, the S&P 500 had set a brand new low of two,546. It took one other 7.7 p.c dive following a sequence of coverage blunders that included Fed Chair Jay Powell’s "autopilot" feedback in regards to the Fed steadiness sheet runoff, President Donald Trump’s assault on Fed independence, and Treasury Secretary Steven Mnuchin's name to main banks confirming that that they had enough liquidity. Monetary markets had zero tolerance for coverage errors in an already weak seasonal correction surroundings.

Studying from its mistake, the Fed will remember to quell any uncertainty round its insurance policies in 2019. The Fed has indicated it is going to transfer to the sidelines, and we anticipate it is going to ship just one extra hike later in 2019 and take away its steadiness sheet runoff from autopilot. This has calmed markets for now, however headwinds stay. International financial knowledge look more and more poor, with Europe main the way in which down. Extra coverage motion might be wanted to keep at bay the recession we see on the horizon. We put the chances of a Fed price reduce at 50/50, and we consider the European Central Financial institution (ECB) will introduce one other focused program to encourage financial institution lending.

The expertise we recount on this quarter’s Mounted-Revenue Outlook ought to function a preview of what's to come back when the cycle in the end turns. For now, we anticipate threat belongings to get pleasure from one other rally whereas the Fed stays on maintain, however the pause will solely permit excesses we now have highlighted earlier than to grow to be extra pronounced. The defensive positioning we established within the third quarter of 2018 will stay intact, which can allow us to keep away from the volatility that characterizes late cycle market conduct and provides us the chance to select up undervalued belongings when others are being pressured to promote.

-Scott Minerd 
Chairman of Investments and International Chief Funding Officer

Portfolio Administration Outlook 
Liquid and Affected person

Decreased unfold period of our funding portfolios helped dampen market volatility within the second half of 2018.

International financial knowledge weakened all through the course of the fourth quarter. Macroeconomic and geopolitical occasions, together with a commerce struggle between america and China, falling oil costs, and issues over slowing progress, triggered a broad selloff in threat belongings. Spreads widened throughout all sectors, whereas rates of interest fell over the quarter.

At its December assembly, the FOMC voted to lift the federal funds price by zero.25 p.c to a variety of two.25–2.5 p.c. On the press convention, Fed Chair Powell didn't convey flexibility across the Fed’s steadiness sheet insurance policies. The Treasury yield curve bull steepened as future Fed rate of interest hike expectations collapsed whereas threat belongings offered off additional. Newer Fedspeak, notably throughout the January post-FOMC assembly press convention, calmed markets by confirming knowledge dependence and adaptability round rate of interest and steadiness sheet insurance policies.

Threat discount in our portfolios continued within the fourth quarter and was concentrated within the first half of the quarter, previous to essentially the most important unfold widening. All methods pared again publicity to remaining credit score sectors, together with CLOs, non- Company RMBS, and different ABS, with proceeds going towards government-guaranteed sectors, and money and money equivalents. Consequently, portfolio credit score high quality additional elevated and unfold period was additional lowered over the quarter.

Within the Core Plus technique, long-duration belongings in our portfolio contributed to constructive absolute efficiency as charges past one yr fell between 20–45 foundation factors. Our funding technique continues to make use of a period barbell by allocating key price publicity on the very lengthy finish of the curve whereas remaining obese floating-rate publicity on the brief finish, leading to an underweight period relative to its benchmark. Whereas spreads widened in all credit score sectors over the fourth quarter, the Core Plus technique outperformed its benchmark on a ramification foundation as structured credit score spreads held in higher than company credit score spreads.

Within the Multi-Credit score technique, our prior threat discount program and comparatively low allocation to beneath investment-grade credit score led to relative outperformance over the quarter. Much like the Core Plus technique, our senior structured credit score publicity outperformed company credit score, notably AAA CLOs. Our brief unfold period helped dampen efficiency volatility.

We consider that the Fed will pause price will increase within the first half of 2019, with the chance that this pause might last more. Moreover, the potential for a price reduce can't be dominated out. Additional weak point in world financial progress might spill into the U.S. financial system, which might spur the Fed to react. Such occasions have occurred up to now. The Fed in the end reduce charges in 1995, within the aftermath of the Mexican peso disaster. Then, after a brief climbing cycle, it reduce charges once more in 1998 because of the spillover impact from the Asian monetary disaster.

The Fed pause is supportive of a rally throughout threat belongings within the close to time period, however it is going to additionally permit excesses to proceed to construct within the system. Lots of the regarding traits beforehand mentioned by our sector groups, together with the potential for top downgrade quantity within the investment-grade market and defaults in sure credit score sectors, stay on the forefront of our long-term pondering. On this surroundings the place we consider credit score spreads should not sufficient to compensate for these dangers, it's prudent to remain up in high quality and keep enough liquidity to select up undervalued credit throughout extra opportune occasions.

Mounted-income sector efficiency traits reversed course within the fourth quarter. Panicked promoting exacerbated market volatility as some traders tried to de-risk amid dwindling market liquidity.

-Anne B. Walsh, JD, CFA 
Chief Funding Officer, Mounted Revenue

-Steve Brown, CFA 
Portfolio Supervisor

-Adam Bloch 
Portfolio Supervisor

Macroeconomic Outlook 
It’s All Downhill from Right here

International progress has peaked, however a decent U.S. labor market will in the end immediate the Fed to tighten once more.

U.S. financial progress was stable at an estimated 2.6 p.c within the fourth quarter of 2018, however we anticipate first quarter progress to gradual to about 1.zero p.c. This stems partly from tighter monetary situations, however reported progress can also be prone to be weighed down by seasonal adjustment points together with the momentary impression of the federal government shutdown.

The excellent news is that sequential progress is prone to rebound within the second quarter as statistical and shutdown distortions are reversed. Nonetheless, progress is now on a downward trajectory in year-over-year phrases. The mix of tighter Fed coverage and fading fiscal stimulus will make sure that progress in 2019 is weaker than it was in 2018. Main indicators affirm that the height in progress is behind us (see chart, prime proper), and our recession forecasting instruments proceed to level to a downturn beginning by mid-2020. Nevertheless, there's a probability that a Fed pause might delay a downturn till late 2020 and even early 2021.

In the meantime, the regular softening in world manufacturing buying managers’ indexes illustrates how world progress momentum has pale (see chart, backside proper). Development in Europe is sputtering, and the continued Brexit saga remains to be unresolved. The regular slide in Chinese language progress has prompted authorities to announce a sequence of stimulus measures with extra forthcoming, however coverage lags will delay any constructive impression.

Towards this backdrop, the Fed has moved to the sidelines. A pause within the climbing cycle is probably going for the primary half of the yr, however we don't consider the Fed is completed tightening simply but. The labor market continues to strengthen, and we see additional wage positive aspects forward. And whereas core inflation ought to stay smooth in coming months, we anticipate it to rebound within the second half. Our baseline forecast now envisions yet another hike later within the yr. Additional price hikes could also be required in 2020 ought to inflation expectations start to rise meaningfully. Stability sheet runoff ought to conclude within the third quarter, with particulars prone to be introduced on the March assembly. This may allay market issues about steadiness sheet discount being on “autopilot.”

A extra affected person Fed and multi-pronged stimulus in China ought to foster a restoration in threat belongings within the close to time period. Moreover, the ECB might add liquidity via long-term refinancing operations (LTRO) or focused LTROs. This may assist our name for an Indian Summer season for threat belongings , which is characterised by the nice and cozy spell that follows a chilly snap. We see this as a window of alternative to additional de-risk portfolios in preparation for a 2020 recession.

Main indicators affirm that the height in progress is behind us, and our recession forecasting instruments proceed to level to a downturn starting in by mid-2020.

The regular softening in world manufacturing buying managers’ indexes illustrates how world progress momentum has pale.

-Brian Smedley 
Head of Macroeconomic and Funding Analysis

-Maria Giraldo, CFA 
Managing Director

-Matt Bush, CFA, CBE 
Director

Charges 
The Starting of the Finish

With yet another price hike anticipated by our macro analysis group, we consider that is the start of the top of the upward transfer in charges.

The fourth quarter of 2018 skilled a considerable enhance in capital market volatility. The poor efficiency of threat belongings drove a flight to high quality. Treasury yields declined 20–45 foundation factors throughout the curve, with the stomach outperforming as forward-dated FOMC price hikes have been priced out of the market (see chart, prime proper). Nominal yields declined greater than actual yields, because the broad transfer decrease in commodity costs drove a lower in breakeven inflation charges (see chart, backside proper).

The numerous transfer decrease in U.S. Treasury yields generated robust returns for the asset class, delivering a complete return of two.6 p.c for the quarter and leading to a complete return of zero.9 p.c for the yr. In the meantime, the Company index produced a complete return of 1.9 p.c for the quarter, and a complete return of 1.three p.c in 2018. Longer maturity Company public sale bonds weren't resistant to the selloff, as they cleared 20–30 foundation factors wider in unfold than comparable Treasury bonds.

Fed Chair Powell acknowledged that the December hike put short-term charges on the decrease finish of the FOMC’s estimate vary for the impartial price. Current expertise reveals a excessive sensitivity of modest price adjustments on financial exercise, supporting this assertion. Earlier work from our Macroeconomic and Funding Analysis Group discovered that given the extent of nonfinancial company debt to gross home product, U.S. corporates might solely assist charges someplace within the vary of two.50– three.25 p.c earlier than the rise in borrowing prices makes it troublesome to proceed to service heavy debt burdens. Thus, our Macroeconomic and Funding Analysis Group’s forecast of yet another price hike within the second half of 2019 suggests this could possibly be the start of the top of the upward transfer in charges for the cycle. Yet one more price hike implies that 30-year Treasury yields, at the moment three.00 p.c, will peak beneath three.25 p.c. It additionally leaves some room for the Treasury yield curve to flatten, however a lot of the flattening we anticipated to see on this cycle is behind us. The 2s/10s and the 10s/30s Treasury yield curves have flattened by 113 and 38 foundation factors, respectively, towards 225 foundation factors of financial coverage tightening since December 2015. As soon as the climbing cycle is over, we predict extra enticing shopping for alternatives will materialize across the stomach of the curve.

Notice: “Charges” merchandise consult with Treasury securities and Company debt securities. Treasury and Company returns are represented by the Bloomberg Barclays Treasuries index and the Bloomberg Barclays U.S. MBS index, respectively.

Treasury yields declined 20–45 foundation factors throughout the curve, with the stomach outperforming as forward-dated FOMC price hikes have been priced out of the market.

Nominal yields declined greater than actual yields, because the broad transfer decrease in commodity costs drove a lower in breakeven inflation charges.

-Connie Fischer 
Senior Managing Director

-Kris Dorr 
Managing Director

-Tad Nygren, CFA 
Managing Director

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