As we bring 2019 to a close and head into the new year, themes of deceleration and lower expectations continue as consensus growth expectations were trimmed for both 2019 and 2020. While this recalibration process can often set a bitter mood, it also sets a more realistic launch pad for 2020 economic comparisons. Our base case continues to call for growth in 2020 to be a trend-like, sub-2% year, but with no outright recession.
The trade situation with China fluctuates daily, oscillating constantly between positive and negative. Due to political influences, we see this continuing for the foreseeable future, keeping capital expenditures (a key factor of cyclical growth) subdued as well. Will the "phase one" deal reverse all that? We don't think so. We believe it remains an issue of symbolism vs. substance. China agreeing to buy some agriculture products in exchange for a lowering of some tariffs does not signal an all clear. Rather, it is analogous to the mid-2017 'early harvest' agreement between the US and China, which presented more optical pros than anything else. While optics are important, especially when they deal with the trade relations of the two largest economies, they don't relieve underlying issues that stem from substantive policy dispute (i.e., intellectual property, forced technology transfer, etc.).
Given the softening in aggregate output, combined with modest inflationary pressure, we believe the Federal Reserve (Fed) will trim its fed funds rate two times in 2020, bringing the terminal rate of the upper bound to 1.25%. We believe that the real neutral rate is zero to negative and thus further cuts are warranted to support a moderating growth picture.
On November 3, 2020, the US will hold elections that could lead to shifts in none, some, or all of the Executive office (President) and control of the House and Senate. Given the vast contrast of the political platforms, the policy picture for '21 could look substantially different depending on which party holds or wins power. While our base case calls for a status quo outcome, we readily acknowledge a dense fog around this prognostication. In economic terms, this means there is a wide distribution around the base case forecast.
Multi-Sector Portfolio Construction
The global economy looks to be basing during its third mini-slowdown after the Great Financial Crisis. As we see it currently however, growth acceleration will likely be much more muted, specifically for the US, this time around. Lower growth rates in the US continue to set the stage for further monetary easing, although the timing and pace of such cuts will be dependent upon macro developments.
Total returns in 2020 are unlikely to match those earned in 2019; however, we think coupon-type returns are still probable. With a broad range of return scenarios given political and other trade-related issues, we are keenly focused on identifying opportunities that generate alpha, excess carry and have the potential to deliver strong riskadjusted returns.
More populist policies are likely to remain going forward; however, we may have reached the nadir of the worsening trade rhetoric. Any version of a trade détente could begin to reduce economic and policy uncertainty. A broader recovery out of Europe and/or more fiscal stimulus should be watched, as the region, particularly Germany has the potential to be a driver of global bond yields.
Given our expectation of mildly steepening Treasury interest rate curves, but an unchanged ten-year year-over-year, we have lowered the difference between the portfolio and benchmark duration across the multi-sector portfolios. We still believe shorter-dated credit/carry positions offer a better risk-adjusted return profile over longer-maturity credit bonds for yield and return. An overweight to long-duration Treasury bonds can offset some of the duration risk.
The rate picture in the US is likely to be range-bound for a while. The Fed wants to maintain supportive financial conditions in order to drive inflation above 2%. Other major central banks are also likely to maintain accommodative policies, keeping the liquidity picture plentiful for a while.
It is helpful to remember why the Fed and other global central banks are keeping rates low and employing other measures to support the market—they want to increase inflation and inflation expectations which should ultimately lead to higher rates.
Some of our largest overweight positions continue to be securitized credit, where fundamentals have remained on solid footing and structural protections continue to be robust. Within corporate credit, company leverage ratios are elevated and, as earnings growth becomes more muted, credit selectivity will be key. Uncertainties around US-China trade negotiations, US politics, and Brexit may lead to volatility, providing attractive entry/exit points.
Investment grade corporates remain a core holding, but we are biased towards shorter-dated credit given our belief that its risk-adjusted return profile is more attractive than longer-maturity bonds. Within corporates, financials are favored given strong capitalization and expected lower event risk compared to industrials. Structured products continue to offer solid carry and return prospects and are supported by stable US consumer and property markets. Select high yield and emerging markets credits have solid carry and return prospects. Treasurys and agency MBS generally provide minimal excess return opportunities.
Expand the sections below for a detailed outlook of each sector.
Investment grade credit surprised many investors in 2019 by posting very strong excess returns as well as total returns. More than likely, last year’s strength will make this year’s excess returns harder to come by. Even so, we believe that by digging deeply into company fundamentals, we can identify some compelling opportunities within investment grade credit.
Over the past several years, market technicals have been a dominant driver of credit spreads. The supply/demand imbalance has created a favorable environment for risk assets, and we don’t see that worsening in 2020. In fact, supply forecasts for next year are coming in lower than 2019, particularly for net issuance. Demand can be harder to pin down, but for now, the US is still one of the last bastions of positive yield globally, and this is leading to strong foreign demand.
Company fundamentals will become more important as we get later in the credit cycle. Our expectations for slower domestic growth will likely lead companies to focus on internal initiatives to reduce costs and drive higher cash flow. We also believe it could be a catalyst for companies to address their high debt balances in order to stay nimble when the credit cycle finally ends.
From a valuation perspective, credit spreads look rich relative to their long-term averages, particularly when you factor in the higher duration and lower credit quality of the index. Sentiment is mixed; investors seem to agree valuations are stretched, but reluctantly put money to work because of their respect for the technical environment.
Given this backdrop, and the added volatility from upcoming US presidential elections, we have a neutral view on investment grade credit overall. We see potential for some credit spread widening next year, possibly eating away at some or all of the positive excess return. Deep fundamental research will be important in identifying outperforming credits.
We are optimistic on the outlook for US private-label securitized (ABS, CMBS, non-agency RMBS) over the coming year as the broad themes are generally positive. Fundamentals and technicals for most subsectors remain supportive while relative value considerations are positive. While a repeat of the total and excess returns of 2019 are unlikely, we believe exposure to private-label securitized will be an important tool for optimizing portfolio performance over the upcoming year, particularly from a risk-adjusted standpoint. Compared to other fixed income sectors, private-label securitized can offer an attractive relative value proposition through higher spreads with better credit quality, differentiated returns, and lower correlation, all of which have the potential translate to enhanced portfolio performance.
Private label securitized fundamentals remain on solid footing and are underpinned by stable property markets and healthy consumer balance sheets. Additionally, structural protections within securitizations remain robust and can provide an additional layer of protection. While credit trends in parts of the ABS market continue the process of normalization, they still remain in good shape from a historical perspective. Commercial real estate (CRE) fundamentals remain healthy, and are supported by positive NOI growth as well as steady property price appreciation. At the same time, CMBS underwriting standards remain stable and supports a constructive view of the sector. Within CLOs, deteriorating quality of the underlying leverage loans remains a slight concern even though defaults are low and will likely remain low in the near term given the presence of covenant-lite loans. On the whole, generally healthy fundamentals cast private label securitized in a favorable light in 2020.
Supply and demand technicals should remain supportive for private-label securitized in 2020. Similar to 2019, the low interest rate environment and stable job market is expected to support borrowing and gross issuance of structured products, while net issuance is likely to remain slightly positive. We expect non-agency RMBS issuance to continue to increase, while ABS and CMBS maintain more stable levels. Within ABS, we forecast a continuation of the recent trend shifting toward esoteric versus on-the-run consumer issuance. On the other side of the equation, demand (both reinvestment and outright) is expected to remain robust as investors search for highquality, positive-yielding fixed income assets.
From a valuation perspective, compelling relative value and lower volatility for private-label securitized compared to other fixed income risk assets remain consistent themes. Despite experiencing spread tightening in 2019, similar to broader risk assets, cross-sector private-label securitized remain off the tight end of the multi-year trading ranges. In the coming year, we expect private-label securitized spreads to be generally range-bound to slightly tighter (subsector specific), but carry will likely be a strong contributor to relative returns. Bouts of volatility are likely given various macro-related uncertainties; however, we expect private-label securitized spreads to widen less than other sectors during these periods.
While we are constructive on US private-label securitized, we continue to favor an up-in-quality investment strategy, particularly in low leverage deals/securities. We believe the combination of a healthy fundamental picture, a supportive supply/demand technical environment, and relative value considerations will continue to lend support to the sector.
Compared to private-label securitized, our outlook for agency MBS is a bit less sanguine. Despite spreads having widened from the all-time tights observed last year, MBS valuations remain stretched from a historical perspective. Given the FOMC continues to reduce their portfolio holdings in agency MBS by up to $20 billion per month and are likely to do so for the foreseeable future, we believe this technical overhang will remain a headwind to MBS performance in 2020. Additionally, while the US and China have announced a phase one trade deal, it remains to be seen if a phase two is possible. As a result, while phase one suspended the implementation of additional tariffs on Chinese imports and modestly rolled back others, it’s unclear if this will be permanent or if it signals a likelihood of further de-escalations of trade tensions. When these uncertainties are combined with other potentially disruptive events such as Brexit and 2020 elections, we see a very high potential for additional interest-rate volatility in 2020. Overall, this leads us to underweight MBS relative to other spread products within fixed income.
High yield fundamentals have been fairly steady over the past several years and we don’t envision that changing. Earnings have been decent in most sectors and leverage trends have been stable. Most high yield companies are benefiting from the drop in rates and have been able to lower their interest costs through bond refinancing and floating rate loan adjustments, which has led to historically strong interest coverage ratios.
However, certain sectors are facing greater challenges than others. Broadly speaking, domestically-focused sectors with US consumer exposure are seeing better times than many of the global cyclicals dependent on business investment. We believe many of the US consumer-related sectors will continue to benefit from a supportive fundamental backdrop—a strong job market, low interest rates and low commodity prices are likely to continue to fuel consumer spending. In addition, we think many of the cyclically challenged sectors, where earnings were down in 2019, will benefit from easier year-over-year comps, relatively healthy balance sheets, and optimistically, some decrease in the business uncertainty created by the trade situation. While individual credit selection is always paramount in high yield investing, on balance, the fundamental backdrop for the high yield market remains supportive going into 2020.
In addition to the healthy fundamentals, high yield market technicals should continue to be supportive in 2020. Further accommodative Fed policy support and no change to the extremely accommodative ECB and BOJ monetary policies, along with the enduring global search for yield, may keep investors looking to the high yield asset class for additional spread. While we don’t expect large inflows, sustained limited supply of new issuance could offset this demand.
From a valuation perspective, high yield appears to be fairly valued, despite relatively low all-in yields. Historically, the yield to worst (YTW) has been one of the most important indicators of future high yield returns; and after the significant move lower in YTW during 2019, we are apprehensive of the high yield market’s ability to repeat the performance experienced in 2019. While price appreciation is limited, the higher carry from coupon makes high yield relatively attractive versus other fixed income sectors.
Looking ahead, we see fundamentals for sovereign and corporates modestly improving based upon, what we believe to be, a slight cyclical economic upswing in the major developed economies and China. Without a substantial change away from a long-term trend of global trade, and more specifically Chinese trade, we remain cautious on the degree of fundamental improvement we see for most major emerging market economies. Of further concern for many emerging countries is how constrained commodity prices remain, with too few economies able to generate domestic growth in the absence of exogenous commodity price gains. There are select idiosyncratic stories that remain outliers to this general assessment, both positively and negatively, and we believe selection will remain key.
Valuations have, in large part, front run this sanguine outlook and we see limited scope for meaningful price performance from spread improvement unless the US dollar establishes a sustained weakening trend.
Past performance is not indicative of future results. This material is to be uses for institutional investors and not for any other purpose. This communication is being provided for informational purposes in connection with the marketing and advertising of products and services. This material contains current opinions of the manager and such opinions are subject to change without notice. Aegon AM US is under no obligation, expressed or implied, to update the material contained herein. This material contains general information only on investment matters; it should not be considered a comprehensive statement on any matter and should not be relied upon as such.
If there is any conflict between the enclosed information and Aegon AM US' ADV, the Form ADV controls. The information contained does not take into account any investor's investment objectives, particular needs, or financial situation. Nothing in this material constitutes investment, legal, accounting or tax advice, or a representation that any investment or strategy is suitable or appropriate to you. The value of any investment may fluctuate. Investors should consult their investment professional prior to making an investment decision. Aegon AM US is not undertaking to provide impartial investment advice or give advice in a fiduciary capacity for purposes of any applicable federal or state law or regulation. By receiving this communication, you agree with the intended purpose described above.
Results for certain charts and graphs are included for illustrative purposes only and should not be relied upon to assist or inform the making of any investment decisions.
Specific sectors mentioned do not represent all sectors in which Aegon AM US seeks investments. It should not be assumed that investments of securities in these sectors were or will be profitable.
Aegon AM US may trade for its own proprietary accounts or other client accounts in a manner inconsistent with this report, depending upon the short-term trading strategy, guidelines for a particular client, and other variables.
There is no guarantee these investment or portfolio strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest over the long-term, especially during periods of increased market volatility.
Investments in high yield bonds may be subject to greater volatility than fixed income alternatives, including loss of principal and interest, as a result of the higher likelihood of default. Value of these securities may also decline when interest rates increase.
All investments contain risk and may lose value. Structured Finance assets (such as ABS, RMBS, CMBS and CLOs) are complex instruments and may not be suitable for all investors. The assets may be exposed to risks such as interest rate, credit, liquidity, issuer, servicer, underlying collateral, prepayment, extension, and default risk. Investors typically receive both interest and principal payments for a security, and these prepayments may reduce the interest received and shorten the life of the security. Although some types of structured finance securities may be generally supported by a form of government or private guarantee, there is no assurance that guarantors will meet their obligations.
This article contains forward-looking statements which are based on the firm's beliefs, as well as on a number of assumptions concerning future events, based on information currently available, and are subject to change without notice. These statements involve certain risks, uncertainties and assumptions which are difficult to predict. Consequently, such statements cannot be guarantees of future performance and actual outcomes and returns may differ materially from statements set forth herein.
Aegon Asset Management US is a US-based SEC registered investment adviser and is also registered as a Commodity Trading Advisor (CTA) with the Commodity Futures Trading Commission (CFTC) and is a member of the National Futures Association (NFA). Aegon Asset Management US is part of Aegon Asset Management, the global investment management brand of the Aegon Group.
Recipient shall not distribute, publish, sell, license or otherwise create derivative works using any of the content of this report without the prior written consent of Aegon USA Investment Management, LLC, 6300 C Street SW, Cedar Rapids, IA 52499. ©2019 Aegon Asset Management US. Ad Trax: 2877804.1 Exp Date: 11/30/21.