Core Fixed Income Outlook

July 23, 2019

Rate Cuts and Slow Growth? Likely. Recession? Unlikely.

The first half of the year saw a strong rally in bond markets, with prices rising and interest rates falling. Prior to May, the Federal Reserve (Fed) was not forecasting any cuts to interest rates. But an intensifying trade dispute between the U.S. and China raised concerns about economic growth globally and in the U.S.

By June, the central bank’s policymakers had grown increasingly divided. While the Federal Open Market Committee (FOMC) voted to leave interest rates unchanged at its meeting that month, 8 out of 17 members changed their forecast to at least one rate cut (typically 25 basis points) for 2019 — with seven of those members forecasting 50 basis points worth of cuts.

In a press conference following the meeting, Chairman Jerome Powell indicated that the members who were not forecasting a rate cut agreed that the risks for additional monetary policy accommodation had increased. Minutes that were subsequently released reinforced these concerns. We think it’s clear that the probability of a rate cut has dramatically increased since the beginning of the year, when the Fed forecast zero cuts.

Did the Fed Lose “Patience”?

Equity markets are at all-time highs, and credit spreads1 are near the low of their recent range. These conditions would not typically be seen as creating an environment where rate cuts are necessary. But, as the Fed acknowledged, uncertainties have intensified in the past month. Consequently, the FOMC’s June meeting notes omitted the word “patient” in describing its expected response to economic and inflation data — suggesting to market watchers that a rate cut could be on the horizon.Chairman Powell cited contracting manufacturing activity, heightened trade tensions, weakening investments, and declining business sentiment as areas of concern.

Yet in this environment, the labor market remains solid, consumers appear resilient, and the U.S. economy has continued to expand. The final reading for first-quarter gross domestic product growth showed a robust 3.1% gain,

which was unchanged from the prior estimate, while growth is expected to be slower but still positive for the remainder of the year.

The Fed contends that the labor market has been expanding at a moderate pace. Chairman Powell emphasized the U.S. consumer (considered a reliable economic indicator) as a bright spot, thanks to low unemployment and higher wages. Therefore, if trade tensions abate and the central bank still ends up cutting rates this year, it will likely be attributed to weaker inflation.

Meanwhile, investors have begun to favor longer-term bonds because they fear economic weakness and anticipate cuts in short-term interest rates — subsequently driving up prices for long-term bonds. As a result, shorter-term bonds have been paying higher interest rates than their long-term counterparts — a phenomenon known as a yield-curve inversion.

Exhibit 1: Inverted Yield Curve

Exhibit 1: Inverted Yield Curve

Source: U.S. Department of the Treasury. As of 6/28/2019.

The Fed is not alone in feeling pressure to support the economy by reducing interest rates to encourage borrowing (and the associated spending). Central banks across the globe, in developed and emerging countries alike, have been moving to more accommodative positions. For example, India’s central bank cut its policy interest rates amid a sharp slowdown in its economy. Similarly, with the eurozone economy softening, investors have been receiving signals from policymakers at the European Central Bank that it will soon become more accommodative.

Our Portfolios

Our investment-grade fixed-income managers do not see a recession on the horizon, but they do anticipate a low-growth and low-inflation environment. Within this context, they have marginally reduced exposure to securities considered as “higher risk.”

This effort has involved managers seeking opportunities to add to their highest-conviction investment-grade-debt positions. They often look to make purchases in the new-issue market (that is, newly-offered bonds) that may offer price concessions. While there is a lower level of newly-issued debt available compared to last year, issuance remains robust. Meanwhile, since yields declined in June, maturing debt has been carrying a higher coupon (that is, the interest rate paid to the bondholder) than new-issue debt. This presented our managers with a compelling reason to let duration (a measure of interest-rate risk) drift closer to neutral—which has lowered the Fund’s overall risk profile.

We remained overweight the securitized sectors (asset-backed securities and commercial mortgage-backed securities). Exposure to agency mortgage-backed securities (MBS) increased as a high-quality alternative to Treasurys, offering some yield advantage.

The allocation to non-agency MBS continued to benefit from improving wages, which tend to be supportive of the housing market. The sector has witnessed considerable price appreciation since the global financial crisis.

Our investment-grade fixed-income funds remained overweight to banks, primarily at the front end of the yield curve. If the yield curve steepens slightly, bank earnings would likely benefit.

Our short-term funds have been slightly short duration, but have continued to out-yield the benchmark as our managers rely on security selection to add value.

1 Credit spreads are the difference in yield between a U.S. Treasury bond and another debt security of the same maturity – but different credit quality. Wider spreads are reflective of heightened investor concern.

Definitions

Asset-backed securities: An asset-backed security is a security whose income payments and hence value are derived from and collateralized by a specified pool of underlying assets. The pool of assets is typically a group of small and illiquid assets that are unable to be sold individually.

Agency mortgage-backed securities: Mortgage-backed securities are collections of mortgages with similar characteristics that are packaged together, or securitized, and sold to investors. Agency mortgage-backed securities are either issued by a government-sponsored entity, such as Fannie Mae or Freddie Mac, or guaranteed by Ginnie Mae, a government agency.

Basis point: One basis point equals 0.01%.

Commercial mortgage-backed securities: Commercial mortgage-backed securities are a type of mortgage-backed security backed by commercial mortgages rather than residential real estate. Commercial mortgage-backed securities tend to be more complex and volatile than residential mortgage-backed securities due to the unique nature of the underlying property assets.

Duration: Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates. A bond’s duration is easily confused with its term or time to maturity because they are both measured in years. However, a bond’s term is a linear measure of the years until repayment of principal is due; it does not change with the interest-rate environment.

Legal Note

Important Information

This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice and is intended for educational purposes only.

There are risks involved with investing, including loss of principal. Bonds and bond funds will decrease in value as interest rates rise. Mortgage-backed securities are affected by, among other things, interest-rate changes and the possibility of prepayment of the underlying mortgage loans. Mortgage-backed securities are also subject to the risk that underlying borrowers will be unable to meet their obligations.

Information provided by SEI Investments Management Corporation, a wholly-owned subsidiary of SEI Investments Company. Neither SEI nor its subsidiaries is affiliated with your financial advisor.