Improving economic conditions and accommodative central bank policies have led some investors away from relatively safe investments such as bonds. But is the economy really firing on all cylinders? And can investors still rely on loose central bank policies to drive growth? Viewpoints checked in with Tom DeMarco, CFA®, a market strategist in Fidelity Capital Markets’ fixed income division, about whether the recent sell-off in the bond market is warranted—and where fixed income investors may find opportunities.
|Q:||How have bonds performed recently?|
DEMARCO: During the past two months we’ve seen a steady sell-off in the bond market, and it has accelerated in recent weeks. I think the sell-off may be a bit excessive, particularly since economic data, as I see it, has been middling. Employment growth has been good, but has slowed in recent months. Core retail sales continue to grow, but the pace has been softening on a year-over-year basis since June. In looking at initial tracking estimates, I think we could see third-quarter gross domestic product (GDP) in the low 2% range, and fourth-quarter GDP could be even lower.
So why the shift higher in rates? In my opinion, the change is related to a key tenet of a relatively bullish outlook—central bank support. We’re seeing a shifting narrative when it comes to central bank actions, and that’s forcing a repricing in the fixed income market. Also, we’re seeing some stirrings of inflation—especially in the eurozone—where inflation hit a two-year high on a year-over-year basis, though the absolute level is still below the European Central Bank (ECB) target. Just a few weeks ago, the market was pricing in the next rate cut from the Bank of England; now that looks to be largely priced out. In the eurozone, markets have pushed back the next anticipated rate cut from the spring of 2017 to the fall of 2017. In addition, the concept of tapering ECB bond purchases has been introduced in the press. In the United States, statements from Fed members have added to this shifting narrative. Boston Federal Reserve president Eric Rosengren recently commented about using the Fed’s balance sheet to steepen the Treasury curve.
|Q:||Do you expect bond rates to keep rising?|
DeMarco: Given the relatively quick adjustment, technical factors are looking a little stretched to me. So, near term, we may see some consolidation, but I wouldn’t be surprised to see yields on the 10-year Treasury potentially make a run toward 2.0% or 2.1%, up from 1.75% in mid-October. That’s if the economic data holds together, and the apparent central bank narrative shift acknowledging the limits of current policies holds. However, should GDP growth in the fourth quarter come in below 2%, we may see bond rates fall in January as markets reassess the pace of rate hikes. Furthermore, there are still some structural issues holding down yields, from aging populations in developed markets to relatively high global debt levels.
As we head into 2017, we’re seeing some central banks attempting to back away from monetary policy and pushing fiscal stimulus as a path toward economic growth. I think the central banks are recognizing the limits of the unconventional policies they’ve used for the last several years. After all, the longer that rates are repressed, the more potential there is for some type of problem in the market, as highlighted by more than one Federal Open Market Committee (FOMC) member. And if rates remain artificially pinned down, central bankers lose a critical tool in their toolkit the next time a downturn comes.
|Q:||Can you highlight specific areas of optimism or concern in the economy?|
DeMarco: One bright spot is the employment situation. While it’s weaker than it was earlier in the recovery, the job market is hanging in there. Wages have been trending higher since 2015. While it would better to see higher wage growth this far into an economic recovery, wages are still moving in the right direction.
On the other hand, I’m concerned about the extremely low productivity growth in the U.S. economy, and relatively low levels of investment by companies. But those areas could change with the right mix of fiscal and monetary policy. The specific measures would depend in large part on the makeup of Congress, but we could see lower taxes and higher spending on infrastructure, as well as higher spending on some discretionary items. In fact, there appears to be support at the Fed for using this type of fiscal policy to boost certain areas of the economy. Fed vice chairman Stanley Fischer recently noted that fiscal and regulatory measures could be a key to boosting productivity.
|Q:||In August, you noted the unusual correlation between stock and bond returns. (Bond check-in: unusual times). Is that still the case?|
DeMarco: Now we’re seeing total returns on bonds taking a modest hit, as markets are reassessing both inflation risk and central bank support. In that environment, it would be reasonable to assume that stocks would be moving higher, since investors appear to be more confident in the health of the economy. But in the stock market, investors seem to be nervous about the potential for rising rates, especially against the backdrop of what has been an earnings recession. And while we may be coming out of the earnings recession, I think we may see profit growth continue to be challenged. Meanwhile, valuations remain relatively high: The price-to-earnings ratio (P/E) on the S&P 500 is just over 20 on a trailing basis and 18 based on forward earnings—well above the long-term averages. As a result, the positive correlation of returns between stocks and bonds may continue, at least in the near term.
|Q:||The municipal bond market has faced relatively strong supply for much of the year. How has the market been coping with that?|
DeMarco: Supply has increased sharply this year. Part of the reason is seasonal, as the issuance calendar traditionally builds around this time of year and redemptions fall off. The municipal market may push past $400 billion in issuance this year, in my opinion, and is on pace to be the second- strongest year for issuance on record.
The level of outstanding municipal securities had been declining since 2013, and appeared to bottom out and begin to rise this year. The recent imbalance between supply and demand has helped support relatively strong returns in the muni market. Now that technical support has been taken away, how the market responds depends on whether municipal issuers are disciplined in debt issuance plans going forward.
Meanwhile, muni bond funds recently had the first week of outflows in more than a year—it broke a streak of 55 consecutive weeks of inflows, during which muni bonds saw more than $37 billion of investment. The question is whether we’ll see a protracted outflow like we did in 2013 and 2011. I don’t expect that right now, but it’s worth monitoring.
|Q:||Where are you seeing opportunities in the bond market?|
DeMarco: Debt from highly rated private universities—those with credit ratings between AA and AAA—is appealing. These institutions aren’t facing the same types of pension and budget pressures faced by local governments. Meanwhile, private universities have more capacity to deal with potential enrollment issues.
Recently, Treasury inflation-protected securities (TIPS) have looked more attractive. Inflation could be moving higher, and central banks are resetting inflation expectations. In the credit markets, the stabilization and recovery in commodity prices may benefit sectors such as energy, and metals and mining.
The high-yield market has rallied in 2016, returning more than 15% through mid-October. As a result, it’s hard to find appealing values. That said, continued economic growth and the introduction of new fiscal policy measures could help sustain returns in the high-yield market through 2017. The high-yield sectors I find attractive include materials, paper and packaging, and commodities and mining. The increasing inclusion of technology in automobile manufacturing also makes the automobile component segment an interesting one to consider. I’m less interested in the consumer-goods sector because of relatively high valuations. The retail segment of the high-yield market may face challenges during the Christmas season, while airlines appear richly valued but appear to be facing declining revenue per seat.
Lower-quality debt securities generally offer higher yields, but they also involve greater risk of default or price changes due to potential changes in the credit quality of the issuer. As well, any fixed income security sold or redeemed prior to maturity may be subject to loss.
High-yield/non-investment-grade bonds involve greater price volatility and risk of default than investment-grade bonds.
In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk, and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible.
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