From a fraught geopolitical landscape to a global slowdown, the major systemic risks in today’s investment landscape are impossible to ignore. We expect such risks to contribute to persistently low and negative yields as well as to bouts of volatility in 2020. With bond yields near historic lows, can fixed-income markets generate solid returns without forcing investors to take too much risk?
Evaluating Systemic Threats
Populist policies and geopolitical tensions—in many ways intertwined—are on the rise. Weaponized conflict isn’t the only risk. The trade war between the US and China has hurt global trade, causing business confidence to falter and manufacturing output to decline. Trade-sensitive economies such as Mexico and the euro area have been hurt the most, while ironically China and the US have seen less damage.
Washington and Beijing made progress toward a trade deal late last year, but some manufacturing indicators that have stabilized since then have done so at levels consistent with contracting output. At any rate, recent progress could reverse with a single presidential tweet.
Could the outcome of the 2020 US election resolve the volatility generated by a populist policy thrust? We don’t think so. Both wings of the US political spectrum support a shift toward trade protectionism, for example, while the center remains skeptical. Furthermore, the rise of populism is a global theme, as evidenced by the continuing and messy Brexit saga. According to the Tony Blair Institute for Global Change, the number of populist leaders around the world has increased fivefold since 1990.
Not coincidentally, the world economy now faces a challenging year and may be entering a protracted period of slower growth. A global slowdown could leave the world even more vulnerable to adverse shocks.
Central banks have sprung into action, and we may see further monetary easing this year. But it will be tough for easier monetary policy to be effective at a time when interest rates in much of the world are already at or below zero. And aggressive fiscal stimulus appears to be off the table, for now.
The picture isn’t entirely gloomy, however.
As measured by the steeper US yield curve, the market thinks the risk of a US recession has receded. We do too. US and other developed-market consumers continue to spend, and the US labor market in particular remains healthy.
In addition, China has targeted a real GDP growth rate of 6% for 2020. Meeting this target will require continued acceleration in policy easing in response to downward pressures, both internal and external. We expect Chinese stimulus to spill over to developed- and emerging-market economies and assets, thus helping to stabilize the global economy in 2020.
Nevertheless, it would be premature to declare that the world economy has turned a corner; the immediate threats we have identified reflect long-running trends.
Accordingly, bond yields are likely to stay low for some time, while market volatility should remain high. But investors can still earn a decent return in their fixed-income strategies.
The 10-year Japanese government bond, for example, began the last three years with a yield near zero, and 11 of the last 12 years with a yield below 1%. But annual returns over this period averaged more than 2%. Likewise, falling yields in Europe have led to healthy price appreciation. The yield on the Bloomberg Barclays Euro–Aggregate Treasury Index began 2019 at 0.74% but earned a total return for the year of 6.77%.
It’s also important to “hold duration”—that is, to have exposure to the risk that interest rates will rise or fall—when there’s significant uncertainty on the global geopolitical stage. During periods of market turbulence, government bonds’ duration serves as an offset to equity and credit market volatility, mitigating downside risk.
But investors shouldn’t hold only government bonds. They should also take advantage of dislocations in credit-sensitive sectors that offer an appealing mix of yield, quality and downside protection potential. Two that we find attractive today are US securitized assets backed by commercial and residential mortgages and subordinated European bank debt.
Securitized assets have been a good way to offset trade-war-related volatility. Commercial mortgage-backed securities (CMBS) and credit-risk-transfer (CRT) securities have weathered the ups and downs of the US-China trade war better than US high-yield credit. They also have low correlations with other fixed-income sectors and other asset classes.
CMBS can boost portfolio income, as they offer a healthy yield pickup over corporate bonds. The sector has been out of favor in recent years, in part due to fears around a retail apocalypse—concerns that our research indicates are exaggerated.
Investors may also want to consider exposure to CRTs, residential mortgage¬-backed bonds issued by the US government-sponsored enterprises Fannie Mae and Freddie Mac. CRTs benefit from a still-solid US housing market, among other positive factors. Home affordability has improved in most regions, and while minor corrections in some high-income areas of the country may slow home-price appreciation, they’re unlikely to stop it outright.
We also think investors can boost yield potential without taking too much risk by allocating to subordinated European bank debt. These securities were issued to comply with the global Basel III regulations that required banks to build up equity capital buffers. Because they’re lower in the capital structure, subordinated bonds issued by investment-grade banks offer yields like speculative-grade securities. In fact, yields on European additional Tier 1 (AT1) bonds, the first securities that would take a hit if the issuing bank ran into trouble, comfortably outstrip those on European and US high-yield bonds.
And developed-market banks are broadly in good health today, making the risk/reward trade-off attractive. European bank debt is particularly attractive because European financials are in a slightly earlier stage of the credit cycle than their US counterparts.
What other credits look attractive in the later stage of the credit cycle? Perhaps surprisingly, BBB corporate bonds, which offer yields like those in the high-yield market. Many of these companies have prioritized debt reduction and still have healthy earnings. Within the high-yield market, shorter-maturity high-yield bonds may see more muted volatility.
Lastly, the dovish tilt by developed-market central banks is broadly supportive of emerging-market debt. The economic fundamentals of emerging-market countries have also markedly improved in recent years. We think these assets may get an added boost as monetary policy around the world gets even easier in 2020.
Putting It All Together
The era of low yields and the investment challenges they bring to fixed-income investors isn’t likely to end soon. But selective investments across regions and sectors, as well as a suitable balance of interest-rate-sensitive and credit-sensitive holdings, can reduce volatility and increase return potential as the world economy loses momentum. In an age of uncertainty, that’s a ray of light—even without 2020 vision.
- Scott DiMaggio
- Co-Head—Fixed Income
- Gershon Distenfeld
- Co-Head—Fixed Income & Director of Credit