We live in a world of inverted yield curves, contracting business surveys, global trade, and falling earnings and CEO confidence. After more than ten years of expansion, the probability of a 2020 US recession has risen. Fixed income is traditionally an excellent investment heading into downturns, as prevailing returns have demonstrated once again.
Yet uneven prospects for different fixed income segments suggest an active manager’s market in 2020, given rising corporate leverage and disparities in global government bond yield levels. We explore the opportunities, and risks, if the R word were to hit.
Global growth and many risky assets peaked this cycle in early 2018. Yet the data – and markets – have moved in slow motion since. While cracks appeared two years ago, they are still only just starting to spread. Rates markets have moved, but investment grade credit spreads have not. CCC spreads are now distressed, but the rest of high yield still looks priced to perfection.
In EM, the hunt for yield is still on, despite the halving of bond prices in Argentina. Global growth has softened but there has been no sudden stop. Yet, if the US enters a recession, despite ample time to prepare, very few markets appear priced for it. Many fixed income sectors – be they governments, sovereigns, EM, credit or FX – have a large embedded cyclical component. If recession hits, investors should get ready for some big moves.
In government bonds, longer-dated treasuries initially perform well into slowdowns. But if the data keeps softening, the front end then starts to discount more aggressive Fed easing (see the figure below). Rising fiscal deficits during recessions and eventual expectations of recovery typically lead to curve steepening. So two-year bonds become the sweet spot.
Very few economists expect Fed Funds to fall from the current 1.75% upper bound to below 0.50% in 2020. Yet that would be our central scenario in case the US economy slips into a recession. While this is not our base case, it remains a meaningful risk. By contrast, in core Eurozone fixed income markets, the ECB may soon be running out of room to cut further, after years of falling yields.
Policymakers are increasingly aware of the so-called ’reversal rate’, the point beyond which further rate cuts into negative territory may become counter-productive. This limits returns in German, Dutch and Swiss government bonds, among others. Our rates universe seems divided into markets with scope for falling yields – and strong returns – versus those without (see the figure below).
While the seeping uncertainty since early 2018 has been gradual, the penalties for allocating capital too far down the quality spectrum have now begun to increase. Argentina’s and Turkey’s currencies delivered negative returns in 2018, but the August 2019 Argentina outcome was much more severe. Similarly, in US high yield, the CCC underperformance versus BBs continues as global default rates start to rise.
There are risks ahead: S&P calculates so-called ‘weakest links’ (debt already rated at or heading into CCC territory) at a 10-year high; while the IMF estimates an unprecedented USD 19 trillion of corporate debt at risk of default in an adverse economic scenario.
Before running for the hills, bear in mind that even in severe recessions, the speculative grade default rate rarely rises above 15%, and for investment grade it is much less than that. But the lesson is that spread decompression is standard in bear markets as the deltas of different credit and emerging markets diverge, depending on their fundamental vulnerability. Should the much talked about downside risks finally materialize in 2020, a focus on quality – governments over credit, investment grade over high yield, BBs over CCCs and so on – will pay off.
Quality should receive extra support in European credit, where the ECB is reactivating quantitative easing. Geographically, we prefer to shelter ’under the umbrella’ of the ECB: if volatility rises, euro-denominated IG credit will have a superior Sortino ratio to other global credit markets. (Unlike a Sharpe ratio, the Sortino only measures downside volatility – this measure is helpful in fixed income where investors prize stability, and becomes ever more relevant when downside risks increase.)
Fixed income returns are typically excellent on the way into recessions. But we see clear winners versus losers: government markets with the potential for over 100 bps of central bank cuts (the US), countries which have not yet imagined a world of negative rates (UK) and those with positive real yields (China) should outperform.
Throughout fixed income, a focus on quality can both improve returns and reduce risk when heading into recessions. The alternative, in the weakest reaches of credit and emerging markets where cyclical vulnerabilities have built, can be treacherous. If we get a US recession in 2020, an active approach that discriminates will be critical.