Like much of the first half of 2019, major market movements in the third quarter were dominated by the U.S.-China trade dispute and monetary policy. In the three months to September 30, the Thornburg Limited Term Income Strategy returned 1.30% (net of fees), slightly underperforming the 1.37% gain in the Bloomberg Barclays Intermediate Government/Credit Index. Over the last decade through September 30, 2019, the
strategy has returned 3.94% on an annualized basis versus 3.05% for the benchmark. This long-term outperformance results in a cumulative 10-year return of 47.17%, ended September 30, 2019, versus 35% for the index.
The U.S. Federal Reserve reduced its key rate 25 basis points (bps) in both July and September in what Fed Chairman Jerome Powell deemed a “mid-cycle adjustment” and an “insurance” cut, respectively. The
July reduction was accompanied by an earlier-than-expected end to the Fed’s balance sheet contraction. The press conference following the July meeting proved particularly eventful as Powell initially seemed to suggest the cut was “one and done,” but then clarified that it was neither that nor a long series of coming cuts, causing markets to gyrate. The September drop in the Fed funds rate and press conference went more smoothly, with asset prices neither jumping nor falling in response.
However, both rate decisions were met with a couple dissents and the July meeting minutes further suggest the case for lower rates was not crystal clear. Also, the September Summary of Economic
Projections (dot plot) median Fed funds projection suggests no further cuts for 2019. We believe another cut or two is likely by year end and futures markets are also pricing in at least one more Fed funds rate reduction in 2019.
The Fed’s actions are interesting for multiple reasons. First, Powell explained the cuts were made to counter low inflation and risks to the economy, largely from the trade war. Yet both conditions were present during the June meeting, when no action was taken. Low inflation, in fact, has been a persistent thorn in the side of policymakers for some time. To many observers, this explanation rings hollow and gives credence to the argument that perhaps the markets are leading the Fed rather than the other way around. Investors around the globe are ultimately left to ponder what “financial conditions” as a term actually means. When conditions are said to be tight, does that imply the S&P 500 Index is too low? If the Fed fund futures market is pricing in a cut with increasing confidence, does it become a self-fulfilling prophecy because the Fed is loathe to disappoint, even when the merits of a reduction are debatable? Whatever the case, U.S. output does seem to be slowing along with the rest of the global economy amid the trade conflict and falling fixed investment, and with few signs of inflation breaking out, perhaps more easing might be helpful. However, a risk that policy makers must consider is the potential lack of firepower should the economy fall into recession and a prolonged easing cycle becomes necessary.
Two other significant developments in the realm of rates took place during the quarter. The two-year/10-year U.S. Treasury yield curve briefly inverted. This is traditionally viewed as a harbinger of future recession, but with “long and variable lags” as recessions haven’t typically materialized for another 12–24 months. Only time will tell. Moreover, the bond buying programs of the Fed and other major central banks may have disrupted
the predictive power of the yield curve. Recent non-economic bond demand has driven term premiums negative in the U.S. and significantly so elsewhere. With a more normal term premium, the curve would not likely have inverted and thus no recession signal would have surfaced. That said, we don’t appear to live in “normal” times.
Take, for example, the recent turmoil in short-term funding markets. In mid-September, overnight repurchase (repo) market rates spiked, dominating headlines around the globe. The immediate cause seemed to be an abnormally large U.S. Treasury settlement coinciding with a U.S. tax payment day, as U.S. firms (and, probably to a lesser extent, individuals) pulled cash from money market funds. The resultant large supply/demand mismatch caused rates to spike, leading to questions surrounding the health of liquidity markets. The Fed stepped in with a special overnight repo operation and an additional 14-day repo program, calming markets. While some have called this “quantitative easing” (QE), we disagree. The action was designed to fix a temporary market supply/demand imbalance, whereas QE was aimed at stimulating the economy. Policy makers are starting to acknowledge that bank demand for reserves is higher than originally thought. The Fed can solve this shortfall by allowing its balance sheet to grow along with the natural rate of the economy, just as it had in the past (see Chart 1).
Credit & Portfolios
Within corporate credit, recent trends persist. Investment-grade (IG) leverage continues to remain high and aggregate growth in debt necessitates a closer look. Since 2009, U.S. non-financial corporations have added $4.3 trillion in new debt, for a 66% increase. After a short pause during the market dislocation in the fourth quarter of 2018, growth in debt has resumed. A dearth of yield globally has kept demand for IG corporate paper generally strong. For example, despite being the fourth-largest month of issuance ever at roughly $160 billion, September saw spreads tighten five basis points. Unfortunately, we may see leverage move somewhat higher from here as total debt continues to grow while EBITDA (earnings before interest, taxes, depreciation and amortization) growth slows along with the broader global economy. Spreads, while
off recent lows, are still tight by historic standards, making all-in yields not particularly attractive. However, the market continues to provide select opportunities within corporates that have less-cyclical underlying cash flows.
Consumers, on the other hand, remain financially healthy with relatively strong balance sheets. Jobs are still plentiful and incomes continue to rise. Total debt is rising, as are loan delinquencies, but consumer credit quality underlying ABS (asset-backed securities) and MBS (mortgage-backed securities) remains solid. We believe credit underwriting and structure within these spaces are still favorable and especially so for our portfolios as we stay focused on the top of the capital stack. Spreads have recently tightened but remain absolutely and relatively attractive.
Overall, we remain defensive across portfolios, maintaining lower credit duration with a focus on defensive businesses. Currently we prefer consumer ABS and MBS over corporates, consistent with our preference for superior balance sheets. Duration in Limited Term Income remains skewed toward the lower end of our range as the relative value of increasing duration is currently muted. We did take advantage of recent rate volatility, removing some duration as the 10-year Treasury hit the 1.45% area and increasing it as the sovereign yield rose to 1.89%.
Risks remain elevated and the U.S.- China trade spat will likely continue to reverberate through global economies, increasing volatility and depressing fixed investment. Growth around the world is indeed slowing as evidenced by weak Purchasing Managers Index numbers abroad and challenged ISM Manufacturing Index data domestically. Additionally, the International Monetary Fund (IMF) recently trimmed developed world economic growth in 2019 to 1.9% and emerging market growth to 4.1%, with global growth estimated at 3.2%, all down from 2.2%, 4.5%, and 3.6% in 2018, respectively. And while the IMF expects better growth in 2020, it describes its forecast as “precarious.”
Looking forward, investors have to contend with BREXIT, the Hong Kong protests, talk around a potential U.S. presidential impeachment, and bouts of geopolitical turmoil, particularly in the Middle East. Not a backdrop most would find appealing, yet risk asset prices remain near all-time highs. Investors would do well to remember that uncertainty often breeds opportunity for astute investors with a long-term, balanced focus.
We believe our time-tested process will allow us to continue this trend for many years to come.