Quarterly Update

Jan. 2019

Gregory S. Kaplan, Director of Fixed Income, Managing Director | Jan. 2019

Conditions Favor Better Fixed Income Returns in 2019

Muted but positive U.S. and global growth improves 2019 outlook

Volatility has created opportunities in certain sectors

Pause by Fed, mild inflation would aid fixed income returns

Fixed income returns were challenged in 2018 as rates rose in response to a combination of central bank tightening and strong economic growth spurred by fiscal stimulus. The bellwether 10-year Treasury yield began the year around 2.4%, peaked at 3.24%, and finished below 2.7% (see first chart). After tightening initially, credit spreads widened steadily after February on growth concerns, political turmoil, and monetary tightening. A less accommodative Federal Reserve raised rates four times and reduced its balance sheet by over $300 billion. While a headwind to longer rates, a tighter stance rewarded our liquidity management strategies as cash returned over 1.5%, and the curve flattened, playing into our core strategy of upgrading credit exposure, owning floating rate securities and taxable municipals, and establishing a maturity barbell.

With recession risk low in 2019 but deceleration in both U.S. and global economic growth already in motion, our previously unpopular call of a Fed pause in 2019 has become the consensus. This and softening inflation suggests that fixed income returns in 2019 should improve. We expect longer rates to be range-bound, no more than two additional Fed hikes, and further credit volatility. Security and sector selection will be increasingly important as manufacturing decelerates, volatility in the energy sector persists, and public pensions come under increasing scrutiny.

Fourth quarter volatility in risk assets improved valuations and made us more constructive on specific opportunities such as senior bank loans and their collateralized loan obligation (CLO) cousins. Domestic high yield, while cheaper, has not yet reached an entry point (see second chart). We also see value in specific maturities and issuers within the diverse emerging market debt space, including local currency exposure. These opportunities will likely lead fixed income returns in 2019 and serve as a valuable diversifier to other risk assets.

Overall we see a better year for fixed income, led by select opportunities and short-term liquidity management. Risks to our outlook include the pace of global economic deceleration, central bank surprises, and the political environment.


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Key Points

Muted but positive U.S. and global growth improves 2019 outlook

Volatility has created opportunities in certain sectors

Pause by Fed, mild inflation would aid fixed income returns

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Important Disclosures

The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. This presentation is not an offer to buy or sell, or a solicitation of any offer to buy or sell, any of the securities mentioned herein.

Certain statements contained herein may constitute projections, forecasts, and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Certain information has been provided by third-party sources, and, although believed to be reliable, it has not been independently verified, and its accuracy or completeness cannot be guaranteed.

Any opinions, projections, forecasts, and forward-looking statements presented herein are valid as of the date of this document and are subject to change.

There are inherent risks with equity investing. These risks include, but are not limited to, stock market, manager, or investment style. Stock markets tend to move in cycles, with periods of rising prices and periods of falling prices. Investing in international markets carries risks such as currency fluctuation, regulatory risks, and economic and political instability. Emerging markets involve heightened risks related to the same factors, as well as increased volatility, lower trading volume, and less liquidity. Emerging markets can have greater custodial and operational risks and less developed legal and accounting systems than developed markets.

Concentrating assets in the real estate sector or REITs may disproportionately subject a portfolio to the risks of that industry, including the loss of value because of adverse developments affecting the real estate industry and real property values. Investments in REITs may be subject to increased price volatility and liquidity risk; concentration risk is high.

Investments in Master Limited Partnerships (MLP) are susceptible to concentration risk, illiquidity, exposure to potential volatility, tax reporting complexity, fiscal policy, and market risk. Investors in MLPs are subject to increased tax reporting requirements. MLP investors typically receive a complicated schedule K-1 form rather than Form 1099. MLPs may not be appropriate investments for tax-advantaged accounts because of potential negative tax consequences (Unrelated Business Income Tax).

There are inherent risks with fixed-income investing. These risks may include interest rate, call, credit, market, inflation, government policy, liquidity, or junk bond. When interest rates rise, bond prices fall. This risk is heightened with investments in longer-duration fixed-income securities and during periods when prevailing interest rates are low or negative. The yields and market values of municipal securities may be more affected by changes in tax rates and policies than similar income-bearing taxable securities. Certain investors’ incomes may be subject to the Federal Alternative Minimum Tax (AMT), and taxable gains are also possible. Investments in below-investment-grade debt securities, which are usually called “high yield” or “junk bonds,” are typically in weaker financial health and such securities can be harder to value and sell, and their prices can be more volatile than more highly rated securities. While these securities generally have higher rates of interest, they also involve greater risk of default than do securities of a higher-quality rating.

Investments in emerging market bonds may be substantially more volatile, and substantially less liquid, than the bonds of governments, government agencies, and government-owned corporations located in more developed foreign markets. Emerging market bonds can have greater custodial and operational risks and less developed legal and accounting systems than developed markets.

As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money. Returns include the reinvestment of interest and dividends. Investing involves risk, including the loss of principal. Diversification may not protect against market loss or risk. Past performance is no guarantee of future performance.

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The Standard & Poor’s 500 Index (S&P 500) is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance.

Indices are unmanaged, and one cannot invest directly in an index. Index returns do not reflect a deduction for fees or expenses.

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