Since 2008, many investors have bought bonds for capital appreciation
and equities for income—a reverse of historical norms. We believe we
are at the beginning of a long transition as both asset classes return
to their traditional roles. In other words, even as rates rise around the
world, there is still a compelling case for fixed income allocations.
For both the year-to-date and third quarter periods, fixed income assets
exhibited resilience in the face of Fed tightening. While the U.S. 10-year
yield has risen over recent weeks, it hovers below where it started 2017,
dispelling the widely held misconception that short-term and long-term
rates rise in tandem. As we have discussed in our past outlooks, these
parallel shifts are more the exception than the rule.
There is lively debate around the Federal Reserve’s course from here,
both in regard to interest rate increases and balance sheet normalization.
The Fed has noted the potential for four hikes over the next 18 months,
but we may see fewer, depending on inflation and global economic
conditions. In regard to quantitative tapering, the Fed’s guidance is
best thought of as a ceiling, not a floor. What we see next will depend
on market and geopolitical conditions, other central banks, and Fed
leadership changes (see “Perspectives on Fixed Income” for more).
In the U.S. bond markets, valuations are not cheap on an asset class
level, as evidenced by narrow spreads for both investment grade and
high yield. As Figure 7 shows, once these levels have been reached,
they can persist for a number of months, as they did prior to the last
recession and in the late 1990s (see the post, “Today’s Risk: Foregoing
Income by Exiting Strategic High Yield”). With high valuations, there is little margin for error, which creates an environment that favors
the skilled and active manager. Indeed, this is a backdrop which is
particularly well-suited to bond-by-bond selection. Overall, we are most
constructive on high yield securities and have identified opportunities in
out-of-favor areas of the market, including telecommunications, retail,
steel and pharmaceuticals that offer appropriate compensation for their
Global economic conditions and reflationary tailwinds provide a
supportive backdrop for equities and other risk assets. However, rich
valuations in some areas and the potential for leadership rotation
and consolidation create an environment that will increasingly favor
experienced, risk-aware managers.