Predicting the future is a hazardous occupation. No one correctly predicted that the 10-year U.S. Treasury's yield would spike to 3.25% in late 2018, before falling to 1.45% in less than a year. But that's what fixed-income money managers do. We seek to invest for the future by navigating through rugged environments.
Unlike December 2018, when the Federal Reserve was still raising interest rates, Fed tightening is no longer a concern. After three cuts in the Federal Funds Rate over the last six months, concern over what we believe is faulty monetary policy has disappeared.
So as another year ends, and people look to rebalance their portfolios, we offer our outlook for 2020.
Let's start with the headline. We believe that there will be no recession in 2020. The yield inversion was a false positive, as there remains a lot of demand for long-dated Treasurys from pension funds and other countries. For more on our views of recession, check out our inaugural commentary, Don't Fear the Yield Curve. But the main reason we don't believe there's going to be a recession is that the economy isn't seeing the runaway growth that typically triggers inflation and restrictive monetary policy.
Today the U.S. has what many believe is a goldilocks economy -- not too hot and not too cold, but just right. We expect economic growth to keep the unemployment rate relatively stable around its current 50-year low of 3.5%. Wages are at 10-year highs, but not as much as one might expect with a 50-year low in the unemployment rate as an absence of skilled labor remains a detriment to both strong wage growth and its resulting inflation.
Gross domestic product (GDP) is expected to be maintained by the enduring strength of the U.S. consumer. We think GDP should be around 1.8% in 2020. This could increase if the U.S. and China make a trade deal or decrease if there is a prolonged production halt of Boeing’s 737Max airplane.
Core inflation, which excludes the volatile food and energy segments, has consistently fallen short of Fed expectations but remains firmly within the 1 to 2% range historically sought. Given the low-rate environment, the Fed is seeking an inflation level that firmly exceeds 2%. In this environment, lower inflation is seen as a sign of slowing economic growth. We expect that a trade deal would help with this objective by opening the flood gates for durable goods and providing the badly needed support for the manufacturing sector. Going forward, we see inflationary pressure increasing mildly; but not enough to justify further tightening in monetary policy.
We think a trade deal gets done because it's in President Trump's best interest to sign a trade deal before the election. We also think China needs a deal. After China posted lackluster third-quarter GDP growth of 6.0%, it seems there is more urgency to get something done. However, the situation in Hong Kong throws a lot of uncertainty into the mix. How China handles that could disrupt many things.
Federal Reserve and Interest Rates
The Fed looks locked in on the Fed Funds rate. It's definitely not going to raise rates before the election; neither do we see any reason to lower rates this year if our forecast for the economy and no recession holds.
The Fed will continue to support the repo market by being its main liquidity provider. For more on the Fed and the repo market we refer you to our October commentary, Treasurys Are Not Risk Free.
The Bond Market
Uncertainty over tight monetary policy and the sustainability of global growth drove yields lower throughout 2019. The disappearance of the inverted yield curve suggests the market is now only focused on sustainability of global growth, which we believe will be stronger than expected.
In 2020, Treasury yields are likely to float higher, in our view, but should remain volatile because of many big issues affecting the market, such as Brexit, a U.S.- China trade deal, the presidential election and the impeachment of the president.
The Fed's recent rate cuts may have prevented a recession but haven't yet spurred meaningful economic growth. We expect Treasurys, especially long duration, to be the worst performing sector of the bond market in 2020. Investors will reprice risk-free assets as their reluctance to uncertainty resides. If you need to be in Treasurys, shorter duration would be the place to be, in our view.
If you need to be in long-term Treasurys, we suggest Treasury Inflation-Protected Securities, also known as TIPS. This bond is designed to protect investors against inflation, and will help if a trade deal happens, the manufacturing sector sees significant job growth, or wages start to rise above currently low inflation expectations. However, we see a trade deal already priced into the market and Brexit being a non-event for the U.S. bond market. For more of our view on Brexit, check out our November commentary, After all the Sturm and Drang, Brexit Will End Up a Non-Event.
Where to Put Your Money
With Treasury yields so low, there will still be demand for yield. Areas like structured products and corporate bonds are going to drive returns.
Within the structured space, we continue to diversify our collateral exposure away from collateralized loan obligations (CLOs) to other asset-backed areas such as student loans and mortgages. While strong supply remains a headwind, due to investors preference for newly issued debt, we continue to find opportunities in higher quality tranches within the collateralized loan universe.
With supply issues in mind, we’re looking to take on additional liquidity risk in newer, less conventional, markets like structured agency credit risk. While this is a more complex source of active return, we are attracted to its solid risk/return potential.
We think corporate fundamentals remain strong, with good ability to handle rising debt levels. The spread to Treasurys throughout corporate credit is nearing tight levels, but that is due to limited supply, strong demand, and the backdrop of a modestly expanding economy. Our opinion is that spreads could continue to trend lower in 2020, although credit selection will be as important as ever. There is a better risk/return profile in Triple B-rated bonds, so we think there is still a lot of value in the Triple B space. However, we are not saying Triple Bs will outperform the whole market.
Investors still need to do their homework. We believe it's an active managers market. For more on Triple B-rated bonds, check out our May commentary, Are Triple B-rated corporate bonds, the new As?