Is the end of quantitative easing (QE) a big deal? Might tax reform provide an added boost to the US economy? Should investors brace for more volatility in 2018? Yes, yes and yes.

In other words, we think 2018 may go down in history as an important turning point for markets. That means bond investors should be extra vigilant when it comes to managing exposure to the market’s two primary risks: interest rates and credit.

Why? To start, we think financial conditions are likely to get tighter this year. The Federal Reserve began draining liquidity from the system through rate hikes and balance-sheet reduction in 2017, but conditions remained loose. Bond yields stayed low, the yield curve got flatter and “risk” assets continued to rise.

That may change this year. We think the Fed will hike interest rates four times in 2018 and continue to shrink its massive balance sheet. And with euro-area growth improving, the European Central Bank is likely to finish tapering its monthly bond purchases in the second half of the year and begin raising official rates in early 2019.

This matters, because it was extremely stimulative monetary policy that has allowed global investors to enjoy nearly a decade of rising asset prices and low volatility. More recently, we’ve also seen the world economy, led by the US, finally emerge from the long shadows of the global financial crisis and the Great Recession.

It May Be Different This Time

Plenty of investors may look at the strong growth backdrop and the normalization of monetary policy and conclude that asset values will continue to rise—especially those for credit assets such as corporate bonds.

We don’t think it’s that simple.

Normally, a cyclical upturn in the economy would benefit markets and tempt income-oriented investors to load up on credit. But the last 10 years have been anything but normal. Thanks to QE, asset prices have already had a big run-up in value. After bottoming in March 2009, the S&P 500 Index took just over four years to recover its inflation-adjusted precrisis peak, en route to today’s all-time high. For US and European high-yield bonds, credit spreads—the extra yield these securities offer over comparable government debt—are hovering near record lows.

As we all know, QE was not as effective at boosting the real economy, which took considerably longer than markets to recover. Despite central banks’ best efforts, growth remained stubbornly low across the developed world for years as economies dealt with a debt overhang. Only recently has growth started to gain traction—a big reason why central banks want to end their emergency monetary policies.

We wouldn’t be surprised if asset values and the real economy traded places in 2018. The slow unwinding of global QE could affect the prices of assets that have already enjoyed a large appreciation. That doesn’t portend a sustained sell-off, since central bank tightening should proceed gradually. But it does suggest more volatile price swings in so-called “risk assets” such as stocks and corporate debt.

Don’t Write Off US Tax Reform

On the other hand, the global economy may continue to improve even as monetary policy and financial conditions tighten. And while the consensus view of economists suggests otherwise, we think change to the US corporate tax rate may give the economy an added boost.

The key will be whether companies decide that a stronger economy will convince enough firms to forgo another round of share buybacks in favor of capital-intensive investment. Citing the new rules, Apple has already pledged to bring billions back to the US economy. It’s possible this could lengthen the credit cycle—but not indefinitely.

That’s because if tax reform ends up pushing inflation higher, the Fed may be forced to tighten policy even more aggressively, making things more difficult for bond investors. As of now, the Fed does expect growth to increase, but its inflation forecast hasn’t changed after the passing of the GOP tax plan.

Why a Barbell Strategy Makes Sense

There are still opportunities in credit markets, including high yield, emerging markets and securitized mortgage assets. But in our view, investors should think twice about taking on too much credit risk, given current prices and conditions.

We believe a better approach would pair US Treasuries and other interest rate–sensitive government bonds with growth-sensitive credit assets in a single strategy known as a credit barbell. Because the returns from the two types of assets are negatively correlated, strong returns on one side of the barbell can outweigh weakness on the other.

Sure, it’s tough to know which way to lean in an environment as uncertain as today’s. That’s why it’s important to have a manager that can monitor market changes closely and alter the weightings as valuations and conditions change.

US Treasuries and German Bunds might struggle over the short term if tighter Fed policy eventually causes the yield curve to steepen. But even in rising-rate environments, these assets provide crucial stability, diversification and income: over the medium term, more than 90% of US Treasury returns come from the yield.

High-quality government exposure can also keep your bond portfolio liquid. Eventually, higher rates will slow growth and put an end to the credit cycle. In these periods, Treasuries tend to beat assets such as high-yield bonds. This means investors can rebalance their portfolios by selling outperforming US Treasuries and buying underperforming credit assets at discount prices.

For bond investors, earning income is too important to leave to chance. Markets have been unusually placid in recent years, but they won’t stay that way forever. Investors who prepare for change will be best placed to benefit from it.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

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