Risk assets have bounced back this year after a dreadful finish in 2018, with a big assist from the US central bank. But are markets overlooking the potential for problems down the road?
A lot seems to be going right in 2019. Policy stimulus appears to have preempted a sharper slowdown in China, and US-China trade talks are ongoing, though agreement remains elusive. Eurozone growth rebounded in the first quarter, while the US economy and corporate earnings have held up well, pushing the S&P 500 Index to an all-time high.
Most important of all, though, was the major course correction by the US Federal Reserve, which went from raising interest rates in December (and signaling more to come) to indicating in March that it expects to stay on the sidelines for the rest of this year—and next.
The market seems to have decided that the Fed took its foot off the monetary brake because it worried that the US economy was slowing. That would explain why so many strategists still think the Fed will cut rates by year-end.
We see things differently. As my colleague Eric Winograd put it in a recent blog, “the Fed didn’t stop hiking interest rates because there’s a growth problem—it stopped because there’s an inflation problem. Simply put, inflation has gone missing, and the Fed is worried about it.”
Low inflation sounds like a good thing. But if it persists, it can lock an economy into a deflationary spiral with falling prices, slowing demand and rising unemployment. Japan’s experience over the past few decades is a case in point. The takeaway here is that the Fed is likely to let the economy run hot for long enough to push inflation higher, even if economic growth remains solid.
Is the Fed Playing Kick the Can?
Here’s the good news: the epic rebound in risk assets is likely to last for a while. US yield curves have steepened and returns from risk assets—high-yield bonds, emerging-market (EM) debt and so on—have soared since January. The market’s dovish reaction to the Fed’s shift is understandable, but we still think rate cuts are unlikely.
The Fed’s about-face on rates may be a green light for risk-taking today. But it delays the eventual reckoning that comes with the end of the economic cycle. We don’t expect that reckoning this year. When it does come, though, it may be painful for investors who have taken on too much risk. What’s more, the Fed doesn’t have as much firepower to fight it. The European Central Bank, which recently said it will keep rates at zero until at least 2020, has even less.
That’s not to say there won’t be opportunities for investors in the meantime. But there are risks to monitor, too. Here are three areas that we think deserve special attention.
1. The US Dollar: The Fed’s decision to keep interest rates on hold and tolerate higher inflation should weaken the US currency. So far, it hasn’t. When measured against a basket of major currencies, the dollar is stronger today than it was in mid-December.
It’s not entirely clear why the greenback has been so resilient. It may be that concerns about global growth and the eurozone, and Chinese economies in particular, are propping it up. It’s also possible that some large institutional investors from low-interest-rate countries, such as Japan, have stopped paying the high cost of hedging out their currency risk when they invest in US securities.
Whatever the reason, investors should keep a close eye on the dollar’s value. Why? Mainly because a strong dollar puts pressure on non-US companies and countries that borrow in the US currency. It was a dollar surge in 2014 and again in 2016 that wreaked havoc on EM bonds and currencies. If the greenback approaches those levels again, it could derail the Fed’s policy shift and hurt risk assets.
The solution: be selective and don’t reach blindly for yield, particularly when it comes to assets that have already rallied sharply this year. The best way to do this, in our view, is to take a global, multi-sector approach that spreads exposure across regions and sectors.
2. Corporate Leverage: When interest rates were rising, highly indebted companies had a strong incentive to repair their balance sheets. But the Fed has probably weakened that incentive with its new focus on accommodating higher inflation—and nominal growth. In other words, don’t be surprised if companies start mis-allocating capital again.
As my colleagues have pointed out, keeping risks in perspective is especially important when it comes to corporate bonds with BBB ratings, the lowest investment-grade designation. We think fears about widespread BBB downgrades to high-yield status have been exaggerated, and we still believe that careful credit analysis can uncover attractive opportunities in mis-priced BBB bonds.
But the change in circumstances makes it more important than ever for bond investors to do their credit homework. If markets suffer a downturn a year or two from now, will the Fed be in a position to cut rates aggressively if inflation is trading well above its 2% target? Hard to say. But we’d certainly expect volatility to rise sharply.
3. Global Growth: We have gradually reduced our global growth forecast over the past six months, but we continue to expect a return to trend, not a contraction. Nonetheless, risks are still tilted to the downside. Global trade continues to decelerate, and even a potential resolution to the US-China trade war could prove a double-edged sword if Chinese concessions encourage the US to get tougher on trade with Europe.
In Europe, inflation expectations—and bond yields—remain low and German manufacturing and exports have disappointed, a direct result of the trade wars and the strong links between the German and Chinese economies. We anticipate signs of stabilization in the second half of the year, but investors will need to be on the lookout for downside surprises.
Mixing and Managing Your Risk
We all know, of course, that we have to take some level of risk to generate returns, particularly in today’s market. But it’s important to be thoughtful about where and how we take it.
In late 2018, investors were being compensated handsomely to take on risk because prices among credit assets had declined so sharply. That isn’t the case now. Assets such as high-yield bonds and some types of EM debt have recovered all of their 2018 losses and then some in the first four months of 2019.
That means investors must be selective in the months ahead and avoid getting over-concentrated in any one sector or region. In credit, we think a multi-sector approach that blends exposure to high-yield bond sectors—US energy companies, European banks—with positions in select securitized assets and EM debt can create a diversified mix with strong return potential.
Investors who want to keep income flowing while limiting volatility and downside risk may want to consider a dynamically managed barbell strategy. These approaches combine exposure to return-seeking credit assets, such as high-yield bonds and safer government debt, in a single strategy and regularly adjust the balance as valuations and market conditions change.
Even in a risk-on atmosphere, it’s important to do your homework and know how much risk you’re taking.
Douglas J. Peebles is Chief Investment Officer—Fixed Income at AllianceBernstein.
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.