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January 2020 Fixed Income Market Update

Economic and market perspective

U.S. economic data surprised to the upside in December with strong employment and growth results and the Fed remained on hold as expected. Progress on tariffs and U.K. election results lowered geopolitical noise for the time being. These developments led to continued improvement in risk sentiment.

On December 13, two days before additional tariffs were to be implemented, the U.S. and China announced they had agreed on phase one of the long sought after trade deal. The U.S. agreed not to implement the December 15th tariffs and to cut the tariff rate in half on the September tariffs, but prior tariffs remain in place subject to further negotiations. China agreed not to implement the scheduled retaliatory tariffs, increase imports from the U.S. by $200 billion over the next two years and put better protections in place for U.S. intellectual property. President Trump said the phase one deal will be signed January 15th at the White House.

The Conservative Party won U.K. elections decisively in mid-December. Boris Johnson, the leader of the party, campaigned on a promise to “Get Brexit Done.“ Subsequent to the election, parliament approved Johnson’s Withdrawal Agreement – assuming it passes remaining steps in the U.K., the law will take effect in January. The European Parliament will also vote on the U.K.’s withdrawal. If all proceeds as planned, the U.K. is set to exit the European Union on or before January 31, 2020. An E.U. summit will then begin in February to negotiate new trade arrangements between the U.K. and the E.U.

Eurozone manufacturing PMI fell to 46.3, the 11th consecutive month below 50 (below the 50 level indicating contraction); composite Eurozone PMI showed expansion with a level of 50.6. U.S. ISM Manufacturing Index declined to 48.1 for November from 48.3 the prior month and below market expectations of 49.4. November was the fourth consecutive month showing contraction. By contrast, Chinese official manufacturers PMI was mildly expansionary at 50.2, exceeding market expectations. After a period of contraction, December was the second month in a row with modest expansion.

The Federal Open Market Committee left the Fed Funds rate unchanged at its December 10-11th meeting, in line with market expectations. In its statement, the Fed emphasized that “monetary policy is appropriate to support sustained expansion of economic activity, strong labor market conditions and inflation near the Committee’s symmetric 2% objective.” The updated ‘dot plot’ showed a downward move in the expectations of Fed members. In the September dot plot, nine dots reflected one or more rate hikes in 2020; in the most recent plot, only four dots projected one hike in 2020. The median expectations of future Fed Funds Rates also came down to 1.6% 2020 (from 1.9%), 1.9% in 2021 (from 2.1%) and 2.1% in 2022 (from 2.4%), though the long run estimate was unchanged at 2.5%. As of the end of December, the market is not pricing in a greater than 50% chance of any additional Fed actions in any of the next twelve months.

Outlook and conclusions

In our view, the fourth quarter was a welcome respite in the otherwise near linear downward trend in rates during 2019. After the first three quarters of 2019 when declining rates drove fixed income returns, in the fourth quarter rates moved moderately higher, but still delivered positive returns on the strength of non-governmental sectors. Progress on longtime geopolitical hotspots – Brexit & U.S./China trade – at the same time U.S. economic data surprised to the upside led to this adjustment higher in rates and strong performance from spread sectors. The fourth quarter highlights the difference between the environment entering 2020 versus a year ago. Last year, tightening monetary policy, slowing growth concerns and continued trade tensions created market volatility, but also wider spreads; though rates declined in the fourth quarter of 2018, they remained elevated versus today’s levels. At the beginning of 2020, loosening monetary policy and easing geopolitical tensions have created a more stable market environment with strong recent performance. The challenge emanating from this recent performance is that while credit could recently be described as fairly valued given the supportive environment, further tightening of spreads has made these valuations more tenuous. With more positive news now factored into valuations, markets have become more susceptible to disappointment. Spreads can stay in the current range for some time and this may be the most likely outcome. Indeed there is not an obvious near-term catalyst to reverse the tightening, but we view the risk of widening as asymmetric to the benefit of further tightening. As such, we remain cautious in terms of portfolio positioning regarding non-governmental exposure, but more comfortable with duration exposure. Even with these valuations, U.S. fixed income remains attractive in a global context; as the search for yield continues, U.S. fixed income offers a relatively benign venue for global investors to achieve higher yields.

Originally Posted on January 2, 2020 – January 2020 Fixed Income Market Update

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