Agreeing with consensus is hardly comforting

2020 may have finally passed into the history books, but it will be forever remembered, referenced and memorialized. From strictly an investment perspective, the fixed-income team at Federated Hermes was pleased that our investment process held up well to the year’s dramatic economic and market shifts. Significant contributions from sector allocation and security selection, and more modest alpha from yield-curve positioning, led to materially better-than-benchmark returns across our multi-sector franchise. In a break from the usual, investment-grade (IG) corporate and emerging market (EM) bonds added more than high yield in a spread-tightening environment. This largely was due to the much longer duration of IG bonds, nearly double that of high yield, meaning they provided the potential for greater price appreciation with even minor changes in interest rates.

But how do investors turn the page from a year characterized by a global pandemic, dramatic election and extreme market volatility? As always, it’s about sticking with a disciplined investment process. But first, let’s consider the economic landscape. Unlike the beginning of last year, when we were cautious about an economy whose expansion—the longest in modern history—was very long in the tooth, today’s economy, at home and abroad, has many positives. As it continues to recover from the fastest and steepest decline ever (and an equally historic ascent), vaccines are being rolled out. Fiscal stimulus passed in December is almost certain to get another dose now that the “blue ripple” gave Democrats slim majorities in the House and Senate, not to mention the White House. The Federal Reserve (Fed) continues to signal that it’s “not even thinking about thinking about raising rates,” and central banks elsewhere remain equally supportive. Earnings almost assuredly will bounce in the months ahead off relatively easy year-ago comparisons when the economy was essentially dead in the water. And high household savings and record net worth stand ready to feed excessive pent-up demand for goods and services that consumers are almost certain to unleash once normalcy starts to return to their lives.

“TINA” argues for continued credit outperformance

In this type of macro environment, lower and medium quality credits with higher yields should outperform the highest quality, lowest-yield bond sectors such as Treasuries and mortgage-backed securities (MBS)—an improving economy means stronger balance sheets and fewer defaults. This would build off the trend that started in early April 2020, when Congress and the Fed began providing explicit and implicit support for risk assets. While spreads have narrowed considerably from their March 2020 peaks, they still represent the “only game in town.” Said another way, while the difference in yields relative to comparable maturity Treasuries are back to tight pre-pandemic levels below their historic medians, their yields still look moderately attractive compared to historically low Treasury yields. And there’s still room for further tightening in an economy that’s expected to grow at a robust rate as it exits the virus crisis. In other words, TINA (there is no alternative) still rules, leading our multi-sector models to overweight IG, high yield and EM. EM arguably is the most attractive of the three, abetted by a weakened (and potentially weaker, more below) dollar and an improving global economy. EM bonds performed well in 2020’s fourth quarter and closed out the year with a strong December, both in the index’s high yield and local (non-dollar) portions. For example, JP Morgan gauges showed EM high yield bonds and EM local bonds returning 3.6% and 3.2% in December, vs. 1.8% for its overall Emerging Market Bond Index.

What does “risk on” portend for rates? Not as much as you may think

Traditionally, risk-on markets include higher risk asset prices and higher yields. But from March/April of 2020, we had plenty of the former and less of the latter on a risk rally driven by extraordinary central bank policies suppressing Treasury yields. This year, we think the economy likely will catch up to the risk markets, restoring the pre-Covid GDP level by year-end and warranting somewhat higher U.S. Treasury yields. Some acceleration of inflation also should support moderately higher yields, both on favorable comparisons (prices plunged in late winter/early spring last year on the lockdown-driven collapse in demand) and partial economic normalization. But it seems unlikely the Fed will alter its pledge to keep short rates near zero and its balance sheet expanding, with both acting to suppress large moves in long yields. After all, to better achieve its desired symmetry around a 2% inflation rate, the Fed recently installed new guidance pledging to sustain its current pace of $120 billion in monthly Treasury and MBS purchases until “substantial further progress” has been achieved with respect to its employment and inflation goals, a sign it’ll be willing to let inflation run above 2% to achieve those goals. With anchored short rates and moderately rising long rates, the yield curve should continue to steepen, a condition that has accelerated somewhat since the election. But despite moving off historical lows, the 2-year/10-year yield to maturity spread is still below longer-term historic averages.

What about overseas?

Is it true? Is Brexit finally over? Well, yes and no! Somewhat lost amid the global pandemic was an 11th-hour ending to the nearly 5-year-old saga, with the resolution to a final stumbling block, fishing rights, that bore no real fundamental significance to U.K.’s economy. There remain many unknowns over Britain’s autonomy and how to translate the split-up into a deliverable source of economic growth. Meanwhile, Covid-19 infections there have surged, threatening another national shut-down, with restrictions already causing GDP to expand at its slowest pace since the economy bottomed in April. Beyond Brexit, it was yet another defensive month for the dollar, which lost ground against all of its G10 equivalents. As measured by Bloomberg against a basket of other currencies, the dollar lost 5.45% in 2020. A weaker U.S. dollar has become a widely accepted consensus trade, which suggests the dollar could be poised for a technical retracement, a taste of which we’ve gotten in the past week. But the conditions that drove dollar weakness last year are still intact, keeping us tilting toward non-dollar trades.

What do you mean, "Framed dependence?”

Speaking of consensus, that’s arguably our biggest concern. Virtually all our current alpha pod biases fall in the “consensus trade,’’ an unusual position for us as we are often contrarian in our value framework. We do view the market as being somewhat complacent. It arguably is not factoring in enough of a repricing of the Treasury market as it balances modestly increasing inflation prospects against current levels of negative real interest rates. This, as lead multi-sector strategist Don Ellenberger points out, reflects the market’s “framed dependence”—a behavioral finance concept that suggests the way market participants respond to situations depends on how the situation is framed or presented, rather than on the actual facts of the situation. Ignoring rising employment costs and consumer prices as transitory, or a very dovish Fed that is committed to significantly increasing inflation, is reminiscent of the early 1980s, when markets took awhile to accept the major inflection point of Fed Chair Paul Volcker’s policies, albeit in the opposite direction that started a 40-year disinflationary trend.

For now, we’re starting the year leaning to risk on with relatively small bets in each of our decision pods—defensive duration on expectations long rates will drift higher, steepening yield curve on the likelihood the Fed will keep short rates anchored; overweight to credit, led by EM, on an improving global economy; and overweight non-dollar on expectations there’s more room for the dollar to decline. We also are looking to other small alpha sources, such as bank loans, which appear set for stronger relative performance, and are looking at potential profit levels in Treasury Inflation-Protected securities after their very strong 2020. Cumulatively, our positions put our predicted tracking errors—projected returns relative to benchmarks—at about half our risk budgets. This gives us lots of room if pivots become necessary as/if conditions change (think 2020, just hopefully much less so!). Happy New Year, everyone.