In Cyclical/Secular Tug of War, Bond Investors Could Still Find Opportunities

In the U.S. the cyclical forces of growth are flexing their muscles considerably more than they were a year ago, but what has not changed are the long-term secular trends pulling on the other end of the rope and keeping them from tumbling head over heels into an inflationary dog pile. These trends include demographics, where aging populations in the U.S. and abroad are reducing consumer spending and growth in the labor force; technology, where wage gains that might otherwise be expected amidst a shrinking workforce and growing economy are being snuffed out by automation; and debt, where growth in government borrowing and unfunded liabilities are limiting economic growth potential (and inflation).

All of this adds up to more-or-less a stand-off between team cyclical and team secular. The current expansion in the U.S. has been impressive in its duration but, notwithstanding the recent momentum, it has been very “gradual” and we foresee “a continuation of gradual” well into 2019.

A different kind of tug of war on trade

We are not overly concerned about the trade disputes that have rattled the markets and dominated the financial press for much of the year. That does not mean we are fans of tariffs—free trade is a win-win, so tariffs are, in turn, a lose-lose. But relative to the size of the U.S. economy the marginal impact of higher tariffs is relatively small. And considering the lopsided trade balance, our main rival in the dispute, China, has much more to lose (even in a lose-lose scenario), giving the White House leverage in negotiations. The strong outperformance of U.S. stocks over China’s in the past year suggests that this asymmetry of pain has not been lost on market participants. To be sure, some U.S. exporters are suffering. But in many cases, the tax cut is providing a powerful counterbalance.

An anchor for global growth

The U.S. economic resurgence comes as growth in much of the rest of the world—which had been tracking with the U.S. last year in a remarkable period where virtually every economy around the globe was expanding—has stalled. That is one reason why many foreign central banks are finding it challenging to wrap up their asset buying programs—the combined holdings of the Bank of Japan, European Central Bank and US Federal Reservice still total almost $15 trillion, representing one-third of the total global bond market—even as the Fed has begun to shrink its portfolio. Nonetheless, we do expect combined central bank balance sheets to peak sometime in the next year.

A deleveraged consumer and a healthy housing market

Growth in the biggest categories of consumer debt—mortgages and credit cards—hase been modest. The one troubling exception is student loan debt which continues to balloon. High student loan balances carried by younger consumers is delaying household formation, a critical driver of economic growth. Still, notwithstanding student loans and a slight uptick in auto loans, the bigger picture is that consumers are less leveraged than they were going into the Great Recession and should not derail the current expansion.

The U.S. housing market has cooled off a bit to a more sustainable pace from a year ago, which we view as a positive. The Case-Shiller Nominal Home Price Index has grown on average about 4% per year since 2008, versus roughly 11% per year going into the Great Recession.

A productivity sea change?

At the most basic level, there are two levers for economic growth, an increase in the labor force or more productivity from the existing labor force. As previously discussed, the demographics of the Baby Boom point to a shrinking labor force in the U.S. In past years this shrinkage was somewhat offset by immigration, but that is unlikely to continue in the foreseeable future under the current Administration. The other lever, productivity, has also been lackluster over the last decade,. Combining those two factors—a shrinking labor force and weak productivity gains—it is perhaps unsurprising that the current expansion, taken as a whole, has been anemic.

But we could very well soon see productivity shift into a higher gear as a result of a big increase in capital expenditures by U.S. companies. Rather than investing in new machines and process during the last decade-and-a-half, it seems that many U.S. companies outsourced work to China and other emerging countries with cheaper labor markets. But the cost of labor has climbed steadily around the globe and U.S. capital expenditures began to climb in 2013. The narrowing manufacturing cost gap between the U.S. and other countries, coupled with provisions in the new tax law that encourage corporate investment, suggest that capex will continue to rise, with productivity gains likely to follow—another tailwind for the economy.

A modest tightening in the labor market, but a benign inflation picture

For the first time in years, the number of job openings has surpassed the number of unemployed workers. This would be expected to lead to upward wage pressure, but many job seekers are workers who lost hope during the Great Recession and are only now returning to the job market. Their skills are often limited or outdated and they are not putting strong pressure on wages for now.

So, while wages are firming, they are not surging, and inflation is finally just reaching the Federal Reserve’s target of 2%. We expect wage pressures to continue building—another component of the cyclical growth story—but again, we expect secular forces will keep tugging in the other direction and keep inflation under control.

The higher interest rate environment

It is probably fair to say that the low point for interest rates is behind us. The 1.36% yield on the 10-year Treasury in the summer of 2016 may be the lowest many will see in their lifetime. As yields backed up from the mid-2016 low, a narrative developed around “the great bear market for bonds” that would be accompanied by faster growth and ramping inflation.

But the market didn’t follow that script. What has transpired is a sideways movement in rates around the 2.85% level. While some worry about a spike in long-term rates and ensuing bear market for bonds, we continue to focus on another secular offset related to demography—the huge well of yield-starved investors (both individual and institutional) who tend to emerge with buy orders whenever rates show any sign of increasing, thereby stabilizing yields. Rates may continue to rise, but we think it will be gradual (and, as always, nearly impossible to time, which is why we don’t make interest rate bets in our portfolios).

One implication of higher U.S. interest rates that is a concern is a stronger U.S. dollar, which is already making it challenging for Turkey and Argentina to repay their dollar-denominated sovereign debt. We share other market participants’ concern that their challenges could foreshadow, or even trigger, a more general emerging market debt crisis.

A flattening—possibly even inverting—yield curve

The U.S. Treasury curve has flattened considerably in the last year, with the “spread” between the two- and 30-year Treasury narrowing from 141 basis points last fall to just 38 today. Even as long-term interest rates climbed modestly, short-term rates have doubled over the period largely due to Fed action. As the curve has flattened, some commentators have focused on a possible inversion, where short rates are higher than long, which they suggest has historically portended a recession.

We would make two points:

1. These “flat curvers” usually cite the two-/10-year spread (now about 21 basis points), while the Fed pays more attention to the three-month/10-year spread (still at 81 basis points) and;
2. Yield curve inversions seem to be a necessary but not sufficient condition for recessions. In other words, while all recessions were historically preceded by an inverted curve, not all inverted curves were followed by recession.

We believe the Fed is acutely aware of the implications of an inversion and will be extremely careful. Indeed, we believe the Fed’s tightening program is driven as much by their desire to “normalize” short-term rates as it is by inflation concerns. While the central bank has raised the Fed Funds rate by 2%, in real terms that account for inflation, short rates are barely above zero. In this sense, monetary policy has gone from “ridiculously accommodative” to just “very accommodative.” And the Fed has hinted that if they are going to err, it is likely to be on the side of letting the economy run hotter rather than tightening prematurely and snuffing out growth—thus, a continuation of gradual.

A puzzling divergence in corporate bond spreads

In addition to rising rates and a flattening yield curve, the third major theme in the bond market this year is the oddly uneven widening of investment-grade and high-yield corporate bond spreads.

Year-to-date, investment-grade corporate spreads have widened by about 21 basis points. The temptation is to blame the flattening yield curve and its implication in some market participants’ minds that a recession could be around the corner. But how then do we account for spreads on high-yield—usually the first to default in a recession—which have tightened by 5 basis points over the same period?

Rather than concerns about corporate fundamentals, we believe supply/demand technical are behind the widening in investment-grade bonds, in particular a sharp decline in foreign demand for the securities in the first quarter. Foreign net buying of U.S. investment grade bonds collapsed from about $52 billion in the fourth quarter of 2017 ($337 billion for all of 2017) to negative $5 billion in the first quarter of this year. The falloff is likely a result of two developments—repatriation of offshore capital by major U.S. companies as a result of tax law changes and, more importantly, a steep climb in the cost to offshore investors of hedging dollar denominated corporates back into their own currencies.

A modest overweight in corporates

Setting aside the technical anomalies, corporate credit fundamentals look solid. Revenues, profits and free cash flow all look healthy and are trending upward with the increase in economic growth. Leverage is down and interest coverage has stabilized at a comfortable level. We do not see signs of a recession and believe calls to reduce corporate credit are premature; we continue to maintain a modest overweight in corporates.

Two other debates raging in the corporate bond market concern the growth of the triple-B sector (at the expense of double- and triple-A) and the huge amount of issuance over the last few years.

The relative weighting of triple-B issuers in the Bloomberg Barclays Credit Index has certainly climbed, growing to 44.5% of investment-grade issuers in 2018 versus just 9.5% in the early ‘70s. The trend shows no sign of slowing in recent years and has prompted some market watchers to lament the deterioration in credit quality.

But what some call management recklessness or inattentiveness, we prefer to call balance sheet optimization and argue that the increased value to shareholders that a triple-B rating can deliver typically outweighs the benefits of maintaining double- or triple-A. A downgrade to triple-B typically comes with a firm commitment to maintaining the status. Moreover, today’s triple-B is not your father’s triple-B: average leverage ratios and interest coverage for the sector are better than they were 30 years ago.

Similarly, we are not overly worried about the record corporate issuance of recent years. In many cases, borrowing was driven by record low interest rates rather than necessity and companies are well positioned to pay down the debt they incurred when rates were at record lows if they decide to do so.

One borrower that is not as well positioned for an increase in rates is the U.S. Treasury. Federal debt as a percentage of GDP is climbing and increased interest cost is already showing up in the federal budget. Treasury can always borrow but we are concerned that its borrowing may marginally crowd out non-government borrowers in coming years.

The Market Opportunity

A backup in interest rates is undeniably detrimental to fixed income assets, but the good news is the power of higher yields going forward and their capacity to continue drawing capital into the asset class—higher yields being the lemonade we can make from the interest rate lemons. For example, while the Baird Core Plus Bond Fund is down modestly for the year, its yield to maturity stands at 3.69%, up from 2.81% a year ago. That means that if nothing changed for the rest of the year and the fund simply clipped coupons, the portfolio would produce a positive return of 1.23%. Admittedly, only a bond manager could get excited about finishing the year north of zero, but this could be what the rumored bear market in bonds feels like—not nearly as bad as many predicted.

In terms of positioning, the $18 billion Core Plus Fund on a duration-weighted basis is underweight U.S. Treasuries and Agencies relative to its benchmark, underweight high-yield and overweight triple-B credits on the view that the market is punishing those companies for what we consider balance sheet optimization. The key in corporate credits is diversification and security selection and we spend a great deal of time on both. In terms of sectors, the portfolio is tilted toward financials, a longtime favorite because those management teams’ interests are intrinsically aligned with lenders like us.

With the flattening yield curve, we see good value on the short end and the Baird Short-Term Bond Fund is hard not to like in the current environment. Its yield currently stands at 3.1%--up sharply from a year ago—while returns have stayed in positive territory. Many of the same allocation themes carry through from the Core Plus Fund, but the relative over- and under-weights are more pronounced, given the relatively lower duration risk. (The Short-Term fund’s duration is roughly one-third that of the Core Plus find, yet it offers 84% of the yield).

Finally, in the tax-exempt market muni yields have risen but not nearly as much as Treasuries and, unlike Treasuries, the muni curve has steepened. The muni curve naturally tends to stay upward sloping, but the steepening has been exaggerated in the last year because individual investors, who tend to buy on the shorter end, saw a relatively smaller tax break than corporates (i.e. the banks and insurance companies that tend to invest on the longer end of the muni curve). The retreat of these institutional buyers on the long end creates terrific opportunities for active managers, including the team managing our Baird Short-Term Municipal Bond Fund and Baird Core Intermediate Municipal Bond Fund, both of which just reached their three-year anniversaries.

Summary

Being in the middle of an evenly matched tug of war between robust cyclical growth and secular forces acting to control that growth is a comfortable place to be right now for bond investors. Those who are prepared to do their credit selection homework, manage their risk and can avoid the temptation to pick sides or attempt to time the outcome of the tug of war with risky duration bets should be rewarded in the coming year.

Past performance does not guarantee future results.

Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the fund prospectuses and summary prospectuses, which can be obtained from a financial professional and should be read carefully before investing.

In a rising interest rate environment, the value of fixed-income securities generally decline and conversely, in a falling interest rate environment, the value of fixed income securities generally increase. High yield securities may be subject to heightened market, interest rate or credit risk and should not be purchased solely because of the stated yield. Ratings are measured on a scale that ranges from AAA or Aaa (highest) to D or C (lowest). Investment grade investments are those rated from highest down to BBB- or Baa3.

For a complete list of the holdings and performance current as of month end for the Baird Core Plus Bond Fund, Baird Short-Term Bond Fund, Baird Core Intermediate Bond Fund and Baird Short-Term Municipal Fund, please visit the Baird Bond Funds website.

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