Heads I Win, Tails I Win Total Return Market Outlook

Fixed income markets will be hard pressed for an encore performance of the second quarter. Risk assets of all flavors rallied in conjunction with Treasury yields falling – whether this is causal or simply concurrent remains to be seen. The market is now expecting the Federal Reserve (the Fed) to cut rates three times – in total 75 basis points (bps) – by the end of the year, and investors are asking two key questions: (1) Can risk assets perform without the tailwind provided by a lowered rate outlook? (2) Is the forecast for lower rates a sign of the end of the 10+ year expansion, or are we simply observing a market cycle within the economic cycle?

While three rate cuts in the coming year may be aggressive, there is no question of the existence of the “Fed put” in this market. Economic data that reflects slowing at the margin can be largely attributed to a decline in confidence and/or activity related to the ongoing trade dispute between the U.S. and (mostly) China. While growth is slowing somewhat, the domestic economy is still expanding, and the level of unemployment and average hourly earnings are not consistent with the notion of a rate cut.

We see two likely outcomes – either the economy finds its footing and continues its expansion, which would be supportive of risk assets but not interest rate exposure (as potential Fed eases begin to be priced out of the rates market), or the economy continues to slow and Fed eases are implemented. In this case, risk assets probably continue to perform well as borrowing rates decline. It’s seemingly a “heads I win, tails I win” scenario for risk assets.

As a result, we remain constructive on Investment Grade (IG) credit for the balance of 2019. While we do not anticipate IG matching its robust performance in the first half of the year, we feel that it will benefit from the current environment and provide attractive relative returns. Mortgage-backed securities (MBS) might see some challenges as lower rates could translate into higher refinancing activity – which means more supply and less carry for mortgage investors. In addition, the Fed’s preference to reinvest runoff from its MBS portfolio into Treasuries has the potential to drive mortgage spreads wider (and Treasury rates lower). Nonetheless, we are neutral on MBS as we think there will be pockets of opportunity in MBS at rate extremes that impact convexity hedgers and prepay-sensitive investors alike.