In a recent research note, we discussed the Vanguard Group’s outlook for stocks in 2019. Overall, the asset manager had little good to say about stocks, predicting stocks would experience substantially lower annual returns over the next decade as the tailwinds from the long post-recession bull market begin to falter.
But Vanguard covers more than stocks its economic and market forecasts. It also addresses fixed income markets. Contrary to its pessimistic view of stocks, Vanguard sees “an improved outlook” for bonds.
With stocks looking increasingly likely to falter, fixed income plays may start to look more appealing in the year ahead.
Thank higher interest rates
The principal driver of Vanguard’s bond optimism is the return of rising interest rates:
“Higher interest rates have improved our outlook for fixed income compared with this time last year.”
This is virtually an iron law of economics and financial market behavior. As interest rates rise, bonds tend to flourish. It is thus no surprise that Vanguard sees improvement in the asset class. At the same time, credit spread expansion offers some opportunities across the fixed income universe:
“Expected returns for the riskier fixed income sub-asset classes appear more differentiated compared with previous years, in part because of a recent expansion in credit spreads, thereby giving them the cushion to capture the risk premium.”
Projecting global annualized returns of 2.5-4.5% over the next decade, Vanguard is fairly optimistic.
Those returns will hardly set the world on fire, but they are pretty healthy when considering the global fixed income space.
Higher yield, higher risk
Vanguard expects U.S. corporate bonds to do quite well, though expected returns obviously diverge based on the risk profile of bonds and credit profiles of issuers:
“The central tendency for U.S. credit bonds (specifically, the Bloomberg Barclays U.S. Credit Bond Index) is in the 3.0%–5.0% range, modestly higher than last year because of the rise in the underlying Treasury rates. The central tendency for high-yield corporate bonds (specifically, the Bloomberg Barclays U.S. High Yield Corporate Bond Index) is in the 3.5%–5.5% range.”
While high-yield corporate bonds are expected to deliver unconventionally rich rewards in the coming decade, Vanguard offers a necessary note of caution:
“We urge investors to be cautious in reaching for yield in segments such as high-yield corporates, not only because of the higher expected volatility that accompanies the higher yield but also because of the segment’s correlation to the equity markets.”
Yield chasing has been a persistent theme over the past few years, and it has only been exacerbated as the bull market has worn on. Investors plunging into riskier assets in pursuit of yield could find themselves in dangerous waters in the event of economic turmoil.
Rate hike risk
After more than a decade of near-zero interest rates, the Federal Reserve under Jerome Powell has been attempting the difficult task of raising interest rates to a neutral level. Unfortunately, that can prove a fraught task:
“Calibrating policy rates to neutral is an extremely complex exercise full of risks. The so-called soft landing requires significant skill by policymakers. The neutral rate (usually referred to as r*) is a moving target and not directly observable, as it has to be estimated with statistical models. The Fed’s extremely gradualist approach during this rate-hiking cycle does help increase the odds of a successful landing this time, however.”
We agree with Vanguard’s assessment of profound challenge involved in raise rates. The markets, having grown used to the low-rate norm of the recent past, are wont to throw tantrums anytime policy is tightened.
While we would tend to concur with Vanguard that Powell’s extreme gradualism offers the best chance for an economic soft landing, we are more concerned about the unique political risks at play today. President Donald Trump has attached much of his economic credibility to stock market performance, so there is a heightened risk of political interference with rate hikes. Policy confusion and politicization could make for a harder landing than one might otherwise expect.
Verdict
A divergence between the performance of stocks and bonds is to be expected during a conventional market. During bull markets, stocks tend to shine while bonds tend to falter. In bear markets, the reverse tends to be true. The present cycle -- marked by one of the longest economic expansions and bull markets in history -- has defied convention. Indeed, it has played host to a veritable bull market in everything.
An improved outlook for bonds may thus signal more than an investing opportunity. It may also be a harbinger of a return to more “normal” behavior across asset classes. That, in turn, might signal the return of value investing as a viable strategy in the eyes of the investing public.
All bonds will offer improved yields thanks to rising Treasury yields. Hunting desperately for yield has pushed many allocators into increasingly risky assets. That could be dangerous in the coming years as volatility picks up and the risk of economic reversals mount.
We will certainly be playing close attention to price action across all major asset classes, including bonds. But we will be very wary of falling prey to the perilous hunt for fixed income yield.
Disclosure: No positions.
