Fixed Income Underdogs Are The Champs of 2018 | ETF Trends

By Jamie Mullen and Eric Kazatsky, Clark Capital Management Group

As equity investors slowly put their Dow 25,000 hats in their bottom desk drawer, let’s take a second to talk about the biggest underdogs of 2018…bonds. Look, we get it. It is so easy to be seduced by a multi-year long bull market constantly hitting new highs. And let’s face it— even in our last quarter’s market review, we were focused on the high probability of a December rate hike and analyst expectations of several more in 2019.

But all that has changed in the fourth quarter. Whether it was the more dovish tone of the Fed, the stock market sell-off, a newly minted Democratic House of Representatives, weak oil pricing, continued tariff talk, or any combination of the above, the fact remains that fixed income got up off the mat in September and has been punching its way to a surprise quarter-long rally.

Every (Under)Dog Has His Day

At the start of 2018, the pews in the church of fixed income were empty to say the least. The mega-congregation of equities continued to find new believers with each new high that was hit, filling even the cheap seats in the back. Bonds, on the other hand, suffered a multi-quarter affliction as U.S. Treasury yields hit their highest levels since 2011, creating a double-edged sword of price loss at the expense of higher reinvestment yields.

But what goes up must come down, right? And as equities hit the skids from October to December, bonds finally had their time in the sun, with the rush to safe haven assets helping to fuel the Q4 rally.

To illustrate how far we have come, at the end of Q3, the Bloomberg Barclays U.S. Aggregate Bond Index was down -1.60% and finished the year at 0.01%. Over in tax-exempt land, the Bloomberg Barclays Municipal Bond Index had declined -0.40% through 9/30/18 and finished the year with returns of 1.28%.

Will the Champs Repeat in 2019?

Top of mind for investors and market participants is how long the Fed tightening cycle will last. Based on the more dovish language we’ve seen from the Fed, the answer may be not very long at all. Based upon the latest Fed models which focus on U.S. Treasury spreads, the probability of a recession may not be that far off.

Data dating back to the late 1960s shows us that the yield curve normally inverts 12-24 months prior to the start of the recession. While we have still not yet seen an inversion in the 10-Year/3-Month curve, it is getting close, with the spread at only 31 basis points at year end, which is the flattest it has been since September 2007.

We are not economists, nor fortune tellers; however, we cannot completely discount what the data is saying…and for now, it points to the likelihood of lower rates.

When the curve inverts this cycle (and we’re getting close), we will surely pay attention and start the clock speculating the timing of the next recession. While the credit impacts of an economic slowdown or a recession would point us to seek the safety of higher rated entities, the portfolio management impacts would direct us to remain fully invested to take advantage of price appreciation should rates head lower.

This article was written by Jamie Mullen and  Eric Kazatsky of Clark Capital Management Group, a participant in the ETF Strategist Channel.

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