by Joe Ramos, Managing Director, Head of U.S. Fixed Income, Lazard Asset Management
Summary
- We believe that the current 10-year US Treasury yield reflects extraordinary investor uncertainty about the economy outside the United States rather than recessionary conditions within it.
- The US economy remains in good shape. Unemployment is low, corporate earnings are growing, and businesses remain confident.
- With so much uncertainty in the market, we believe it’s time for investors to focus on the preservation of capital and on historically reliable characteristics of liquidity.
Fixed income markets in much of the developed world are sailing in uncharted waters. Outside the United States, a large portion of the developed fixed income market is trading at negative interest rates (Exhibit 1). In the United States, the 10-year US Treasury is trading at an extremely low yield—one that has historically been consistent with conditions of severe US economic distress.
Exhibit 1: Negative Yielding Debt Went from $0 in 2013 to More than $15 Trillion in 2019
As of 30 September 2019
Source: Bloomberg
Investors must understand the factors contributing to this extreme interest rate environment in order to safely navigate these uncharted waters—that is, to preserve capital and maintain enough liquidity to meet cash obligations. Does the low interest rate environment reflect underlying weakness in US economic fundamentals? If not, why are rates so low? And regardless of the answer to those two questions, how should investors position their portfolios in order to maintain the margin of safety expected from a US fixed income allocation?
A Sea of Calm
Economically, the United States remains a sea of calm. Unemployment is at historically low levels. The headline U-3 unemployment rate is at a multi-decade low of 3.7% (Exhibit 2). Corporate leverage has grown, but so have corporate earnings. As a result, default rates are running below their historic long-term average. Contrary to the pessimism implied by US rates, default forecasts from the likes of JPMorgan and Moody’s remain low (Exhibit 3) and lending conditions are easy, according to the Federal Reserve’s index of financial conditions. Nominal GDP growth and inflation remain positive, and we expect trends in both measures to remain steady.
Exhibit 2: Unemployment Has Fallen to a 50-year Low
As of 31 July 2019
Source: Bloomberg
Exhibit 3: Corporate Default Rates Are Expected to Remain Low
As of 31 December 2018
Source: Bloomberg
Smooth Sailing or All Hands on Deck?
The US Treasury yield has reached levels last seen in the depths of the Great Depression, but we do not believe the 10-year US Treasury yield reflects weakness in the US economy (Exhibit 4). Instead, foreign investors fearing weakness in their home economies have crowded into Treasuries of late, driving yields down. The 10-year US Treasury has become, in effect, the developed world’s insurance policy.
Exhibit 4: The 10-Year US Treasury Has Become the Insurance of Choice for Global Investors
As of 31 August 2019
Source: Bloomberg, Federal Reserve Bank
Demand from China and exports from Europe, two of the most important engines of global prosperity, have slowed, leaving unsettled conditions in their wake. In Germany, Europe’s largest economy, real GDP, a measure of purchasing power, has fallen to zero; German manufacturing PMI is below 50, signaling contraction and raising the prospects of a recession; inflation is stagnating around 1.4%, below the European Central Bank’s 2% target; and inflation expectations have turned negative. If conditions worsen, it is possible that Europe as a whole may experience a recession where nominal GDP—real GDP plus inflation, a measure of the ability to service debt—turns negative. In such a recession, debtors would no longer be able to count on growing nominal revenues to cover their debts and many would face the prospect of bankruptcy (Exhibit 5).
Exhibit 5: Germany is Flirting With a Recession
German Inflation has dropped below the ECB's 2% target...
and German business expects to fall further
As of 31 August 2019
Source: Bloomberg
With rates for the German bund at -31 basis points (bps) and the 10-year Japanese Government Bond at -12 bps, there is little room to go lower. Negative yields are evidence of real distress in the economy, but the more insidious threat lies in the fact that the European Central Bank (ECB) and Bank of Japan (BOJ) have few other, if any, monetary tools to revive growth.
Traditionally, investors have sought protection from severe economic distress by purchasing developed market sovereign debt—in effect, the long-term securities issued by the three large sovereigns: the United States, Germany, and Japan. However, the negative interest rates in Germany and Japan virtually foreclose the upside possibility of investing in long-term government debt in those countries. Thus, investors are relying largely on US Treasuries for insurance in a very uncertain world.
From Term Premium to Term Discount
The bid for this form of portfolio insurance has turned risk-reward relationships in the Treasury market upside down. In the past, a tightening 10-year US Treasury term premium (which reflects investors’ desire for compensation against inflation surprises) reliably signaled economic contraction. Yet, even as the American expansion shows sign of extending into a new capital investment phase, the term premium has not merely tightened. For the first time in the 54 years we have recorded the data, it has gone negative. At a time when inflation expectations are positive, investors are no longer compensated with extra yield for holding 10-year US Treasury securities into an uncertain future (Exhibit 6).
Exhibit 6: The 10-Year US Treasury Term Premium Fell to an All-Time Low
As of 10 October 2019
Source: Bloomberg
We interpret the Fed’s recent round of rate cuts as an effort to balance a functioning American economy against the dysfunction elsewhere in the world. Despite the fact that the US derives a comparatively small fraction of its GDP—14%—from global trade, its exposure to global supply chains warrants concern. In our view, the rate cuts acknowledge that risk, much as rate cuts in 2000 reflected a sensitivity to the potential for systemic risk that Y2K posed to the world’s internet connectivity. Then as now, we believe that by cutting rates when the US economy is doing well, the Fed has compromised some of its ability to stimulate the domestic economy in the event of a future US-driven downturn in order to demonstrate that it is willing to protect the US against a severe downturn in the global economy now. However, the Fed must temper this willingness with the risk of overheating its home economy. In our mind, the key metric to watch in order to gauge the Fed’s likely future actions is business confidence, which is healthy (Exhibit 7). With consumer metrics also healthy, a break in business confidence is the only visible catalyst we currently see to a potential recession.
Exhibit 7: US Business Confidence Remains High
As of 31 October 2019
Source: Bloomberg
Act Like a Lender, Not a Trader
As long as central banks in developed countries attempt to stimulate their economies by intervening to hold down yields, and as long as local investors support that policy by keeping long-term sovereign rates negative, global demand for Treasury bonds will pin down US long rates, too. In these circumstances, we believe the US yield curve has lost its predictive value.
In uncharted financial waters, investors should focus on the seaworthiness of their ships. Keeping their destination clearly in view, we believe investors should focus their efforts on the specific characteristics of the individual investments that make up their portfolios: credit strength, structure, and institutional support.
- Credit Strength: identify issuers with a demonstrated ability and willingness to pay interest and return principal
- Structure: identify securities with a capital structure that favors lenders and that are contractually written, using generally accepted terms and conditions
- Support: to maintain true liquidity, identify bonds that enjoy robust long-only institutional demand. Operationally, institutions have infinite time horizons, and those that invest without leverage are indifferent to passing market storms. They ultimately give investors a ready, resilient, and liquid market to convert securities into cash when liquidity is scarce
As a rule of thumb, non-financial senior and senior secured securities issued by US entities that are constituents in the standard fixed income indices likely meet these three characteristics. For those looking to build a bulwark, these securities offer a place to start looking for material.
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Important Information
Originally published on 18 November 2019.
Author:Eulogio (Joe) Ramos
Managing Director, Head of US Fixed Income
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