5 wild cards for bonds in 2020

After a year of outsized returns for both equity and fixed income markets, expectations for 2020 returns have settled closer to their long-run averages: roughly 5% for stocks, and coupon-like returns of about 2% for investment-grade bonds and 5% to 6% for riskier bonds.

What could upend these market expectations? We see five potential disruptors.

1) Politics – Opaque outcome

The biggest “wild card” of 2020: the U.S. presidential election in November, the outcome of which will trickle down to and influence all other issues in 2021 and beyond. These layers of uncertainty could lead to large surprises – in either direction. For investors, political uncertainty is one of the most difficult risks to measure because the outcome, as well as the market reaction, can be very hard to predict. For instance, when it comes to monetary policy and changes in interest rates, investors can guess at outcomes and policymaker reactions to those outcomes and try to assign reasonable likelihoods for different scenarios. Political uncertainties, on the other hand, are typically less amenable to quantification because their outcomes can have a series of cascading effects on other issues.

2) Trade strife – Dormant…for now

Trade was a big issue in 2019. By splitting the U.S.-China negotiations into a Phase 1 agreement—which basically confirms a pause on any further tit-for-tat tariffs—and pushing the deeper, more substantive issues into a future Phase 2 deal, the risk of an escalating trade feud has been temporarily abated. Call it the “olfactory” effect of trade: it might smell bad, but if it doesn’t get worse you eventually stop noticing the smell altogether.  So, though trade uncertainty remains high, as long as it doesn’t increase, then the negative drag from trade negotiations will likely be limited this year.

The politics on trade are multilateral and opaque. Both the U.S. and China have an incentive to pause, but it is doubtful that trade risk will be dormant for all of 2020. By mid-year the democratic nominee will emerge, clarifying for China an alternative to Trump. In turn, Trump may again use acceleration in trade rhetoric to his advantage to secure portions of his base. The Phase 2 issues are the big ones he likely will run on again, so expecting trade uncertainty to remain low throughout 2020 is a good way for the consensus outlook to be disappointed.

3) Monetary Policy – “Appropriate”

Certainly, the policy shift toward interest rate cuts ended up being a critical return catalyst in 2019. For 2020, however, the policy outlook looks generally on hold. The Fed signals policy is “appropriate” (to the situation) and globally, monetary policy expectations for further cuts in Europe, EM and Japan have abated.

The Fed’s policy stance may be skewed dovish—meaning it may be more likely to lower rates in response to a slowdown than raise rates in response to an uptick in growth or inflation.

4) Valuations – Where do we go from here?

Valuations represent a headwind to return potential in 2020. That partly explains the lowered return expectations relative to last year: higher starting prices in 2019 implies lower returns in 2020.

Low starting yields and tight spreads make further valuation based on price appreciation unlikely for bonds. That leads to expectations for coupon-level returns in the riskier portions of fixed income. The good news is that an absence of recession risks may truncate the downside potential for returns. However, this exacerbates an ongoing trend we have been seeing in markets—investors reaching further and further down in quality in the search for yield.

5) Market vulnerabilities – (Over)reaching for yield?

As the below chart highlights, we observe some unique characteristics in today’s corporate credit markets. The figure compares high yield bond spreads against the credit ratings migration rate. A negative credit ratings migration rate indicates that more firms are being downgraded than upgraded, typical in late cycle environments.

Generally, credit downgrades lead to eventually higher credit spreads, as investors shy away from the riskiest bonds. In 2019, however, a rise in credit downgrades was followed by tighter, not wider spreads. That disconnect fuels concerns of “reach for yield” behavior, adding to future financial vulnerabilities.

From our list of five potential “wild cards” we see political risk and trade negotiations as those most likely to be the main determinant of returns in the year ahead. Yet, given the opaque and highly unpredictable nature of these issues, it is difficult to forecast possible market repercussions.  So for now, we will have to wait and watch how these wild cards play out.

Jeffrey Rosenberg, CFA, is a senior portfolio manager for BlackRock’s Systematic Fixed Income (“SFI”) team and a regular contributor to The Blog.

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