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Growing Tail Risks Threaten Economic Growth, Market Performance, Report

August 27, 2018, 07:12 AM
Filed Under: Economic Commentary

Guggenheim Investments, the global asset management and investment advisory business of Guggenheim Partners, provided its Third Quarter 2018 Fixed-Income Outlook, “Tail Risks Are Getting Fatter.”

“Ten-year Treasury yields once again flirting with 3 percent is prompting much handwringing about how high rates can go,” said Scott Minerd, Global CIO and Chairman of Investments. “We have held for some time that the upper bound on long rates is 3.25–3.50 percent, which we believe will be the terminal rate in this tightening cycle. If rates do get there, however, it will probably be short-lived because the greater possibility is that the yield curve will invert, as 10-year yields will be held down by any number of looming risks.”

These risks include the possibility of an inflationary trade war, increasingly restrictive Federal Reserve policy, a potential fall budget showdown, instability in Europe and emerging markets, saber-rattling with Iran, and the consequences of the midterm elections. The markets have reflected this uncertainty, evidenced by spasms of volatility and repricing in credit markets.

Investors need to be prepared for this shifting environment, said Minerd, as well as a recession that will likely begin in early 2020. “With these and other exogenous factors threatening asset values, market confidence, and the strength of the U.S. economy, the situation calls for a duration barbell and a move up in credit.”

With this quarter’s outlook, we also release timely and relevant video commentary, from Portfolio Manager Adam Bloch and Brian Smedley, head of the Macroeconomic and Investment Research Group.

According to the report:

General investor confusion prevails as the mid-2018 market theme. Investment-grade corporate bond spreads are wider while high-yield corporate bond spreads are tighter since 2017.The addition of tariffs creates a dilemma for Fed policymakers, who must lean against this inflationary impulse. As a result, our Macroeconomic and Investment Research Group predicts six more rate hikes over the next six quarters, which would put real pressure on U.S. corporates and risk assets.

  • After months of gradual repositioning we have reduced corporate credit exposure to multi-year lows as we see an unfavorable risk/reward tradeoff given tight spreads, escalating trade tensions, and a recession approaching in 2020.
  • Within corporate credit, our preference for bank loans over high-yield corporate bonds is working in our favor as loans outperformed high-yield corporates for a third quarter in a row.
  • Our investment-grade team notes that BBB-rated bonds now account for around half of the investment-grade corporate bond universe, up from 30–35 percent 10 years ago. The glut of BBB corporates is cause for concern as they are increasing leverage in a rising rate environment.

Investment-grade corporate spreads remain vulnerable. For example, the rise of passive investors in the investment-grade space also exposes the market to forced selling in the event BBB bonds get downgraded.

Our asset-backed securities (ABS) team continues to uncover value in esoteric commercial ABS, fueling higher yields by capturing information premiums, as opposed to taking additional credit or leverage-based risk. We also believe AA-rated collateralized loan obligations (CLOs) are mispriced and represent compelling value relative to A CLOs.

As the U.S. economy approaches the turn in the credit cycle, our portfolio management team expects liquidity will become a more challenging factor. For this reason, we believe maintaining a reasonable liquidity buffer will grant us the opportunity to pick up undervalued credits when others are forced to sell.

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