Don’t Take the Bait
Credit and equity markets bottomed out in March of 2020, so the last 12 months have been all recovery, making for very pleasant reading in annual performance comparisons. The Bloomberg Barclays US Credit Index, for instance, is up 7.9% over the past 12 months. But it may be better to consider the last 13 months as a whole to judge by how much the recovery over the last year outweighs the drawdown in March of 2020. For that period, the same index is only up about 0.7% annualized. We are very pleased with the results of our process and our active management over this last credit cycle, and we think our clients have been as well. In addition, credit impairments among our positions have been negligible over the course of the last 15 months. Given all the fear and disruption in the pandemic, and our investments in several cyclical sectors before and after March 2020, we are gratified – if cautiously so – with our credit selection process.
The big story in fixed income in the first quarter of 2021 was a major move up in rates, bringing total returns on intermediate and longer duration notes and bonds into negative territory. The price performance of credit indexes, which was very powerful in the second half of last year, weakened over the last two quarters with the rise in rates. Index credit spreads1 (extra yield for credit risk) were rangebound for much of the first quarter. Meanwhile, economic trends from earnings to payrolls came in very strong, the Federal Reserve (Fed) has been steadfast that stimulus will remain in place, the government is considering a third huge stimulus spending bill, and investors are struggling with very low risk premia in fixed income.
This is a market heavily distorted by government action and, very likely, prone to significant bouts of volatility. Yet the economic context will likely include above-trend growth and some signs of inflation. It all adds up to an unprecedented combination. Accurate predictions are difficult even with solid historical parallels, let alone at a time like this.
Strong consumer trends, better-than-expected recovery in pandemic-affected sectors, massive fiscal and monetary stimulus, and continued trade frictions and interruptions in global trade have created inflation worries and driven investors from longer maturities.
The 10-year Treasury Note yield increased from 0.91% to 1.74% (see Exhibit I), with a negative return of about -7% for the quarter. While such a rise in rates certainly felt unfamiliar, we saw similar increases in 2008-2009, in the “taper tantrum” of 2013, and even in the second half of 2016. With short rates anchored around zero, the 2-10 year Treasury curve steepened to 1.57%, well above its average since 1977 of 0.91%, but certainly short of levels typically seen entering an expansion as well as its post crisis highs of 2.64%. These rate rises reversed some of the strong total returns in credit since April of 2020 (see Exhibit II). In summary, there has been a dramatic move in rates, but we are not in unprecedented territory, and there is risk of further moves if inflation rises above expectations. At the moment, the Treasury Inflation-Protected Securities (“TIPS”) market suggests a short run of inflation around 3%, moderating to 2.6% through 2025, then 2.2% thereafter. This market-implied forecast is quite similar to the forecasts of the Fed Governors, as well as those of many economists, but falls short of consumer surveys.