As we entered 2019, there were many clouds on the horizon.
The Fed had just hiked rates for the fifth time in the last twelve months, geopolitical tensions were on the rise, and the economic growth outlook was cooling. Financial markets had just experienced one of the worst quarters in recent memory with the S&P 500 Index down 14%.
As we moved through 2019, many of these clouds slowly disappeared. The Fed made a remarkable pivot in January and ultimately cut the Federal Funds Rate three times during the year. A phase one trade deal with China is set to be signed in the coming weeks. The growth outlook is stabilizing. This led to a sharp rebound in risk assets with the S&P 500 Index up 31%. The saying “bull markets climb up a wall of worry” was never more true.
Interestingly enough, like stocks, investment grade bonds also had a great year. Typically, when risk assets do well, bonds suffer as investors demand higher yields to account for a stronger growth and inflation backdrop. 2019 was an exception as central bank easing combined with below target inflation and a demand for yield from global investors pushed U.S. Treasury Rates lower across the curve.
Tax-Free Municipals: A strong technical backdrop was the main story in the municipal market during 2019. Investors poured over $100B into muni mutual funds and ETFs last year, a new annual record. This demand, coupled with reasonable levels of issuance, helped munis outperform government bonds across most parts of the yield curve.
Broadly, fundamental credit quality has strengthened over the last several years as the improving economy and strong financial market environment has improved the financial position of many municipalities. The issues around underfunded pension and healthcare liabilities remain acute, however, and must be analyzed carefully when searching for opportunities in the tax-free market.
Taxables: The riskier the better in 2019 as corporates, particularly those rated BBB, led the way for investment grade taxable bond returns. The Fed’s January pivot, stable credit fundamentals and an insatiable appetite for yield from overseas investors led to credit spread tightening. Other taxable sectors like taxable municipals and government mortgages performed well, but lagged corporates.
In general, credit spreads are near post-financial crisis tights across most sectors. Given this backdrop we believe sector diversification is important and have positioned portfolios as such.
Overall: Looking ahead, many outlooks are calling for a much more benign environment in 2020, where bond investors can expect to collect their coupons, but little more. As we’ve come to expect in recent years however, when consensus calls for a low volatility environment, it is reasonable to assume the opposite. Further trade negotiations, the impact on inflation from tariffs and the presidential election are a few items on our radar.