Signs of Slower U.S. Growth on the Horizon
The U.S. economic expansion, which began in 2009, is already one of the longest on record. This begs the question, how much longer can it last? While the recently passed tax reform bill may help to prolong the economic cycle, there are signs of slower growth, as the year progresses. And, this can have significant implications for the fixed-income market.
An Extended Cycle
While we don’t believe a recession in the U.S. is imminent, numerous indicators that have signaled economic slowdowns in the past are pointing to moderating growth. On average, economic cycles in the U.S. last roughly 34 months. The current expansion has now exceeded 100 months, and it will soon reach the second-longest period in the country’s history. We believe the U.S. is nearing the peak of the economic cycle, followed closely behind by the U.K. Meanwhile, Europe and Japan’s economies are moving up the expansion curve.
The World Economy Moves in Cycles
Sources: MacKay Shields, Bloomberg (U.S. expansion data provided by Bloomberg). Recent U.S. Expansion beginning 2009. Grey shade represents recession. This graphic is for illustrative purposes only. It represents a stylized economic cycle and does not represent the GDP growth of any given year.
Tighter Monetary Policy
Since it began normalizing monetary policy in December 2015, the U.S. Federal Reserve (Fed) has increased rates four more times. The Fed currently expects to implement three additional rate hikes in 2018 and two more in 2019. Meanwhile, the Fed continues to gradually reduce its sizable balance sheet. As shown in the chart below, before every recession, the Fed has been in a tightening mode. This generally begins well before the downturn. The Fed then often stops raising rates several quarters before the recession starts. They then typically start cutting rates about three quarters before the recession begins, in hopes of limiting the severity of the contraction.
Before Every Recession, There Was a Fed Funds Tightening
Federal Funds (Effective) Rate
Sources: Federal Reserve Board/Haver Analytics.
A Flattening Yield Curve
Another leading economic indicator has been the shape of the Treasury yield curve. Generally speaking, the yield curve is upward sloping. When the Fed thinks the economy is starting to grow too fast, it starts to raise rates, pushing yields on the short end of the curve higher. In some cases, the Fed raises rates so much that the two-year yield surpasses the 10-year yield. At that point, we have a negative slope, also known as an inverted yield curve. The yield curve has been flattening considerably, from about 250 basis points (bps) (2.50%) between the two-year and the 10-year notes to about 50 bps (0.50%) today.
Narrowing Credit Spreads
High-yield bond spreads have also been a fairly accurate indicator of an impending economic slowdown. Historically, these spreads start to widen two to six quarters before a recession occurs. In recent years, high-yield spreads have been narrowing and are currently moving closer to their all-time tight levels that occurred in 2007. While high-yield spread widening does not appear to be imminent, we don’t see them tightening much more, which limits their upside potential.
Asset-backed security (ABS) spreads are also worth monitoring. These spreads tend to tighten considerably before a recession, only to then widen meaningfully after a recession has started. ABS spreads have narrowed, as investors look to generate incremental yield.
Strong Job Market
While inflation has been a non-event for many years, this trend may be reversing course. We’re currently at, or near, full employment. This tends to be inflationary, as employers look to attract and retain talent. Should wage growth accelerate, the Fed could start to raise rates at a faster pace, which would push up the timetable for an inverted yield curve and be a headwind for the economy.
Strong Labor Market: Declining Unemployment Rate & Wage Growth
(9/30/91 – 12/31/17)
Sources: Bureau of Labor Statistics/Haver Analytics.
Strategies for a Slower Growth Environment
Given the signs of slower growth down the road, what steps should investors consider for their fixed-income portfolios? With the likelihood of higher interest rates, reducing duration could help to temper a portfolio’s overall risk exposure. From a sector perspective, less compelling valuations, coupled with the Fed reducing its exposure, could limit upside for the mortgage-backed security (MBS) market. Stretched ABS valuations also make them less attractive. Finally, while high-yield spreads have significantly narrowed, they could potentially be range-bound for the time being, and continue to offer a yield advantage. That being said, it may be prudent to take some risk off the table by paring one’s exposure to lower-rated CCC securities, as well as reducing allocations to industries that are experiencing idiosyncratic problems (i.e., retail).
While earnings growth should remain supported by accommodative fiscal stimulus, the potential headwinds from higher interest rates and slower loan growth warrant our attention. As observed in past cycles, credit spreads have stayed below historical averages for an extended period of time. Therefore, adopting a less aggressive, targeted risk profile, while staying invested, is a prudent choice in a low-yield environment.
Opinions expressed are current opinions as of the date appearing in this material only. The information and opinions contained herein are for general information use only. MainStay Investments does not guarantee their accuracy or completeness, nor does MainStay Investments assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. There can be no guarantee that any projection, forecast, or opinion in these materials will be realized. Past performance is no guarantee of future results.
There is no assurance that the investment objectives can be met. It is not possible to invest directly in an index. All investments are subject to market risk, including possible loss of principal. Diversification cannot assure a profit or protect against loss in a declining market. A portion of the municipal bond fund’s income may be subject to state and local taxes or the alternative minimum tax. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. Funds that invest in bonds are subject to interest-rate risk and can lose principal value when interest rates rise.
High-yield securities carry higher risks and some of the Fund’s investments have speculative characteristics and present a greater risk of loss than higher-quality debt securities. These securities can also be subject to greater price volatility.
Credit rating agencies, such as Moody’s, Standard & Poor’s, and Fitch Ratings, have letter designations (such as AAA, B, CC) which represent the quality of a bond. Moody’s assigns bond credit ratings of Aaa, Aa, A, Baa, Ba, B, Caa, Ca, and C, with WR and NR as withdrawn and not rated. Standard & Poor’s and Fitch assign bond credit ratings of AAA, AA, A, BBB, BB, B, CCC, CC, C, and D. Past performance is no guarantee of future results, which will vary.
Asset-backed securities, called ABS, are bonds or notes backed by financial assets. Typically these assets consist of receivables other than mortgage loans,1 such as credit card receivables, auto loans, manufactured-housing contracts and home-equity loans.
Basis points (bps) refer to a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01% (0.0001), and is used to denote the percentage change in a financial instrument.
A credit spread is the difference in yield between two bonds of similar maturity, but different credit quality.
The Eurozone is a geographic and economic region that consists of all the European Union (EU) countries that have fully incorporated the euro as their national currency. As of 2018, the Eurozone consisted of 19 countries in the EU: Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherands, Portugal, Slovakia, Slovenia, and Spain.
The International Monetary Fund (IMF) is an international organization that provides financial assistance and advice to member countries.
A mortgage-backed security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages. The mortgages are sold to a group of individuals (a government agency or investment bank) that securitizes, or packages, the loans together into a security that investors can buy.
A yield curve is a curve on a graph in which the yield of fixed-interest securities is plotted against the length of time they have to run to maturity.
MacKay Shields LLC is a federally registered investment advisor and an affiliate of New York Life Investment Management LLC. MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. The MainStay Funds® are managed by New York Life Investment Management LLC and distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, NJ 07302, a wholly owned subsidiary of New York Life Insurance Company. NYLIFE Distributors LLC is a Member FINRA/SIPC.