Fixed-income managers acknowledged volatility’s return in the second quarter, with many now implying that a recession is on the horizon.
According to the Russell Investments Fixed Income Survey for the second quarter of 2018, global bond managers feel less bullish and are looking for increased volatility in valuations and spreads as interest rates continue to rise.
Managers now expect more rate hikes, on average, as they are now evenly split between three or four rate hikes in the U.S. for 2018, whereas in the last quarter a majority expected three increases. This expectation is now priced into the bond market.
“In previous surveys, the views of global interest-rate managers have implied weakness in economic growth, which contrasts completely with what we have heard from credit managers where there has been some strong opinion about corporate credit’s improving fundamentals,” said Adam Smears, head of fixed-income research at Seattle-based Russell Investments.
The Federal Reserve funds rate is now expected to peak at three percent, which would mean five more rate hikes from today -- Russell says that means we’re more than halfway through the cycle of rate hikes, but as the Fed continues to hike, the expected terminal rate hike has continued to increase. The 10-year Treasury rate is expected to increase to 3.28 percent.
Inflation is ticking upward as well, with U.S. core CPI expected to increase to 2.16 percent over the next six to 18 months.
“This time around there’s a meaningful increase in managers’ views as to where the Fed could get, but if you look at expectations for inflation, they’re still implying a weak economy,” said Smears. “CPI around 2.15 percent and a terminal rate around 3 percent implies a real GDP growth of 85 basis points, but we’ve seen headline growth of 2 to 2.3 percent -- the expectations would require a recession of some degree” to verify.
While over half of corporate credit managers expect spreads to be range bound over the next six to 18 months, more managers now expect moderate spread widening for investment grade and high yield bonds. In the second quarter survey, 38 percent of managers expected widening vs. 19 percent last quarter, while 6 percent now see spread tightening, versus 19 percent in the last quarter.
Most credit managers believe spreads will continue to compensate for the risks of deteriorating fundamentals to at least some degree and that leverage will remain stable for most companies. Over half of the managers in the survey, 55 percent, felt that corporate fundamentals were modestly or materially improving, down from 90 percent last quarter.
“Credit managers have shifted opinions to come more in alignment with global rate managers, and that stands out to us,” said Smears. “There’s still a weak view in rates and a strong view in credit, so perhaps there’s more convergence to come.”