The Core Bond Fund has a 9% allocation to Treasury Inflation-Protected Securities (TIPS). Very tight labor markets in the U.S. and decent global growth have been adding to inflationary pressures, which the markets haven’t priced in, says Palfrey. That has colored his perception of riskier assets: His fund’s allocation to high yield (5.5%) is its lowest in the more than 20 years he’s run the product, he says.

“If we get a better level of comfort that this is just a market correction and not a harbinger for a downturn in the U.S. and global economy,” he says, “our inclination would be to selectively add back to some of the risk positions that we sold a year-plus ago.”

Finding Value Anomalies

One of the biggest issues for bond and equity investors in 2019 is whether companies will be able to pass along to customers their greater input costs from higher wages and possibly higher tariffs, says Jack McIntyre, a portfolio manager for global fixed-income and related strategies at Brandywine Global Investment Management, an affiliate of Legg Mason. He thinks the disruption in retail because of the Amazon effect and other competitive factors will block companies from raising prices but also, in turn, help keep inflation in check. This would make the Fed less inclined to raise interest rates. He also thinks the Fed is reluctant to cause further inversion of the yield curve (when yields are higher on short-term debt than longer-term debt) because that’s generally been a harbinger for a recession.

Brandywine, which is always looking for value anomalies, has 75% of its fixed-income portfolio in sovereign bonds and 25% in credit, says McIntyre. He says Brandywine’s exposure to credit, where the firm doesn’t see many value opportunities, is largely limited to short-dated cash equivalents.

Brandywine’s sovereign debt investments are skewed toward emerging markets, particularly commodity producers. McIntyre says these instruments have been overly discounted because of investors’ fear of the overall market forces, “the 40,000-foot influences,” he says—namely concerns about Fed tightening and U.S.-China trade tensions. Yet nominal yields in this area exceed 9% on 10-year and 30-year government bonds. “You’d have to take on very risky credit to get the same yields you’re getting in emerging market sovereigns,” he says.

He thinks a weakening U.S. dollar will be the big catalyst this year for the emerging market sovereign space, which had a bumpy 2018. If the Fed pauses, it will remove some interest rate support for the dollar, he says—and that will help developing market bonds. Another possible boost to these bonds would be any buildup in Chinese economic traction—since the country has now stepped up monetary stimulus to try to offset the drag from trade uncertainties, McIntyre says.

Mexico tops Brandywine’s list for value anomalies. The markets have been too negative about what President Andrés Manuel López Obrador’s policies will ultimately be, says McIntyre. Meanwhile, Mexico’s central bank plans to keep tightening rates.

“Currency and bonds are positioning for what happened in 1994—the Tequila crisis,” when the devaluation of the peso affected currencies in neighboring economies. “Yet the Mexican economy is in much, much better shape today than it was back then,” McIntyre says. Brandywine is also invested in sovereign debt issued by South Africa, Indonesia, Malaysia and Brazil.

Emerging markets could be risky, however, if the Fed tightens rates until the U.S. economy and the U.S. dollar break, he says, or if the lack of progress on trade tensions with China pushes the global economy into a recession. But McIntyre doesn’t anticipate either scenario.