It’s been three years since the Federal Reserve commenced its rate hikes, and fixed-income experts are hoping for a pause in 2019. Should the Fed continue to ratchet up the federal funds rate, which it has raised nine times since December 2015, bond investors fear it could push the U.S. into another recession sooner rather than later and send the markets tumbling.

They don’t anticipate this gloom and doom, but they are exercising caution amid mixed messages from the Fed, market volatility, investor anxiety and big global question marks.

In December, the Fed initiated its fourth rate hike of the year and projected two more hikes in 2019, although it sees economic growth moderating. The language of Federal Reserve Chairman Jerome Powell has been keenly observed. In October, he said that interest rates were “a long way” from their neutral level—the rate at which GDP is growing along its trend rate and inflation is under control. Those words sent equities plunging. In November, those seemingly innocuous words were changed again to the even more innocuous statement that rates were “just below” their neutral level. After that, markets took off again.

U.S. economic news has been good, says Peter Palfrey, co-manager of the Natixis Loomis Sayles Core Plus Bond Fund, “but markets are fearful and we’re starting to speculate that things are going to get uglier before they get better.”

Global growth has slowed, partly from the spat the U.S. has had with China and its tensions with many of its other trading partners as well, Palfrey says. The tariffs President Donald Trump imposed on steel, aluminum and washing machines apply to all countries the U.S. partners with and “was kind of a one-two punch against trade relations,” Palfrey says. If the U.S. and China remain at odds, it will disrupt trade globally and have “a dramatic ripple effect across all markets,” he adds.

Palfrey thinks U.S. economic growth can remain robust this year, though its big drivers have waned. These drivers included the “sugar high” from former very expansionary fiscal policy, the one-off tax cuts at the corporate and individual levels and the continued recovery from the 2015-2016 commodity bust, he says.

Loomis Sayles had already expected the Fed to initiate two rate hikes in 2019, most likely in June and December. If there were going to be more than two hikes, there would first have to be stabilization in the oil and equity markets and some progress in U.S.-China trade relations, Palfrey says.

“We do feel that the market has perhaps priced in too much bad news,” he says, so he’s been shaving duration in the Core Bond Fund, whose chief allocations are to agency mortgage-backed securities (30%) and investment-grade credit (26%).

When taking pricing into account, he finds foreign credit (particularly in emerging markets) more interesting than domestic credit. “We think you can get a little more yield without taking on too much incremental credit risk,” he says.

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.

The House Isn’t On Fire

At Northern Trust Asset Management, a large investment portfolio would typically be fully invested or overweight in most fixed-income asset classes, says Colin Robertson, managing director of fixed income at the firm. “We don’t think the house is on fire so we wouldn’t invest in cash,” he says, although a small allocation is OK.

Heading into 2019, Robertson thinks the fixed-income markets are a much better place to be, on a risk-reward basis, than equities. Equities are volatile and pretty elevated, he says, though he doesn’t expect a stock crash.

Northern Trust doesn’t think the Fed was dovish enough at its December meeting. Robertson and his colleagues expect economic data to soften because of a weakening global economy (particularly in China and Europe), because of “stuckflation” worldwide (inflation is below 2% in most countries), because of the natural waning benefit from the recent U.S. tax cuts and because of the trade issues with China and other nations. According to a Northern Trust review, the credit markets in aggregate also seem to be in “solid condition.”

“I think the Fed has gone too far too fast,” says Robertson, whose biggest fear is an inversion across the entire yield curve. He thinks a couple of the 2018 hikes were justified by strong domestic growth, which he had underestimated. But the Fed overestimated inflation based on “their hope, not on their facts,” he says.

Northern Trust Asset Management thinks high yield presents attractive opportunities this year. Although the firm is cautious when selecting individual bonds, it likes the financials sector here. Valuations are good, default rates are relatively low, and “there aren’t a lot of entities with a bunch of debt coming due or stressed leverage ratios that would make it look like they could fall out of bed and be problematic,” says Robertson.

Ultra-short fixed income (instruments with an average duration of six to 15 months) offers some income stability and “sleep-at-night money” in this volatile environment, he says. With such a flat yield curve, investors don’t have to sacrifice much yield by being in the shorter end of the curve instead of in the longer end of the curve. Ultra-short securities can be exited quickly if rates rise—though they shouldn’t be used as a substitute for cash, Robertson says.

Mark Heppenstall, the chief investment officer at Penn Mutual Asset Management, anticipates a “return to Goldilocks growth” in GDP, around 2.5% this year, he says. The rapid decline in oil prices will put some downward pressure on inflation, keeping it around 2%, he says.

He expects higher swings in asset prices as markets readjust to curtailed purchases of financial assets by central banks and pockets of stress in parts of the globe. The problems in Italy could affect risk assets elsewhere and the country could pose a much bigger problem than Greece did, he says.

To add value, Heppenstall, who advocates being nimble and opportunistic, is taking advantage of spread-widening events. “We think you’re getting paid now to own some degree of interest rate risk, especially in that five- to 10-year corporate-focused part of the market,” he says.

He sees opportunities across sectors in investment-grade corporate credit, especially in consumer staples, utilities and banking/finance names that he thinks are well positioned to withstand a downturn in the economy. Penn Mutual’s unconstrained bond strategy, initiated in 2016 and rolled out in mutual fund format last year, has about half its assets in the corporate bond market (focused on the U.S.) and 30% in structured securities. The balance is in Treasurys, TIPS and taxable municipals.

The strategy’s structured security holdings include commercial mortgage-backed securities and parts of the asset-backed market, including securitized student loans. The appeal of structured securities is that they are less widely followed than parts of the corporate bond market, making it easier to identify undervalued securities, and it’s a diversifier, he says.

Penn Mutual isn’t actively invested in master limited partnerships, but it owns bonds in this space, primarily from large, diversified investment-grade MLP issuers. MLP bonds are less sensitive to commodity price fluctuations than other energy credits, says Heppenstall. MLP cash flows are contracted (related to the transportation and storage of oil and gas) and aren’t tied to oil’s underlying price.

Calming Client Nerves

Becky Gersonde, a vice president and portfolio manager at Heber Fuger Wendin, a Michigan-based independent, fee-only financial advisor and investment counsel, says the shape of the yield curve could change if there’s not enough demand to swallow up the billions of Treasury debt hitting the market to fund the swelling budget deficit. But she expects the yield curve to remain relatively flat in 2019, at around 3% straight out.

With spreads so narrow, the vast majority of her firm’s community bank clients (whom it primarily works with, besides credit union clients) have a 50% to 60% portfolio allocation to Treasurys and U.S. agency securities. Many firm clients pared their municipal holdings last year when tax law changes cut the corporate tax rate, diminishing the attractiveness of tax-free muni bonds.

Heber Fuger Wendin tends to buy individual securities for individual clients, and it has been educating them on the difference between individual bonds (in which the principal is preserved at maturity) and bond mutual funds (where the investments aren’t guaranteed). “As long as you don’t panic and sell the bond, it’s just an unrealized or paper loss,” says David Barnes, the firm’s chairman, president and CEO.

The firm is also explaining to clients that in a rising interest rate environment, funds lag individual bonds in upside performance because managers don’t churn investments fast enough to try to catch up with current rates. “If in a year or two we hit a recessionary track,” says Gersonde, and the Fed starts lowering rates, “we might be making the opposite move” by shifting from individual bonds into funds that may help preserve yield for clients.

She and Barnes are closely watching the spread between 10-year and two-year Treasurys, which they’ve found to be the best indicator of a recession. For a recession to occur quickly, says Gersonde, “you’d have to get economic data just completely falling out of bed,” with sub-2% growth and out-of-control inflation. In other words, she says, “Everything would have to turn upside down from where it is now.”