I enjoy writing the fourth quarter commentary; other than the highlights of the quarter, it provides an opportunity to look back at some of the prominent events of the entire year. And what a year it was. Coming into 2019, the market was expecting the Federal Reserve to hike rates two or three times. In the end, the Fed cut rates three times, with the final cut coming at the October meeting in what was viewed mainly as an insurance cut. It was (and still is) viewed as the last rate change for the foreseeable future. Market expectations were for the Fed to shrink its balance sheet and for yields to rise, in effect keeping rates from going negative, as is the case for many other central banks. Instead, the Fed restarted buying Treasury securities (but please don’t call it quantitative easing) and expanded its balance sheet, and the market reacted with lower yields and a flatter yield curve.
Inflation was expected to rise and get to the Fed’s 2% target. Other than a small rebound in the fourth quarter as crude oil prices trended higher, breakeven inflation rates generally fell throughout the year and never did reach 2% at any point in 2019. A tight labor market has the potential to push wage inflation higher, but after peaking in February of last year, hourly earnings fell seven of the remaining ten months. The U.S. is at generational lows in unemployment but the mix of jobs (less goods-producing employment than service sector employment) is preventing any material wage pressures. As such, we are not expecting a wage push increase in inflation.
Sector returns varied across the fixed income markets, as they always do, but each finished the year well ahead of expectations. You could say the market was caught by surprise a few times throughout the year but none of them strong enough to derail the huge demand for yield. Entering 2019, corporate credit was in disarray from the spread widening and negative returns as 2018 came to a close. For 2019, investment grade credit had its best performance since 2009. The lower end of investment grade and the top of high yield produced the best returns. Our exposure to triple-B and above issuers was rewarded as was our selective use of double-B credits.
And more than just an honorable mention, all hail the consumer who has pulled the domestic economy from the dire predictions of certain contraction once the Treasury curve inverted in August last year. Employment growth was probably a major contributor to strong consumer spending, as employers added over 2 million jobs in 2019.
Looking at some of the fourth quarter statistics, the Bloomberg Barclays Intermediate Government/Credit Index, our benchmark for total return portfolios, returned .37%. The fourth quarter was the smallest of 2019’s quarterly returns but added to an impressive full-year which returned 6.80%. For this high-grade, intermediate maturity index, nine of the 12 months of 2019 had positive returns. For the broader fixed income market, the Bloomberg Barclays US Aggregate Index returned 18 basis points for the fourth quarter—another breather quarter of a 2019 that saw an 8.72% full-year return. The slowing performance in the fourth quarter was mainly due to government securities. All indications were for a Treasury market ahead of itself when 10-year yields fell through 1.5% at the end of August last year. Treasury yields drifted higher throughout the fourth quarter with the 10-year Treasury ending the year at 1.92%. Coupon income balanced the price drop of intermediate Treasuries, providing a total return of only a few basis points. On the other hand, intermediate credit kept up its impressive quarterly performance with almost a 1% gain in the fourth quarter. Any amount of issuance was met with very strong demand.
It seemed as though the more issuers brought to market, the more investors wanted. Spreads tightened throughout the year and finished at the lows (1). Credit returns, like governments, were higher for longer maturity bonds versus short maturities.
Switching gears to the municipal bond market, 2019 was also a year of extremes. In the broader sense, I can’t really just say “municipal bond market” without identifying if the issue was tax-exempt (traditional municipal bonds) or taxable (not new, but a market that came into its own in 2019). Taxable municipal bonds grew to about a 17% share of the overall market as issuers refunded older, higher coupon issues. Demand for traditional municipal securities, as measured by mutual fund inflows, set a record at over $94 billion. Since mutual fund purchases are just one aspect of the market, even that amount does not fully quantify the desire for tax-free income. The fourth quarter also saw a continuation of the strong demand for individual securities (which is how we manage portfolios at Howe & Rusling), especially in high tax states.
The Bloomberg Barclays Quality Intermediate Municipal Bond Index, our benchmark for tax-free portfolios, returned .86% in the fourth quarter, bringing the total for 2019 to 5.88%. The intermediate maturity market drew eleven of the 12 months into positive returns. A-rated bonds outperformed the broad market as investors sought out yield. While we expect new issuance to pick up in 2020, we also expect demand to remain strong. Most of the conditions which led to a healthy municipal bond market in 2019 are still in place as we move into 2020.
Looking ahead to the new year, we believe performance in 2020 for most if not all sectors in the fixed income market will be driven more by coupon income than the price appreciation the market experienced in 2019. We agree with most Street economists that yields will be lower at the end of 2020, but only marginally. The Fed has done a fine job of getting the markets comfortable with no rate changes this year, leading to a range-bound Treasury market as the most likely outcome. Credit spreads in corporate and municipal debt are at or very near historically tight relationships. We do not anticipate a dramatic spread widening event, though we are always vigilant for the off chance our economy weakens to reignite recession fears. For corporate bonds, demand should remain strong as yields, when viewed from a global perspective, are still quite attractive. In the municipal bond sector, the SALT cap (limited deduction for state and local taxes) is still in place, and it is an election year, which will keep the debate of higher taxes at the forefront of investors’ decisions—both of which will lead to strong demand for tax-free income. Our strategic allocations in the new year will attempt to capture as much incremental income as possible relative to our desire to maintain high quality portfolios. We should enjoy another year of positive fixed income returns, but at levels that typify a nice jog and not a sprint.
(1) Bloomberg Barclays US Aggregate Corporate Average Option Adjusted Spread was .93% as of December 31, 2019; the low for the year and down from 1.53% at 2018 year-end.