Volatility: Three Timely Perspectives for Investors
Our experts offer their insights on the implications of the trade-fueled market tumult.
A renewed escalation in U.S.-China trade tensions, along with Beijing’s decision to devalue the yuan, sparked a fresh episode of market volatility on Monday, August 5. Global equity indexes slumped, while investors flocked to haven investments such as government bonds; in the United States, the three-month/10-year U.S. Treasury curve reached its deepest inversion since the lead-up to the 2008 financial crisis, according to Bloomberg. Based on fed funds futures data from Bloomberg, investors expect a 100% chance of a rate cut by the U.S. Federal Reserve (Fed) in September, with a strong likelihood of similar moves over the next 12 months.
What should investors be thinking about right now? We asked three Lord Abbett investment experts to assess the implications of the current volatility for select asset classes:
Investment Strategist, Taxable Fixed Income
It is our view that the market response to flare-ups in tariff tensions with China is more about sentiment than actual changes in economic fundamentals. The ultimate impact on U.S. gross domestic product (GDP) is likely to be fairly small and more than offset by the Fed’s accommodative tendencies, along with still-easy financial conditions in the United States. The United States, with a large trade deficit, is not overly sensitive to trade the way that some export-driven economies, such as Germany and Japan, have been.
We have paid close attention to the growing short-term disconnects between investor sentiment and economic fundamentals, and the way that markets respond. In short, we find that sentiment has had an outsized impact on shorter-term market moves, but that as the initial sentiment fades, fundamentals reassert themselves as the dominant drivers of valuations. Thus, we believe sentiment-driven swings represent compelling investment opportunities. We would point to recent examples such as the fourth quarter 2018-first quarter 2019 selloff and subsequent reversal, and a similar, smaller-scale situation in May and June of this year.
The U.S. economy remains in robust health, in our view, with very strong labor markets. This most recent market overreaction, while entirely predictable given the news cycle, is yet another reminder of why investors should not make decisions solely based on prevailing sentiment, but retain a long-term outlook tied to fundamentals, and view these swings as either noise—or compelling investment opportunities.
Partner & Portfolio Manager, Currency Strategies
The return of volatility to the equity and foreign exchange markets means that we are seeing weakness in emerging market asset classes and U.S. dollar strength against most currencies. Certain currencies, such as the Japanese yen and the Swiss franc, are considered “safe havens” to which investors turn when they want to reduce risk.
The euro, which has historically had a positive correlation to equities and would have weakened as volatility rose, has instead appreciated against the dollar in the past few days. In our view, this is due to the very low interest rates in the Eurozone, which have caused investors to sell euro-denominated assets and the euro itself and buy other developed-market and especially emerging-market (EM) currencies and securities that carry higher interest rates. These types of “carry trades” typically get unwound when volatility spikes higher.
Meanwhile, global, developed-market government bond yields have moved sharply lower, led by U.S. Treasuries, as expectations for further central bank easing increase. Given this backdrop, investors may wish to become more selective in their allocations to EM securities, favoring certain countries and sectors less exposed to the trade tensions over a broad index, and reconsider pure carry trades that should underperform in higher volatility environments.
Partner, Director of Municipal Bonds
Municipal bonds have not seen the same volatility as other markets. While muni yield rates are falling, similar to the move in U.S. Treasuries, the pace of decline has been slower, making ratios of municipal yields to Treasuries rise. Muni-bond mutual fund flows continue to be very positive, based on Lipper data, with trading volumes on the lighter side. While new issue supply is higher than normal this week, it is primarily due to a few outsized deals and overall the amount of new issues coming to the market continues to be on the lower side.
The tax-free market is adjusting to 30-year high-grade bond yields being well below 3.00%, but the muni yield curve remains steeper than the Treasury curve, based on data from Thomson Reuters MMD, providing incremental yields for extending maturities. Overall, the municipal bond market has been rallying at a slower pace than Treasuries, but there hasn’t been much change in trading volume, and overall credit quality remains strong.
A Note about Risk: The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk. Credit risk is the risk that debt issuers will become unable to make timely interest payments, and at worst will fail to repay the principal amount. The municipal market can be affected by adverse tax, legislative, or political changes, and by the financial condition of the issuers of municipal securities. Income from municipal bonds may be subject to the alternative minimum tax. Federal, state and local taxes may apply. Investments in Puerto Rico and other U.S. territories, commonwealths, and possessions may be affected by local, state, and regional factors. These may include, for example, economic or political developments, erosion of the tax base, and the possibility of credit problems. Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes. Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements. The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. The securities markets of emerging countries tend to be less liquid, especially subject to greater price volatility, have a smaller market capitalization, have less government regulation and may not be subject to as extensive and frequent accounting, financial and other reporting requirements as securities issued in more developed countries. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.
Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.
This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.
A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates.
The Thomson Reuters Municipal Market Data (MMD) AAA Curve is a proprietary yield curve that provides the offer-side of “AAA” rated state general obligation bonds, as determined by the MMD analyst team. The “AAA” scale (MMD Scale), is published by Municipal Market Data every day at 3:00 p.m. Eastern standard time, with earlier indications of market movement provided throughout the trading day. The MMD AAA curve represents the MMD analyst team’s opinion of AAA valuation, based on institutional block size ($2 million+) market activity in both the primary and secondary municipal bond market. In the interest of transparency, MMD publishes extensive yield curve assumptions relating to various structural criteria which are used in filtering market information for the purpose of benchmark yield curve creation.
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The opinions in the preceding commentary are as of the date of publication and are subject to change. Additionally, the opinions may not represent the opinions of the firm as a whole. The document is not intended for use as forecast, research or investment advice concerning any particular investment or the markets in general, and it is not intended to be legal advice or tax advice. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information.