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Market View

Lord Abbett investment leaders offer their insights on key fixed income and equity sectors for the remainder of 2019. 

 

In Brief

  • We surveyed Lord Abbett investment leaders for their insights on trends that may shape the equity and fixed-income markets in the final quarter of 2019.
  • The panel represented a wide range of our firm’s investment disciplines: U.S. equities, U.S. taxable fixed income, U.S. high yield, emerging market debt, and municipal bonds.
  • The participants identified a number of factors to watch in the months ahead, including U.S. economic growth, corporate leverage, U.S.-China trade tensions, and technological innovation.

 

Three down, one to go. With the first three quarters of a tumultuous year in the books, what might investors expect for the final months of 2019? We surveyed five Lord Abbett investment leaders for their thoughts.

U.S. Equities
Brian Foerster, Investment Strategist, Equities

On the surface, the final month of the third quarter may have appeared to be calm when looking at price movements of the major U.S. stock indexes. While the S&P 500®, Russell 1000® Growth, and Russell 1000® Value indexes posted modest gains or losses for the month of September (through September 28), the volatility beneath the surface was historically massive, with price swings of as much as 200% in the CBOE Volatility Index (VIX), based on Bloomberg data.  Specifically, we saw a concentrated rotation out of industries that have been leading the market for the majority of the period since early 2017, namely secular growth areas such as software and biotech, as well as defensive groups such as utilities and consumer staples.  Simultaneously, we have witnessed a powerful rally in economically-sensitive areas that have been depressed during the same period—especially industrials, financials and some areas of consumer cyclicals.

Some observers have simplified this rotation as “Value-Growth,” but we believe it is important to focus on the specific movement described above, as it reflects the particular dynamics of the equity market today.  Trading activity among algorithmic strategies, quant hedge funds, and exchange-traded funds has accelerated and amplified factor rotations in the market—often without much fundamental rationale, it appears to us—and in this case the trade revealed a shift from momentum/defensive stocks to cyclical issues.

This rotation occurred in direct parallel with a sharp reversal in interest rates in early September.  After a steep decline in the 10-year U.S. Treasury yield during August, rates bounced off a low of 1.47% in early September to over 1.8% in the course of a week.  This reversal was sparked by economic data that suggested inflation and gross domestic product (GDP) growth in the United States may be stronger (or just not as weak) than expected, along with the view that “trade peace” could break out soon between the United States and China.  And while this intense rotation has extended into quarter-end, we do not believe it is a lasting one for two reasons. First, upcoming third-quarter earnings reports are coming and in our view, they likely will remind investors where there is, in fact, earnings growth and stability.  Second, we find it very difficult to believe that global GDP will reaccelerate soon, which would be the required scenario for a sustained lift in cyclical stocks.

Our outlook and expectations for the fourth quarter are roughly the same as they appear for the next 12 months as we head into what is shaping up to be an extraordinarily contentious U.S. election season. And that outlook is for more volatility (for example, certain health care stocks have already been stung by investor concerns about presidential candidates’ views on health insurance). What’s the bright side?  We see strong fundamentals in many innovation growth areas of the market as well as durable earnings growth among many stable, well-performing companies not threatened by innovation.  We continue to believe that short-term volatility should provide attractive entry points for long-term investors in areas of high innovation such as biotechnology, software, ecommerce, artificial intelligence, and robotics.  Moreover, companies that cannot be “disrupted away” with strong managements and durable business models should also benefit from an environment where investors separate winners from losers in this low-growth environment.

Municipal Bonds
Daniel Solender, Partner and Director of Municipal Bonds

After a very strong first three quarters of 2019, the focus for the municipal bond market during the fourth quarter will be upon the same dynamics which have been supporting the market all year.  These are:

Individual Investor Demand:  With many people facing higher tax bills due to the cap on the deduction for state and local taxes, there has been tremendous demand for the tax-exempt interest of municipal bonds.  This factor, along with people being comfortable buying bonds in the falling-to-stable interest-rate environment, has led to a record amount of money flowing into municipal bond mutual funds (see Chart 1).  Separately managed accounts have also received strong flows. This positive sentiment will be followed closely because we believe it will impact greatly the direction of the market going forward.

New Issue Bond Supply:  Thus far, the level of supply has been on the average-to-lower side while the actual amount of municipal bonds outstanding actually has been slightly shrinking rather than growing as older bonds are maturing.  Lower supply has led to strong demand for new issues which has also helped push bond prices up.  There are signs that the volume might be ticking up somewhat so it will be important to see whether any increase puts pressure on the market going forward but, with the strong demand evident at the end of the third quarter, we think prospects for such a development appear to be unlikely.

Credit QualityCredit quality in the first three quarter of 2019 has been strong, with the rating agencies announcing more upgrades than downgrades, based on data from Standard & Poor’s, Moody’s, and Fitch.  Also, most states had surpluses due to higher-than-expected tax payments.  With the economy growing at a steady, although not robust, pace, revenue patterns will need to be watched for any indications of weakness. 

In summary, the supply and demand dynamics along with the positive credit trends have allowed the municipal bond market to perform well so far this year as overall interest rates have fallen.  The same dynamics that led to the strong performance in the third quarter will be monitored carefully for the remainder of the year.

 

Chart 1. Strong Demand for Municipal Bonds Is Reflected in Monthly Mutual-Fund Flows
Flows into U.S. municipal-bond mutual funds, October 2018–September 2019 (through September 18)

Source: JP Morgan, Lipper, and EPFR Global. Data as of September 18, 2019.
The information shown is for illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.  Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.
Past performance is not a reliable indicator or a guarantee of future results.

 

U.S. Taxable Fixed Income
Andrew O’Brien, Partner & Portfolio Manager for Fixed Income

On the investment-grade side, we see two major issues affecting the corporate market: investors’ concerns about the possibility of a U.S. recession and the increase in leverage (i.e., debt) on corporate balance sheets.

Recession:  Some combination of higher rates, trade war uncertainty, and disappointing growth elsewhere in the world (Europe, in particular) has led investors to worry that the United States might not be too far from a recession. Even if a recession doesn’t materialize, investors who are worried about it tend to invest conservatively, which definitely has an impact on the valuation of risky assets overall and on the relative pricing of risk across sectors with different sensitivity to economic growth. In our opinion, the U.S. economy is not in imminent danger of recession, but the fact that so many people are worried is definitely affecting valuations.

Balance Sheet Leveraging: Thanks to a decade plus of low interest rates, managers of investment-grade corporate entities have found it advantageous to increase leverage to the point where the average credit quality of the investment-grade index is as low as it has ever been in a nonrecessionary environment. The share of BBBs as a percentage of the overall index has steadily climbed. Thanks to low rates, interest coverage hasn’t worsened as much as overall leverage, but it’s still bad. Whether or not this leveraging trend continues is a key concern for the investment- grade market going forward.

U.S. High Yield Bonds
Emanuela Scura, Partner & Deputy Director of Global Credit Research

As we head into the fourth quarter of 2019, we remain constructive on macro trends—especially our expectation of continued U.S. economic growth—and on the U.S. high yield asset class, which recently featured a yield spread of around 390 basis points above U.S. Treasuries (see Chart 2).

 

Chart 2.  U.S. High Yield Spreads Remain Well Above 12-Month Lows
Spread versus U.S. Treasuries, September 26, 2018–September 26, 2019

Source: ICE Data Indices. Spread data based on ICE BofAML U.S. High Yield Index. Data as of September 26, 2019.
The information shown is for illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.  Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.
Past performance is not a reliable indicator or a guarantee of future results.
 

In terms of ratings categories, we have been reducing portfolio holdings of ‘BB’-rated debt (we view BBs as the most overpriced category in high yield), and added ‘CCC’-rated credits (which have largely underperformed year to date).

From a sector exposure standpoint, we have been shifting from defensive sectors into cyclical ones—adding energy, industrial, building products, and automotive issues, and reducing healthcare and media holdings. Our biggest sector overweight is now exploration and production, based not on a bullish view of the underlying commodity (oil and gas), but rather on our view on the fundamentals of select credits within the sector. Our biggest sector underweight is wireline telecom, a group which we believe is experiencing a secular decline.

As the sustainability of the U.S. expansion remains the key question for credit markets, we continue to watch the weak growth trends internationally and developments in U.S.-China trade tensions. We believe there is still cause to be optimistic that the trade situation will improve, as the two nations have slated talks for mid-October.

Emerging Markets Debt
John Morton, Portfolio Manager

We have been bringing down portfolio risk levels throughout September, getting ready for potential volatility in the fourth quarter. Two key developments at the macro level could influence emerging-market (EM) debt prices, in our view: a nascent global slowdown in manufacturing and softening growth in China, where GDP growth may actually retreat to the 5% level. The health of the Chinese economy, and by extension, its demand for commodities, is especially important for the EM outlook. In particular, we have reduced our exposure in the Chinese property market.

We are also reducing some of our exposure in Indonesia, including some natural resource companies there. We are also very much focused on the developments in Argentina, especially how its debt restructuring process plays out, along with prospects for political change. Elsewhere, we’ve modestly reduced our exposure to Brazilian corporates, and scaled back positions in Mexico to very low levels.

Note, however, that though we have adopted a more defensive posture, we continue to believe there are attractive opportunities in the EM space. In particular, we are monitoring some potentially positive developments in Turkey (the subject of an upcoming edition of our podcast series, The Investment Conversation). EM corporates (as measured by the J.P. Morgan Corporate Emerging Markets Bond Index Broad Diversified) have had a double-digit percentage return year to date through September 27, even with the negative headlines on Argentina and U.S.-China trade. So while it's been quite a good year for emerging markets debt so far, we continue to be very selective.

A Final Word
As 2019 enters the home stretch, investors may well be looking ahead to next year. We will convene a panel of Lord Abbett experts in November to examine the economic and market landscape for 2020 and the implications for investment portfolios. Stay tuned.

 

MARKET VIEW PDF


  Market View

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