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Starting with consensus

| November 22, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Somewhere out there in the future the economy grows or not, rates shift, spreads widen or tighten, policy and events shape asset returns. The annual exercise of making a call on all of that has started. Tradeable advantage in making those calls is hard to find. But that is not really the point. It is an exercise in putting consensus on the table so the market knows what is already priced. Then the real work starts of finding the unknown opportunities.

The big calls are necessary but not sufficient for most portfolios. A view on the broad economic backdrop is essential. Expectations of supply and demand in distinct markets are useful. Plausible shifts in fundamental risk are valuable, too. Potential shifts in policy or the business models of major investors also can make a difference. The range of views almost certainly helps, too. These are the raw materials of an investment market outlook, but each one is contingent on a complex of influences. It is hard to know how those influences will interact. With rare exception, it is hard to argue for investable advantage in making a call.

The art and possibly the investable advantage comes in reducing the complexity of the analysis, in narrowing the number of risk dimensions that an investment thesis has to get right in order to work. Making a call on one point on a yield curve rather than another, on one sector or one name in a corporate index rather than another, on one type of MBS or ABS structure or collateral rather than another reduces the risk dimensions of the investment. There are fewer moving parts. There is more opportunity to get informational advantage, which often is the starting point for excess return.

There’s a long list of ways to get competitive advantage in investing—improving size and operating efficiency, increasing access to funds, lowering costs, improving hedging and so on. But when it comes to information, consensus is beta. Out-of-consensus is alpha, and that’s where most portfolios earn their keep. The value in the annual round of looking into the future is really in figuring out where to look next.

* * *

The view in rates

The rates market will likely have to live without a Fed in motion next year. That will be a change. The Fed looks very likely to stay on hold into 2021. That should pin down rates in the front end of the curve. The market currently implies a 75% probability of another cut by the end of 2020, but that is likely predicated on continuing deceleration in the economy. Look for a plateau in growth instead. That should relieve concerns about recession and allow yields in the long end of the curve to rise. The curve should steepen more than forward rates imply. Volatility should drop. The wildcards remain US-China trade and Brexit for now, but the pressure there has dialed back. A halt or rollback in tariffs or a reversal in Brexit would likely both push longer rates up quickly.

The view in spreads

Stable growth around 2% would be Goldilocks for credit, and that is a likely outcome. Investment grade and high yield credit broadly should continue to tighten. The weakest part of the leveraged loan and CLO markets could widen, but that’s an idiosyncrasy of heavy issuance of weak loans into a market dominated by CLOs, which are ill-equipped to absorb the supply. There is fourth quarter liquidity risk as banks start to draw down balance sheets. Less liquid names in investment grade and high yield should widen to more liquid names, and more complex products should widen to simplier. MBS has lagged credit as heavy volumes of refinanced loans flowed through the market. But refinancing peaked in October and spreads should start tightening.

The view in credit

Even steady 2% growth will catch the most leveraged credits, and spreads in leverage loans reflect some of that concern. Leverage in investment grade corporate credit also has trended up this year, but an accommodative Fed has provided a buffer. As for the US consumer, low unemployment, high income and high aggregate household wealth leave consumer balance sheets in good shape. The readiness of the Fed, the ECB and other central banks to backstop growth makes broad recession unlikely. The weakest credits should feel a slowing economy, but without recession, the averages should remain good.

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