After three years of gradual rate hikes, the Federal Reserve has warmed to cutting rates this year in response to waning economic momentum and persistently low inflation. However, we’re not convinced it will cut as many times as the market is expecting, raising the potential for interest rate and market volatility. Regardless, fixed-income investments should still prove their worth for the portfolio protection they can provide.
The bigger question is, “How many rate cuts?”– We expect the Fed to cut rates at some point in the second half of 2019 to sustain the economic expansion, but we are not convinced it will need to cut rates three or more times in the coming year. A recalibration between these expectations and the Fed’s actions could spur market volatility. However, if better-than-expected economic data is the reason for fewer cuts, we think markets would likely respond favorably..
Rates low for now, not forever – Inflation has averaged 1.7% for the past three years, below the Fed’s desired target and somewhat surprising given wage growth and tariff disruptions. The higher U.S. dollar, demographics and automation are likely responsible, though we don’t believe inflation will remain this subdued indefinitely. Low inflation expectations, substantially lower foreign interest rates and the Fed’s dovish stance will likely keep longer-term rates low a while longer. We expect rates to rise again before this cycle is over, however.
Keeping an eye on corporate debt – Corporate debt levels have risen to all-time highs. With corporate debt relative to assets still at below-average levels, companies aren’t teetering on the edge of a financial disaster. That said, borrowers’ credit quality has deteriorated, which can hinder corporate flexibility and the performance of investment-grade bonds if economic conditions weaken. This is an imbalance we’re watching for any signals of corporate financial stress.
We still think bonds offer high portfolio value despite ongoing low yields. During the late 2018 selloff when the stock market fell 19%, bonds returned 1.4%, stabilizing portfolios. Maintain a fixed-income allocation near your long-term target, favoring investment-grade bonds with smaller allocations to high-yield and international bonds..
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