Finding Perspective Amid Turbulence

I do believe 2019 will continue to see a higher level of volatility than we’ve seen in past years, and we’ll see quality continue to be a driver of performance.

December, most certainly, was a very volatile month when you look across the capital markets from equities to fixed income. Few asset classes got spared. But the volatility really started towards the end of third quarter and into fourth quarter. It wasn’t just concentrated in December; it took a few weeks for the volatility to play out. When we look at the S&P from Sept. 21 through Dec. 26, 2018, looking at the intraday peak to trough, the S&P 500 was down about 20 percent.

That’s definitely a major threshold in investors’ minds. Ten percent is a selloff. Twenty percent starts to get people to pay attention. But what’s important to remember is that it’s not that we haven’t been here before. The last time we saw an S&P go through that type of a magnitude of a selloff wasn’t back in 2008. It was actually back in 2011. That selloff did not lead to a recession, and the market actually recovered quite strongly thereafter.

A lot of factors may have contributed to the volatility we saw in December: the trade war, the potential government shutdown, the weeks leading up to actual shutdown and maybe potentially some of the comments coming from the Federal Reserve (Fed) in recent weeks. The current Fed tightening cycle actually started in December 2015. As you may recall, that was the first time since the easing cycle that the Fed started to raise rates. It’s been about three years since we’ve been on this journey. The Fed fund rate has gone from zero to 0.25%, that’s the range, to what it today 2.25-2.50%.

So again, putting that in historical context, it’s one of the slowest paced Fed tightening cycles in history. Typical Fed tightening cycles—when we look back three to four decades—they average somewhere around 2-3 times of the current pace. One of the things we saw play out in mid to late November, and all the way through the end of the year that we really didn’t see as equity markets started to sell off in late Q3 and early October, was the fixed income market, largely speaking, held together pretty well. That changed right around mid- to late November, when we started to see the high-yield market, as represented by the high-yield spread, start to widen.

So, to put the sort of movements in perspective, at the end of Q3, the broad high-yield market high-yield spread was in the low to mid-300 range. And by the end of the year, the high-yield spread had widened out by 200+ basis points to the low to mid 500-point basis range. That’s a pretty violent spread widening in that short amount of time.

As we typically view with the high-yield to be the fixed income segment that tends to be more correlated to equities, it’s not a complete surprise that as equity markets start to face more challenging environments, that a high-yield would have a similar move. But it was more of the pace and the magnitude of the high-yield market selloff that I think may have caught investors by surprise.

With that type of move in a high-yield market, it most certainly has impacts on adjacent fixed-income markets. For instance, bank loans. Sort of we saw a quick movement in spreads in the bank loan segment.

What this means for active managers in general is that as risk and disparity amongst different credit names in the market start to move, active managers tend to have a better opportunity to separate those credits that we think have better upside/downside tradeoffs versus those that we think are more limited. So, I do believe this creates a more conducive environment for active managers to add value to their fixed income portfolio.