Guggenheim Investments, the global asset management and investment advisory business of Guggenheim Partners, released its Fourth Quarter 2018 Fixed-Income Outlook, “Jogging to the Exits.”

“Economic growth has been strong, but while others trumpet the current moment of peak growth in this business cycle, our investment team is focused on the recession that we foresee beginning in the first half of 2020,” said Scott Minerd, Global CIO and Chairman of Investments. “Investors must understand the history of market performance during the run up to past recessions to appropriately position their portfolios.”

In credit markets, spreads tend to stay flat in the penultimate year of the expansion before widening in the final year. Rising defaults and increasing credit and liquidity risk premiums drive a sharp pullback in the performance of high-yield bonds before and during recessions.

“The key here is to manage this shift in a timely manner,” Minerd said. “So as our investment management team describes in these pages, we are focused on upgrading credit quality, reducing spread duration, and maintaining a barbelled yield curve position to take advantage of further curve flattening. Call it a jog to the exit rather than a run.”

In the 32-page report and video, the investment management team presents a sector-by-sector outlook on relative value, opportunity, and risk. Among the highlights:

• Every recession since 1970 was caused by the Federal Reserve (Fed) tightening monetary policy too far in response to a decline in the unemployment rate to a level below full employment. We do not think the Fed will negotiate a soft landing this time either. 

• The market is just now coming to grips with our base case that the Fed will hike once more this year and four more times in 2019. We are positioned for further bear flattening toward our 3.25–3.50 percent terminal fed funds rate projection over the next year.

• We will continue to upgrade quality, position defensively, and remain underweight duration relative to the benchmark, and limit exposure to the short and intermediary parts of the curve in anticipation of higher rates and a flatter yield curve. We continue to believe the entire curve will converge to around 3.75 percent at the end of this hiking cycle. 

• As we approach the turn in the credit cycle, we expect liquidity to become challenging and spreads to widen. We believe our positioning will afford us the opportunity to pick up undervalued credits when others are forced to sell.

• The rise in rates is already hurting activity in housing and autos, two of the most rate-sensitive sectors. Home and auto sales are well off their respective cycle peaks as rising rates dampen consumer sentiment, which is typical toward the end of an expansion. 

• Within corporate credit, unsustainable leverage in the BBB universe warrants heightened scrutiny. We view the current compression in A–BBB spreads as an opportunity to move up in quality and liquidity ahead of what could soon become an extremely hostile environment for fixed-income investors.

• In high yield, CCCs offer less than 500 basis points over BB spreads, compared to an average of 688 basis points. This does not bode well for future returns. When CCC bonds have traded inside of 500 basis points over BBs, they have underperformed BBs by 4 percentage points over the following 12 months.

• Our asset-backed securities (ABS) team continues to uncover value in short-tenor collateralized loan obligations (CLOs) and select esoteric ABS. CLO supply pressures have flattened the term curve for CLOs to the point where defensive short spread duration CLOs are now comparably priced to riskier longer-spread duration CLOs.

• In rates products, we are constructive on low-coupon, long-maturity callable Agency bonds, which have seen durations extend and are trading at deep discounts because of the call option being out of the money. These look especially attractive to us given that we do not see much more rate upside from current levels.