1. The New York Fed has placed a roughly 40% probability that there will be a recession in the next 12 months, a trend that has been steadily increasing.
2. Higher economic risk and lower rate expectations has been positive for high-quality core fixed income, but it is not a good combination for lower-quality spread sectors. Valuations in high yield and other riskier spread sectors are at historically tight levels, offering little cushion in a spread-widening scenario.
3. Correlations to equites among higher-risk fixed income are also at historically high levels, suggesting a greater vulnerability to any risk-off environment.
4. Core fixed income still offers investor diversification benefits vs. equities with negative correlations to equity returns. Using 4Q18 as a recent example – investors reaching for yield too aggressively will be hurt in an equity drawdown scenario.
5. An outlook that includes Fed rate cuts and higher economic risk suggests higher allocations to fixed income. Core fixed income looks the most attractive when weighing risk-adjusted returns with diversification benefits.
*Source on all charts is Bloomberg.
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