Fixed Income Market Views
Sector outlooks from our Fixed Income Investment Strategy Committee.
Country and sector allocation will continue to be a key consideration for investors moving forward as rates persist in their slow ascent. We maintain our favorable outlook for inflation-linked bonds; though the investment opportunity here has narrowed somewhat, inflation markets continue to doubt the ability of central banks to meet their inflation targets on schedule and thus maintain appeal. We are positively biased toward rates markets in Australia and New Zealand, while holding a significant underweight toward core Europe and Japan. Given our expectations that the credit cycle has yet to peak, we are upbeat on U.S. investment grade credit and a variety of securitized assets, agency MBS being a notable exception. While the impact of U.S. policy on the emerging markets remains uncertain, milder rhetoric of late suggests substantial geopolitical discord is unlikely in the near term; our preference is for emerging sovereigns in both hard and local currencies, as well as hard-currency short-duration issues. Meanwhile, we are constructive on a variety of global currencies, including the Japanese yen, which may be undervalued at current levels, especially if reflation can take hold in Japan.
More detail on individual sectors is provided in the table and text that follow.
Views by Sector
Committee views by sector over the next 12 months.
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Global Rates and Inflation: After spiking in the immediate aftermath of Donald Trump’s victory, U.S. Treasury rates have settled into the lower end of their post-election trading range thanks to the ongoing division between hard and soft data readings and mounting impatience around the execution of “Trumpenomics.” The Federal Reserve’s March rate hike, its second since the election, bolstered the central bank’s credibility in terms of delivering on its commitment to policy normalization—and perhaps doing so at a pace faster than that seen in prior cycles. With its rate-hike program on schedule, balance-sheet adjustment should dominate the FOMC’s debates during the second half of 2017; minutes from the latest meeting suggested the central bank was considering a change to its reinvestment program as soon as year-end.
Although the global reflation trade has paused, if not reversed somewhat, in recent months, we expect this trend to re-emerge in the back half of the year. Increased global economic synchronization points to a growth reacceleration, as do signals from credit spreads and corporate profits. With real rates remaining negative across many parts of the global term structure, we continue to forecast modestly higher rates and inflation across much of the G10 due both to valuations and expectations for an emergence of fiscal impulse in late 2017 and 2018.
Though the investment opportunity is less pronounced than it was a year ago, inflation markets continue to price the inability of central banks to meet their inflation targets in a reasonable time frame and thus maintain appeal. That said, short-term inflation dynamics appear a bit mixed. On the negative side, commodities markets are consolidating last year’s gains and still face the prospect of absorbing excess oil inventories. However, inflation should find support from the aforementioned synchronized global expansion in combination with continued improvements in labor that are driving the unemployment rate toward and perhaps through the non-accelerating inflation rate of unemployment (NAIRU)—the level of unemployment consistent with stable inflation.
Credit: U.S. investment grade credit has been remarkably stable over the past two months, with the market holding on to most of its post-election rally. Market technicals remain strong, with supply moderating after a very aggressive start to the year and demand persisting, particularly from outside the U.S. Fundamentals, meanwhile, have stabilized after a few years of deterioration. We expect leverage will pull back slightly from its 2016 peak thanks to the recovery in commodities and a generally less-aggressive use of corporate balance sheets.
The key issue for corporate credit moving forward will be whether the economic cycle—nearly eight years in duration already—will continue. As discussed in this Outlook, we do not expect the cycle to turn over in the near term. Without any imbalances to disrupt the economy, modest growth should continue; spreads—even from current tighter levels—should perform well in such an environment. Uncertainty around European elections, which have already abated somewhat, should prove to be manageable, while tax reform in the U.S. could be a tailwind for corporates should it become a reality. Speaking of tax reform, a resolution to this debate will likely be needed in order to extend the recovery in capital expenditures.
Securitized Assets: While the Fed ended its bond-buying program in October 2014, it has continued to reinvest principal and maturing securities ever since. Minutes of the Fed’s March meeting suggested that the FOMC likely would make a change to this reinvestment policy in late 2017 or early 2018 in order to reduce its balance sheet, which now stands at around $4.5 trillion. Such a move would probably cause only modest widening in MBS spreads; a slow unwind of the balance sheet combined with central bank over-communication should prevent any dramatic reactions from the market. Meanwhile, the rate backup post-election has slowed prepays such that the sundown of reinvestment would be a smaller market event.
CMBS spreads are currently trading at fair value. While a strong risk-off trade could negatively impact spreads, we expect CMBS to fare better than most fixed income assets and trade in a fairly tight 10 – 15 basis point range. Non-agency RMBS, in contrast, have already experienced a fairly dramatic 50 – 75 basis point tightening this year. We expect attractive carry, low duration and credit improvement—a significant portion of the sector is in the process of migrating to investment grade from non-IG—will drive demand for RMBS and push spreads modestly tighter. U.S. ABS is a high-quality, short-duration asset class that trades off Libor; with short Libor rates elevated, ABS appears attractive relative to Treasuries. Looking ahead, we think the strong demand for high-quality short cash flows will pull these assets tighter.
High Yield and Leveraged Loans: While U.S. economic activity has been sluggish in the first quarter of 2017, we expect growth will improve and allow the Fed to continue to take a measured approach in terms of further rate hikes. This is a constructive scenario for high yield bonds and senior floating rate loans, which historically have performed well during rising-rate environments. That said, we wouldn’t be surprised by periods of increased volatility as the year progresses, driven by policy uncertainty, the pace of global economic growth and geopolitical developments.
We continue to believe that the high yield market is compensating investors for default risk. We think defaults peaked in 2016 and could remain below historical averages in 2017 as U.S. economic growth picks up; we foresee the trailing 12-month default rate finishing the year below 2% as revenue and leverage ratios improve. Loans have performed steadily thus far in 2017. Technicals have been driving the loan market since late last year, with loan funds recording $20 billion of inflows over the past 22 weeks. Net supply has been negative since this time last year and has allowed issuers to refinance/reprice a significant portion of the market. In terms of fundamentals, leverage levels remain controlled, and companies continue to post steady growth in profits. Given our expectations for below-average defaults, we think loans offer fair value.
Following the strong gains in 2016, we believe European high yield securities are likely to provide coupon-driven returns in 2017, driven by solid issuer fundamentals, accelerating economic growth and continued support from the ECB. The credit quality of the European high yield market remains strong; the market carries an average rating of BB-, new-issue leverage remains just over four times, and default rates remain near historical low levels below 1% thanks in part to limited exposure to energy. Still, we anticipate volatility will emerge from time to time given the robust political calendar facing Europe over the next several months.
Emerging Markets Debt: Following the selloff in emerging market assets after the U.S. elections, hard data and sentiment toward the space has improved on the back of strong global growth momentum. While uncertainties around U.S. trade and tax policies and their implications for emerging market economies will persist in the near term, trade war rhetoric has become milder and actually could enhance global trade.
Hard-currency sovereigns continue to be supported by strong basic balances and low external debt levels, and we expect low net issuance in the remainder of the year to provide technical support. Current sovereign spreads are close to fair value in absolute terms in our view but remain attractive on a relative basis compared to similar-rated developed market bonds. Hard-currency corporate valuations are tight in aggregate, but pronounced sector and regional differences provide opportunities for alpha generation. Balance sheet quality has improved in general due to rapid cost-cutting and proactive liability management, alleviating concerns about refinancing risks ahead. Local-currency bonds are supported by nominal and real yields that provide a large premium over developed markets as well as positive credit developments that enhance the high-yielding issuers especially; this is countered to some degree by low-yielding countries taking their cue from U.S. and European rates. We remain selectively overweight high yielders while maintaining an overall duration profile close to neutral.
Emerging currency fundamentals have been improving thanks to better economic and trade growth prospects, more balanced current accounts and attractive valuations, driving our overweight EM FX bias.
Municipal Bonds: After selling off sharply post-election, sentiment toward the muni market has improved significantly in the first part of 2016. Higher yields, compelling relative value to Treasuries and reduced expectations for tax reform have triggered the rally, as evinced by decidedly positive fund flows; high yield muni funds took in roughly $4 billion in the first quarter, while long-duration funds have also experienced strong inflows. Supply has not been able to keep up with demand in the high yield space, driving credit spreads tighter. Intermediate-maturity munis appear inexpensive, meanwhile, as property and casualty insurers have pulled back their interest in anticipation of corporate tax reform.
We are constructive on the muni market in the short term, as seasonal factors come summer may further constrict supply. In the meantime, we will be keeping a close eye on both tax-reform legislation and the prospects for infrastructure investment, both of which have the potential to impact muni valuations and supply.
U.S. Dollar: Though the dollar appears moderately overvalued, we remain constructive on the greenback due in part to the U.S. unemployment rate approaching the non-accelerating inflation rate of unemployment (NAIRU)—the level of unemployment consistent with stable inflation. Moreover, yield differentials are supportive, and tax reform could provide a catalyst for the dollar to strengthen further. Risks include uncertainty around Trump policies and their potential impact, as well as the level of dollar strength policymakers in Washington will accept.
Euro: ECB policy is still loose, and a further pickup in inflation would push real yields further into negative territory. Lingering concerns about the banking system along with potential volatility tied to the political calendar reinforce our slightly negative view. Stronger economic data of late—both in the euro zone and globally—serve as a potential risk to our positioning, as does a large current account surplus and noise about tighter policy from certain ECB members.
Yen: The yen will always find a bid when risk aversion rises. That being said, purchasing power parity and real exchange rates suggest the yen is now undervalued, especially if reflation can take hold in the economy. Risks to our small overweight include widening yield differentials exacerbated by the BoJ’s yield curve policy, disinflation and erosion of confidence/profits due to a stronger yen.
Pound: Notwithstanding the British pound appearing undervalued, our outlook on the currency is neutral. The BoE’s likely intolerance of an overshoot in inflation is supportive of the sterling, as is the appeal to foreign investors of U.K. assets denominated in a weak pound. However, economic activity is expected to slow once Brexit actually happens, and political uncertainty surrounding the issue persists.
Canadian Dollar: The Canadian dollar has depreciated significantly since the beginning of the year despite an improving U.S. economy and stable energy prices benefitting Canada. The deterioration in terms of trade has hurt the currency, and with the market already discounting import taxes and revised trade agreements with the U.S., it is attractive to be tactically overweight the Canadian dollar.
Norwegian Krone: The krone’s valuation is attractive given signals from Norges Bank suggesting optimism about the economy and a potential end to policy easing, along with the recent improvement in terms of trade. However, weakness could reemerge if energy prices fall again or if Brexit uncertainty causes a change in monetary stance.
The Business Cycle
Our Fixed Income Investment Strategy Committee weighs in on the business cycle and how much longer it may run.
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Originally Published at: Fixed Income Market Views