Outlook 2017: US multi-sector fixed income
Politics and policy will drive markets in 2017.
The themes which defined the latter half of 2016 will likely continue to shape fixed income markets as 2017 takes over.
A rise in global populism, exemplified by the historic Brexit vote as well as the US presidential election mark a fundamental shift in the investment backdrop for fixed income. Markets are transitioning away from an environment of excessive central bank stimulus, subdued inflation and austerity towards one of reflation and more expansive fiscal policy.
With four major elections taking place in the eurozone next year, we believe that the political shocks – and associated volatility - that have occurred in the US and UK are likely to continue into 2017. While the US was the center of the interest rate repricing in 2016, European sovereign yields could lead the move higher in 2017.
The implications of a transition from monetary to fiscal policy for the various sectors loom large. While record low interest rates overseas have driven foreign investors into higher-yielding US corporate bonds (credit), any material change in interest rates abroad could have a meaningful impact on already-ordinary US credit valuations. Similarly, changes in domestic tax policy could diminish demand for the municipal market – with lower tax rates reducing the need to have tax-free income.
It’s all about fiscal policy now
The market reaction to the US election was immediate and in our view justified, supporting our thesis of the passing of the baton from monetary towards fiscal policy. Over the next few years, we anticipate wider deficits, reduced regulation, lower taxes and a potentially inflationary, protectionist trade policy. The overall outcome of such reflationary policy should result in higher interest rates, steeper curves, and higher inflation expectations. We believe that the Federal Reserve will continue to be gradual in its approach, and agree with consensus expectations of approximately three interest rate hikes next year.
Corporate valuations are less compelling than a year ago, so we are taking less risk
While credit markets began 2016 with compelling valuations, they end the year looking much more ordinary. Though it is likely that corporate fundamentals will benefit from pro-growth economic policies in the US that could extend the credit cycle, we are conscious that much of the optimism is already reflected in valuations and the market could become vulnerable to a correction.
The real determinant for investment grade credit, however, will be the direction of global flows. Quantitative easing from the European Central Bank, Bank of Japan, and Bank of England has driven government bond yields to record lows, causing global fixed income investors to pile into the higher-yielding US investment grade market. We are intently focused on these capital flows and believe they will have a significant impact on returns across markets in 2017.
The high yield corporate market should remain well supported in 2017 as it will benefit from positive technical support, stable fundamentals, and investors’ ongoing search for yield. However, after a 15% total return in high yield credit in 2016, and the potential for volatility ahead, we are cautious on how much tighter valuations can compress without a hiccup first.
With ordinary valuations and volatility likely to continue in 2017, portfolios enter the new year with a reduced level of credit risk. It is our belief that credit returns in 2017 will be driven by proper sector and issue selection, rather than a broad overweight to US credit. Our sector preferences continue to be concentrated in financials as well as energy. We remain positive on the US banking sector as rising government bond yields and the potential for less punitive regulation will benefit bank profitability in the US.
It feels a little bit early for the European banking sector but that could well provide an opportunity as we watch the Italians sort through their problems and hopefully move forward. The energy sector was the stellar performer in 2016 and we continue to believe that this sector will perform well in 2017.
Is the municipal bond market about to undergo the perfect storm?
The municipal bond market performed well for most of 2016, benefitting from 39 consecutive weeks of inflows in addition to negative net supply. During the summer our propriety indicator, the Net Implied Tax Rate (NIT) hit negative territory for the first time since we have been measuring it, over thirty years. To put that in plain English, based on this metric, long dated municipal bonds were as expensive relative to similar corporate bonds as they have ever been. Just a few weeks later, significant underperformance put them back around fair value, at least at today’s income tax rates. We may be approaching the perfect storm for municipals however, as lower personal income tax rates diminish the need for retail investors to purchase municipal bonds and municipalities issue debt in order to fund some of the much-anticipated 2017 infrastructure spending program. This could be exacerbated by retail selling upon seeing negative total returns due to rising bond yields. Although we have only just begun to see outflows in the municipal market, we are watching closely as municipal dislocations tend to overshoot – and could offer a compelling opportunity in 2017.
Fiscal policy and the Fed will determine the outlook for securitized and Emerging markets
Within the securitized sector we continue to take a defensive posture regarding agency mortgages. Although the sector has been amongst the worst performers in recent months we see no urgency in addressing our underweight stance. Valuations are not attractive and the technical overhang of the Fed’s balance sheet still hangs heavy on the sector. We continue to see more opportunity in certain ABS and CMBS sectors. CMBS, in particular, looks more attractive from a valuation perspective and a cyclical upswing in economic activity will likely be beneficial to the sector.
We remain selectively positive on emerging markets. Although the knee jerk reaction from the Trump victory has been negative for emerging markets with higher Treasury yields, US dollar strength and potential trade policy acting as a headwind, recent weakness may create a buying opportunity. Many emerging market economies reached an inflection point economically and politically earlier this year, making country differentiation paramount. Open trade focused economies may be more vulnerable in a new protectionist regime, but domestically orientated economies that have undergone structural reform should outperform. We expect higher volatility to persist as US trade and immigration policies take shape, but valuations remain generous and we continue to prefer countries such as Brazil.
More volatility, more uncertainty as we pass the baton from monetary to fiscal policy
Going forward we expect markets to be characterized by a broader reflationary theme and increasing volatility as central banks step away from the markets. Investors have become heavily reliant on the largesse of central banks and how they react as this support is withdrawn will be important for bond markets in 2017. The growth outlook is likely to show signs of improvement over the course of 2017, but the valuation backdrop in many sectors is far less compelling than it was twelve months ago.
This view is reflected in the reduced level of overall risk in our portfolios. The portfolios have significant liquidity to take advantage of opportunities arising from increased volatility next year which may result as accommodative monetary policies are phased out and replaced by fiscal stimulus. The opportunity may arise in municipals, corporates or the securitized sectors and we will have plenty of liquidity to take advantage of it. Treasury yields are likely to rise modestly in the US, but an environment of subdued overall yields, and the paucity of yield elsewhere in the world means that spread sectors will remain a focus for investors.