The global economic environment has improved since Capital’s Portfolio Strategy Group’s (PSG) June forum. Growth continues to run modestly above trend across many countries and regions, a phenomenon that has not occurred in many years. We have to look to periods before the global financial crisis of 2007-08 to find an expansion this broad-based. Europe, for example, is a particularly bright spot this year after acting as a drag on global growth in recent years. However, fixed income markets may be too optimistic that this Goldilocks scenario will continue for an extended period.
Our fixed income group’s PSG forum takes place three times each year. The two-day event brings together the entire fixed income group from across the globe for an in-depth discussion on the macroeconomic environment and fixed income markets. Our proprietary fundamental research is the foundation of the discussions and any recommendations that result from these meetings. The outcomes inform our investment decisions and positioning within our fixed income portfolios. Below is a recap of views that emerged from the recent two-day meeting in October.
Outlook and Conclusions
Inflation appears to have bottomed out in most regions, and we expect a modest pickup in global inflation. This view is supported by continued strength in labor markets, particularly in the U.S., where we believe wage gains will further accelerate.
While our base-case scenario assumes a continuation of these recent trends in the near term, we believe this improvement in economic fundamentals is fully reflected in current valuations of many, if not most, fixed income assets. In particular, corporate bond valuations appear to reflect a view that this “Goldilocks scenario” – where growth and inflation are neither too hot nor too cold – will continue for the foreseeable future.
In our view, the global economy must continue to operate in this narrow band of “just right” to support current credit market valuations. Should growth momentum accelerate and break out above recent ranges, this would likely trigger more aggressive policy responses by global central banks. The resulting tighter monetary policy, delivered via higher policy rates and a faster withdrawal from quantitative easing, would likely hamper growth.
Our view, however, is one of skepticism regarding the resilience of the global growth momentum. We have yet to see the improvements in productivity and investment necessary to produce sustained higher growth.
Further, we expect the market may be underestimating the potential impact of tighter monetary policy. As the Federal Reserve and European Central Bank begin to unwind their $4 trillion balance sheets, we are doubtful that it will be a smooth transition and that the current pace of growth will continue.
As such, we recommend somewhat cautious positioning in fixed income portfolios today. Stretched valuations do not, in our opinion, warrant taking large risks at this late stage of the economic cycle. We also favor some hedging positions should the current environment of high valuations and low volatility persist for longer than we expect.
PSG holds a cautious view toward credit sectors, given stable to declining fundamentals and higher valuations. For investment-grade companies, net leverage is higher than it was pre-crisis, while investment in organic growth opportunities remains low.
Although we do not expect a material rise in defaults for high-yield corporations, we recommend minimal allocations to high-yield in core bond portfolios. Moreover, in this challenging environment, fundamental research is absolutely critical. While we don’t find these sectors compelling overall, there are select credits within these sectors, as well as in investment-grade emerging markets debt, where we continue to see attractive investment opportunities.
We continue to believe in a “lower for longer” thesis regarding the future level of interest rates. Muted global growth and inflation, as well as the attractiveness of U.S. interest rates in a global context, are a few factors contributing to this view. Despite the Fed having begun reducing its balance sheet, we think this will have minimal impact on longer term rates.
However, current consensus for market expectations of shorter term interest rates are lower than our expectations for the Fed’s path over the near term. Said another way, we believe the market underestimates how many times Fed hikes in the near term, as it suggests fewer than 40 basis points of hikes in 2018. We, therefore, recommend a short duration position at the very short-end of the yield curve, which would benefit as and when short-term yields rise.
Although we expect a continued modest pace of interest rate increases in coming quarters, we do not anticipate a smooth transition from the unprecedented level of quantitative easing that has been in place for nearly a decade.
We continue to believe the bias of central banks will be to maintain an accommodative stance, and expect the yield curve to steepen, where intermediate maturities typically outpace long maturities, especially relative to the significant yield curve flattening the market anticipates in coming years.
In light of our view that inflation will continue to rise modestly, particularly in the U.S., we recommend an allocation to Treasury Inflation-Protected Securities (TIPS). Further, TIPS valuations are attractive relative to prospective inflation. The market expects annualized inflation of just 1.8% over the next 10 years.
We continue to recommend an underweight to agency mortgage-backed securities on expectations of future spread widening as the Fed’s balance sheet reduction ramps up. The market has been somewhat sanguine about the Fed’s plans, given the level of transparency around implementation.
However, it will provide significant additional supply that will need to find a new buyer base, particularly as the Fed holds about one-third of the agency mortgage market today and will be allowing an additional $20 billion in agency MBS supply to enter the market each month in the later part of next year. An underweight to agency MBS would likely fare well against a potential pickup in volatility.
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