Why Western Asset continues to favor specific spread sectors and a long duration bias for a fixed-income portfolio.
There has been a significant shift in interest rates and valuations since the US presidential election, but looking at the fundamental landscape, we don’t believe things have changed that much. Markets are reacting to the anticipation of improved growth, higher but manageable inflation and a better economic backdrop for businesses. The agenda of the new administration is certainly pro-growth, and there is likely to be a positive economic impact. However, when it comes to the implementation of their initiatives, the administration is likely to face some challenges. In our view, the level of optimism that is priced into the market is perhaps unwarranted and at this point it is not validated by fundamentals. The outlook for global growth remains slow but sustainable at about 3%, and although they have rebounded significantly following Donald Trump’s election, inflation expectations remain lower than mid-2014 levels.
The Fixed-Income Environment Post Election
- The new administration’s agenda includes strong pro-growth policies.
- The market is pricing in successful implementation of these new initiatives. Furthermore, concerns involving trade and immigration appear limited.
- While we are likely to witness rapid action on certain policies, fulfillment of all the President-elect’s objectives will be met with challenges.
- In our view, the markets have moved too far too fast. Our current portfolio positioning emphasizes specific spread sector strategies complemented with a long duration bias.
Growth, Inflation and the Federal Reserve (Fed)
- Global growth is slow but sustainable at about 3%. It is a bit optimistic to think that the US economy, which is approximately 20% of world GDP, will be able to reverse that global growth trend.
- Looking at the S&P 500, almost 50% of revenue for those companies comes from outside the US. To think that the US will be immune to global forces is somewhat flawed. We are in a global economy, like it or not.
- Global debt-to-GDP ratios are continuing to grow and we believe it is reasonable to assume that these global debt loads will create a bit of a drag when it comes to improving growth prospects.
- Inflation expectations remain lower than mid-2014 levels, although they have rebounded significantly following Trump’s election.
- Following the change in the outlook for fiscal policy and growth, expectations for Fed hikes have moved closer to the Federal Open Market Committee’s own expectations.
Focus Items for the President-Elect
- While the new administration is seeking to improve growth, challenges remain and it will likely take time to enact reforms.
- Tax cuts, particularly for corporations, have been a primary source of market optimism. The administration wants to hit the ground running and tax reform is one area where they may be able to enact change fairly quickly. While there are still details to work out, we feel we will see some meaningful reductions in corporate taxes early in the Trump presidency.
- The administration is proposing $1 trillion in infrastructure spending over 10 years. The impact of this magnitude of spending could be powerful, but funding these projects can be complicated. During the Obama administration, projects that were thought to be “shovel-ready” weren’t as “shovel-ready” as they anticipated. We think we will see infrastructure spending that will be a net positive for the economy. There is some likelihood that it won’t be as robust as the Trump administration is projecting—we think there will be a pickup, but it will be a measure of magnitude.
- When it comes to the administration’s plans for deregulation, it is important to remember that regulatory changes are complex, and not all can be approved solely by the executive branch. Regulation related to energy, the Department of Labor Fiduciary Rule and other labor laws will need to go through a rulemaking process, which will take time. Full repeals of Obamacare and Dodd-Frank are unlikely, given Congressional involvement, and the White House has almost no control over the regulations that the Fed manages in regard to banks, such as capital requirements and leverage and liquidity ratios.
- Regarding trade and immigration, on a net basis the US balance of trade appears manageable. In isolation though, exports and imports are very large numbers. We think it’s unreasonable to assume that the trading partners of the US won’t retaliate in some way, shape or form if the US changes its trade agreements on an individual basis.
- We favor a fixed-income portfolio with emphasis on specific spread sectors and a long duration bias.
- In developed country corporate credit, we continue to see opportunities in investment-grade credit, high-yield and bank loans. Within investment-grade, bank asset quality continues to improve. We are maintaining an overweight to financials. We currently favor US versus non-US, although we are seeing select opportunities in Europe, and we remain cautious on healthcare/pharmaceuticals.
- In high-yield, default rates are likely to remain historically low and we are maintaining opportunistic exposure. We feel US valuations are more attractive than non-US and we are maintaining overweights to metals and mining and energy.
- With its compelling valuations and a strong fundamental backdrop, the bank loan sector works well as a complement to our duration bias and we are maintaining an overweight.
- In emerging markets (EMs), headwinds for EM growth have increased with the election results. Given policy uncertainty, we favor sovereigns/currencies with less sensitivity to US trade policy, such as Brazil and Russia.
- Within mortgage-backed securities (MBS), consumer and real estate fundamentals remain strong. We currently favor non-agency residential MBS to agency MBS due to more attractive valuations.
- We believe rates have moved too far too fast and we plan to maintain a long duration position.