Western Asset CIO Ken Leech explains why growth and inflation expectations have proven more optimistic than fundamentals could support. His base case continues to be slow but steady US growth and moderate inflation -- and that spread sectors will continue to be an attractive opportunity for fixed income investors in this environment.
Our base case calls for slow but steady growth and moderate inflation
Market expectations of both robust growth and improving inflation since late last year have proven more optimistic than fundamentals could support—transitioning from a consensus of secular stagnation before the US election to global reflation afterward, to a more moderate tone today focusing on central bank monetary policy normalization. We are still hopeful that the extraordinarily accommodative stance from central banks will continue to moderate, but we believe it will be a very, very slow process and even slower than we expected earlier this year.
Global debt burdens are still higher than they were before the financial crisis and continue to serve as an impediment to greater growth. While the US growth and economic outlook remains positive, we are a little more cautious than we were at the start of the year based on weaker-than-expected manufacturing and housing data, and stubbornly low inflation. We do not see a dramatic or sustained rise in interest rates over the near term.
Our base case continues to call for slow but steady growth and moderate inflation. Upward growth trends have also slowed somewhat, leading us to lower our growth forecast to 1.5%–2.0% for the second half of 2017. Spread sectors should continue to be the best place for fixed-income investors, as we believe they will outperform both US Treasuries and global sovereign bonds.
- Most spread sectors performed very well over the quarter with emerging markets (EMs) continuing to lead the way and offer the best opportunities. We were overweight all spread sectors, with the exception of US MBS.
- Very small changes in the yield curve can mean big differences in total returns. Yield-curve positioning is just as important as overall duration.
- The long end of the curve also performed very well.
US Economic Outlook
- Normalization of interest rates and inflation is going to occur slowly, with the still-significant slack in the labor market and capacity utilization.
- Inflation remains soft; personal consumption expenditures (PCE) inflation—a favorite measure used by the Federal Reserve (Fed)—has not recently turned down as sharply as the consumer price index (CPI).
- We see headline PCE inflation rates coming down over the course of the year, now that oil prices seem to have peaked and may be heading lower.
- We continue to believe the “Trump-trade” optimism (global reflation) went too far, too fast but sporadic progress is on the horizon with deregulation proceeding, healthcare reform stalled, tax reform delayed and the infrastructure spending plan still unknown.
Global Economic Outlook
- Global growth is improving, but the pickup has slowed somewhat. The headwinds of high global debt loads, however, are a cautionary sign that improvements will take time and require continued central bank support.
- The market narrative has evolved from secular stagnation through most of 2016 to global reflation after the US election, to a more moderate tone today focusing on policy normalization.
- As a backdrop, the secular view of inflation continues to inform our decision-making. Over long periods of time, the story of long-term interest rates is the story of inflation.
- Europe: Improved GDP growth is a positive sign; political anxiety has given way to cautious optimism. Growth has benefited from domestic demand strength, but inflation remains subdued.
- Japan: Inflation remains well below target despite explosive growth of the Bank of Japan’s (BoJ’s) balance sheet.
- China: Supporting growth with a tremendous amount of stimulus to make growth resilient; at some point policy will turn back to neutral, and growth will likely slow.
- We expect spread sectors will continue to outperform, but caution is needed.
- Investment-grade: As spreads have tightened, we focus on industries that are deleveraging; subsector and issue selection are critical.
- High-yield: Spreads have narrowed as defaults have slowed; high-yield is a fairly valued market with subsector- and issue-specific opportunities.
- Agency mortgages: Spreads have widened and volatility is down, presenting a somewhat more attractive environment for mortgages; the potential for the Fed unwinding its balance sheet provides additional uncertainty and yields remain low.
- EM: Valuations look attractive both on a historical basis and relative to developed markets, particularly given improving fundamentals, lower risks in China and commodity stabilization.
- We think the eventual unwinding of the Fed’s balance sheet will be pretty benign with Fed Chair Janet Yellen outlining its moves with no desire to do anything abruptly.
- When Yellen’s term is up, we find it unlikely she will be replaced by a Democrat given the current political environment.
- The Fed may have difficulty achieving its goal of 2% inflation in the short term. We think this will take time and agree with the dovish approach utilized thus far.
- We believe EM presently offers the best opportunity set. We like local currency debt, USD-denominated debt and EM corporate debt, so we are overweight all three but volatility is always a concern.