The market’s enthusiasm for massive growth immediately following last year’s US presidential election waned significantly after healthcare initiatives failed to materialize, infrastructure spending stalled and geopolitical tensions flared. While we were skeptical of too much optimism at the start of the year, we now think pessimism may be too strong as fundamentals slowly and steadily improve.
Global growth continues to increase from the low levels seen in 2015 and 2016. While stubbornly low inflation does persist, deflation fears have abated as inflation is beginning to show signs of life from what we believe is the long, slow bottoming process. The monetary policy accommodation from central bankers around the world is helping to underpin low policy rates as they continue to take a measured and well-communicated approach to rate normalization, even as they begin to decrease accommodation.
Looking ahead, we see US growth in the 2% range for the rest of the year, and perhaps slightly higher into 2018. Global growth is also picking up, but we believe it will continue to be moderate. Our top investment theme remains that spread sectors should outperform Treasuries and sovereign bonds, and we continue to favor emerging markets as the best opportunity for superior performance going forward.
- Most spread sectors performed very well over the quarter with emerging markets (EMs) continuing to lead the way and offering the best opportunities.
- In both investment-grade and high-yield, spread compression is behind us, so our focus is on name selection, even more than on industry selection.
US Economic Outlook
- We continue to believe in moderate US growth, looking for 2% the rest of this year and perhaps slightly higher into next year with the potential for a boost from fiscal policy.
- The US inflation backdrop is very subdued and continues to puzzle the Federal Reserve (Fed), with Fed Chair Janet Yellen earlier claiming it is “transitory” and more recently calling it “temporary”; she nevertheless seems resolved to move ahead with the balance sheet unwind and another rate hike this December.
- Headwinds facing US growth include underemployment, political gridlock—as evidenced by the failed healthcare bills, delayed infrastructure spending and non-specific plans for tax reform—but a significant tailwind has been successful, pro-growth deregulation. Regarding tax reform, we think tax cuts are more likely than systemic changes, and implementation is probable.
- With a new Fed Chair expected in February 2018, we’ve been consistent in our belief that President Trump will nominate a dovish Republican and our pick from August, Jerome Powell, is still in the running.
Global Economic Outlook
- Global growth was positive but declining from 2013 to 2016, while it has started to go back up modestly this year. We think growth will be very slow and restrained due to global headwinds.
- The greatest headwind to global growth is debt, which is now higher than it was at the end of the Great Financial Crisis.
- The low-inflation, low-growth backdrop means that central bank policy will generally continue to be very accommodative —underpinning low rates—especially by the European Central Bank and Bank of Japan (BoJ).
- Europe: A temporary inflation pop after Brexit has been replaced by softness. The Bank of England has signalled its intent to get on a path of tightening, but given the softness, we are skeptical of meaningful tightening.
- Japan: Accommodation by the BoJ has been extraordinary but Japan’s inflation rate is barely above zero and continues to be very stubborn and slow to move.
- China: With the help of considerable stimulus, growth has improved and stayed strong. China’s currency is ceasing to deteriorate, and now beginning to improve.
Chart: Finding value in Emerging Markets: Effective Exchange rate by country
Chart shows EM valuations as a percetentage of their full value (100), according to the Bank of International Settlements.
Source: Bloomberg and Bank of International Settlements as of 4 October 2017. Past performance is no guarantee of future results. Please find definitions in the disclaimer.
- Most spread sectors performed well over the quarter, with EM once again leading the way.
- Investment-grade: We are focusing on industries that are deleveraging, with a keen eye on avoiding the underperformers; this is truly a stock-picker’s market.
- High-yield: Spreads have narrowed as defaults have declined, with ex-commodity defaults very low.
- Agency mortgages: The fundamentals for real estate and consumers are constructive and we believe these sectors continue to look attractive on a risk-adjusted basis.
- EM: Valuations look attractive both on a historical basis and relative to developed markets, particularly given a better global recovery, lower risks in China and commodity stabilization.
We think the Republican Party needs to get some things done before the 2018 elections or it risks a big backlash at the polls. Tax cuts look promising. Given the multiple factions within the party, however, approving them will not likely be easily accomplished.
If we’re wrong and global growth and inflation pick up rapidly, then we would have to expect central banks to tighten meaningfully.