Keeping in mind the enormous amount of policy uncertainty there is around the world and particularly in the US, upside growth prospects are coming amidst challenging secular headwinds and a constrained global growth background.
There has been an incredible level of policy experimentation that has taken place since the financial crisis and we believe it is important to remain humble about how all of that experimentation will ultimately play out. While we have strong thoughts about how we want to position our clients’ portfolios, we need to be mentally flexible and willing to change as circumstances warrant.
As we think about our global outlook for 2017, we remain cognizant of the potential downside risks, such as those emanating from China. Our base case is for steady but unspectacular global growth, and US growth and inflation may rise with fiscal stimulus. We are encouraged to see that global inflation has stopped declining; however, central banks, which have been a big source of accommodation for the global recovery, are becoming a little less accommodative. Nonetheless, government bonds should remain underpinned by low policy rates and we believe spread sectors should outperform over the longer term. US rates reflect growth and optimism and upside risks to US growth may come from potential fiscal policy changes. Issue selection and sector rotation remain crucial for performance.
Global Economic Outlook
· Global growth has steadied and appears set to improve. There is optimism that growth can finally pick up speed and perhaps be sustainable.
· Global inflation has stopped declining, which is good news, but historically we are still at a very low rate of inflation.
· Global growth appears slow but sustainable at about 3%. Global debt loads, however, are flashing a cautionary sign that improvements will take time and take much more central bank support.
· We expect the eurozone to grow 1.75% in 2017 as headline inflation remains at zero. We believe the European Central Bank will expand quantitative easing, both in duration and size.
· In the UK, we think that Brexit-induced uncertainty will slow growth to 1% in 2017.
· Now that central banks are beginning to reduce the amount of accommodation they provided previously, the question remains whether the global recovery will be self-sustaining.
· There are secular headwinds we also need to take into consideration, such as demographics, productivity and debt burdens. With Brexit and the election of Donald Trump, one could argue that we are seeing a deceleration of globalization and the political ascendency of nationalism. These are things that we are continuing to watch very carefully, and we remain thoughtful about how positions may need to change.
· Worries about the Chinese economy have abated, but we think we will still see a declining growth rate driven by the move from an export-led economy to one that is more consumption-led.
· It was partially fears of a Chinese slowdown that led to the bottoming of the spread sector market in February 2016. One of the reasons we were optimistic that the slowdown would not lead to a global recession was that Chinese policymakers had significant policy levers they could deploy.
· We believe the current level of optimism surrounding China is perhaps overdone and we remain alert on macro developments there. There has been a rapid buildup of debt in the country, there are emerging signs of property froth and China is losing foreign reserves at an alarming pace. That said, it is our strong belief that the Chinese authorities have no interest in a major devaluation of the yuan.
· Some of the issues we mention regarding China may not end up being problems in 2017 (they could be next year’s problems), but markets don’t always wait and the US and China could be on a collision course in 2017. The probability of a major break in the markets may be small, but with the Federal Reserve (Fed) poised to tighten and the US administration preparing to discuss trade and foreign policy in a more challenging way, we think we need to remain attentive to China in 2017.
US Economic Outlook
· While there appeared to be little change in the US Treasury (UST) yield curve between 2015 and 2016, 2016 was really a story of two volatile halves. The total return of the 30-year UST was a whopping 44.9% from December 31, 2015 to July 7, 2016, and an incredible -31.6% from July 7, 2016 to December 31, 2016.
· The US is now close to the Fed’s unemployment and inflation mandates and Fed Chair Janet Yellen has said that “Fiscal policy is not obviously needed to provide stimulus to help get us back to full employment.”
· The market has really embraced the optimism that US growth is going to get better and that fiscal policy is going to help charge growth. The market is taking the Fed seriously, at least for 2017, and, we believe, may be taking things too far too fast. We feel it is important to see which of the new administration’s policies are enacted and what will actually develop as opposed to embracing the idea that the entire agenda will be implemented right off the bat.
· Looking at the Trump’s proposals, tax reform is likely to be an early focus, but outstanding questions remain: Which “loopholes” will be closed? How will foreign profits be treated? Will there be more significant changes to structure of corporate taxes (e.g., taxing imports, deductibility of interest payments)? Trump has proposed looser fiscal policy, but deficit concerns may constrain the size of fiscal easing. In terms of trade policy, Trump pledged to name China a currency manipulator and suggested he would renegotiate NAFTA. This could be very disruptive to growth given the gross amount of US exports and imports of goods.
· US manufacturing has been in the doldrums and we don’t think a turnaround is possible in just one or two years; we think it’s more of a five-year process.
· With inflation breakevens just now reaching 2%, we think inflation expectations are not suggesting anything other than “gradual” in terms of Fed policy.
· Another reason we don’t feel US rates will be surging upward in 2017 is that very attractive spreads over Japanese and European government bond yields will limit the upside for long-term UST yields.
· Last year was a terrific year for spread sectors, particularly high-yield and emerging markets (EMs). Within investment-grade, an asset class that returned 440 basis points (bps) for the year, the biggest returns were within energy and metals and mining, where there has been significant deleveraging. Positioning within sectors is becoming more and more important, since the returns can vary greatly depending on where a sector is in the credit cycle.
· 2016 was also a championship year for long credit. Western Asset’s economist Mike Bazdarich wrote a paper in March 2016, “The Case for Long Credit” at a time when long credit was really being challenged, and the asset class ended up with 904 bps of excess return in 2016.
· We believe investment-grade credit should offer attractive income in 2017, but we have trimmed the overweights across all spread products because the valuations are not as attractive as they were last year. We remain constructive on banks.
· US credit spreads appear attractive at long-term averages given our economic outlook.
· In high-yield, valuations are on the tighter side and we intend to have smaller overweights while remaining very thoughtful about positioning and quality ratings. There is a strong case to be made for high-yield, and we expect better earnings in 2017, particularly for energy companies. In addition, the prospects for corporate tax reform are straightforwardly positive.
· We believe the mortgage-backed bond sector continues to look attractive on a risk-adjusted basis. Consumer and housing fundamentals remain constructive, house prices are projected to grow at 2%–3% over the next 12 months and the pent-up demand for housing should be a positive.
· In EMs, valuations look attractive on a historical basis and relative to developed markets. While the possibility of protectionism and border taxes can be very difficult, the spread between EMs and developed market continues to be very near the wides that we saw in the financial crisis. EM balance sheet strength continues to be a pillar of support. We intend to remain very thoughtful about opportunities in the EM sector. We continue to like Russia, India, Brazil and Mexico.
· In terms of watching elections, the one we are looking at most carefully is in France. From our perspective, a Marine Le Pen victory would be extraordinarily challenging for the EU and the EU’s need for cohesion and its desire to help the periphery perhaps, mildly, at the expense of the core.
· While some of our competitors are calling for an end of the UST bull market, we recall that many people have called for the end of the UST bull market over the last 35 years and we are still waiting. Our thought is that this bull market should be coming to an end, and if we are right, and the global recovery does remain ongoing, then over time we will see interest rate normalization and inflation normalization. It’s been a long time coming, however, and it’s slow.
· We have been maintaining slight underweights in both the euro and the yen, particularly the yen. Given the enormity of the move up in US dollar and the move down, we reduced those positions a little bit, but that really was the aftermath of the US dollar’s rally post-election. As a value investor, our style tends to be to reduce positions after big price increases and vice versa.
· Thinking about a slow global environment and the negative correlation between USTs and spread product, duration can be a very powerful portfolio tool to help mitigate downside risks when you get bad news about growth or that some crisis has occurred. It continues to be an important positive portfolio tool.
· Our strong view is that duration is an effective complement, given the negative correlation between bonds and stocks or spread products and fixed-income. We do not believe that we are moving into a highly inflationary US and global economy. We think that turning the global inflationary environment around will continue to be a very slow process.