Western Asset CIO Ken Leech explains why changes to current conditions may come gradually, why Western sees selective opportunities in credit sectors, and what the Fed's next move might be.
- While 2017 began with a groundswell of high hopes that the new White House Administration would be able to rapidly stoke US growth with fiscal policy, we held to our position that optimistic expectations had gone too far, too fast. Global political disruption remains a risk, with key issues on watch including Brexit, upcoming elections in France and Italy, US-China relations, and North Korea.
- After months of conjecture about secular stagnation—the idea that there would not be any growth in the developed world for an extraordinary period of time—the dominant theme in the markets shifted to the reflation trade and the idea that global growth and growth inflation were about to take off significantly.
- Our base case for the global outlook in 2017 continues to be steady, but unspectacular growth. Global growth is improving, but it remains very weak by historical standards.
- Central banks all over the world are still very accommodative, but they are becoming less so. While government bonds are still at very low rates, they will probably continue to be underpinned by the low policy rates. As such, we’re holding fast along the same themes you’ve heard from us the last few years. We continue to focus on various spread sectors where we believe value opportunities in fixed income should outperform over the longer term.
Summary Market Review
- Very small changes in the yield curve can mean big differences in total returns. Yield-curve positioning is just as important as overall duration.
- Most spread sectors performed well over the quarter with emerging markets (EMs) leading the way.
US Economic Outlook
- In the US, optimism and confidence surveys seem to have outrun the hard data while rates are close to fully reflecting the Federal Reserve’s (Fed’s) forecasts. We think the markets may have moved too far too fast.
- The Fed will be very cautious in how it unwinds its balance sheet. This will likely be a passive process.
- The US expansion is long in months, but not in magnitude, and we think this expansion has room to continue.
- Given the pace of expansion, the Fed is unlikely to get behind the curve even if it takes its time hiking.
- Normalization of interest rates and inflation is going to occur, but the process is very, very slow.
- There is still a lot of slack in the labor market; another reason why we think the Fed is not wrong to be thoughtful about raising rates too quickly.
Global Economic Outlook
- Global growth has steadied and there is optimism that growth can finally pick up speed and perhaps besustainable.
- Global inflation is increasing slightly from a low level, but has come off the deflationary risk seen last summer.
- Global debt loads, however, are a cautionary sign that improvements will take time and take central bank support.
- Central banks across the world continue to be accommodative, but are becoming a little less so.
- Inflation seems contained in the real estate markets—owner’s equivalent rent should ease as the rate of
- home-price appreciation has slowed—but some wage measures show acceleration.
- In France, risks will be meaningful if Marine Le Pen wins, but this is not our base case.
- Italy’s debt sustainability situation is improving.
- Regarding the UK’s Brexit, we’re also optimistic that some of the worst-case scenarios will be avoided.
- We think monetary policy will continue to be accommodative in France, Italy and the UK.
- China has been able to support 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.
- US Treasuries (USTs) present very attractive spreads over Japanese and European government bond yields. This will limit upside for UST yields.
- We expect spread sectors to outperform over the longer term
- In investment-grade, we are focusing on industries that are de-leveraging
- In high-yield, spreads have narrowed as defaults have dropped, but lower-rated bonds have lagged.
- Consumer and housing fundamentals remain constructive with house prices projected to grow at 2%–3 over the next 12 months. We believe this sector continues 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. Our counter-consensus trade in EM proved positive in 1Q17 with both EM US-dollar-denominated and EM local currency performing very well.
- Regarding the Fed’s reinvestment of its balance sheet, we think it is going to continue to reinvest proceeds from maturing bonds in 2017, but we think it won’t reinvest all of its proceeds in 2018. If it didn’t invest any of its proceeds, that would be about $400 billion of additional UST instruments, and the private market would need to buy $200 billion of mortgage-backed instruments.
- Any reduction to the Fed balance sheet is likely to be passive; we don’t expect any selling to come about and we think the Fed’s balance sheet is going to be large for a long time.
- Potential banking industry deregulation from the Trump Administration is potentially very bullish for banks. Our base case is that Dodd-Frank stays in place, as you need bipartisan support to change it in any meaningful way.
- We do, however, see banking regulations being applied with a much lighter touch. We don’t expect to see any big fines like we’ve seen over the last several years.