The current steady but unspectacular global growth backdrop has not materially changed. We remain optimistic that global growth of around 3% is sustainable while...
recognizing that high debt loads and other headwinds, including low productivity and aging populations, continue to flash a cautionary sign in many economies. Global inflation appears to have stopped declining as the extraordinary monetary policy effort seen in developed nations finally seems to be bearing fruit.
Our view, however, remains that this may be a very slow process, taking many years and continuing to require meaningful monetary and even fiscal support. This view suggests that spread sectors may continue to be preferable to holding developed market government bonds. It also suggests, however, that any meaningful or swift increase in inflation or interest rates is not imminent.
A continuing moderate pace of US growth, and an improving global backdrop suggests US Federal Reserve (Fed) policy will stay on course. We expect the Fed to tighten policy once again in June, continuing the process of inching up the Fed funds rate. Excitement about the possibility of tax cuts, deregulation and infrastructure spending characterized the consensus earlier this year. Presently, however, the enormous political turmoil in Washington has left investors very doubtful that any meaningful fiscal thrust will be accomplished. This now appears too pessimistic. The prospects for tax cuts to emerge from a Republican-controlled House, Senate and presidency are meaningful. In our view, market sentiment on the political front has swung too far toward pessimism. We favour long US duration with a bias towards 30-year US maturities, while favouring short duration in core European bonds and Japan.
Europe and Japan
We expect the Eurozone to grow at around 1.7% to 2.0% in 2017, notwithstanding the uncertainty caused by the UK’s decision to leave the European Union. With deflation risks in the Eurozone dissipating, however, the market’s focus has shifted to when and how the European Central Bank (ECB) will normalize its monetary policy stance. While underlying measures of core inflation remain subdued, it is likely the ECB will continue to keep interest rates low and we expect asset purchases to continue into 2018. Despite the uncertain political landscape, over the longer term Italy is likely to continue with its reform agenda and so valuations are likely to remain attractive versus German bonds at current levels.
In Japan, we expect growth to improve to around 1% to 1.5% in the context of the current fiscal and monetary policy mix, the delay in the consumption tax increase and the improving global economy. Inflation remains low but should increase gradually due to a tighter labor market and the receding effects of the decline in oil prices. With 10-year nominal yields capped around 0% by the Bank of Japan, we expect real yields to decline further and for this reason we favour exposure to Japanese inflation-linked bonds.
With the political risk in Europe receding somewhat following the outcome of the French elections, we favour European currencies versus the US dollar. While over time, we still expect the yen to continue its weakening trend versus the US dollar.
Our base case view for credit spreads remains a tighter destination in the near-to-midterm, but the aggressive tightening of spreads over the past several months has valuations nearing what can only be described as fair. We also remain vigilant about global risks which may impact credit markets, such as a sharp deceleration in Chinese growth. The technical tailwind remains favorable as demand is expected to remain firm given investor flows from lower-yielding markets abroad. Supply trends, after many years of increases, are now expected to decelerate despite the fast start in the beginning of the year. We remain cautious about the potential for further mergers and acquisitions and shareholder-friendly activities in certain industrial sectors such as healthcare/pharmaceuticals and telecommunications. We favour the financial sector, where deleveraging, capital build and regulatory constraint remain credit-positive.
We also favour attractive valuations in spread sectors, in particular investment-grade corporate bonds and select emerging market USD- and local-currency-denominated bonds. We continue to look for opportunities to benefit from market anomalies. Our focus remains on longer-term fundamentals with diversified strategies to manage risk.