Is global monetary policy finally bearing fruit?

Western Asset Global Outlook

Is global monetary policy finally bearing fruit?

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.

Coming into 2017, our view had been that US President Donald Trump’s new administration would struggle to deliver on all the prom­ises made during the election campaign. Last month’s Republican failure to pass the healthcare reform bill highlights the challenges the administration faces to find comprise not only with the Demo­crats but also within the Republican Party. We expect equally tough negotiations surrounding tax reform and infrastructure spending. As a consequence, we expect consensus expectations for an accelera­tion in US growth to recede and for the Fed to continue to adopt a cautious approach to policy normalization. While we expect inflation to fall back below the Fed’s targets, it will probably not decline fast enough to restrain the Fed from raising rates in line with current market expectations in 2017. We continue to favour a long US duration position,

 

Europe and Japan

We favour short duration positions in core European bonds 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 EU and an increase in anti-establishment politics across the eurozone. 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, we believe 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 we believe Italy will continue with its reform agenda and that valuations 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 maintain exposure to Japanese inflation-linked bonds.

With the euro currently trading at the lower end of the range versus the US dollar that it has held for two years, and political risk ahead of the upcoming European elections now likely factored into the euro’s current low valuation, we have a more neutral/modest view of European currencies versus the US dollar.

In Japan, and over time, we still expect the yen to continue its weakening trend versus the US dollar. 

 

Credit

Our base case view for credit spreads remains a tighter destination in the near-to-midterm, but the aggressive move tighter in spreads over the past several months has seen valuations move closer to historic averages. We also remain vigilant about global risks which may impact credit markets, such as a sharp deceleration in Chinese growth and political events in Europe. The technical tailwind remains favorable. Demand is expected to remain firm given continued investor flows from low-yielding government markets, but the pace of central bank asset purchases may now have peaked. Supply trends, after many years of increases, are expected to decelerate in 2017 despite the fast start to the beginning of the year. We remain cautious about the potential for further Merger & Acquisition activity and shareholder-friendly activities in certain industrial sectors such as healthcare/pharmaceuticals and telecommunications. The favour the financial sector, where deleveraging, capital build and regulatory constraint remain credit-positive. 

 

Emerging Markets

Mexican bonds and the peso have begun to recover since weaken­ing significantly after the US elections. We expect the worst case outcomes with respect to potential border tariffs and immigration will be avoided and Mexican assets therefore have the potential to continue to recover further. In Poland, macro fundamentals remain solid and yields are attractive in our opinion, especially versus core eurozone yields. 

Overall, we continue to favour spread sectors, in particular to investment-grade corporate bonds and select Emerging Market bonds, to take advantage of attractive valuations. With volatility likely to remain elevated, we continue to look for opportunities to benefit from market anomalies. Our focus remains on longer-term fundamentals with diversified strategies to manage risk.

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