Securitized debt: Mortgages benefit from general stability
In mortgage credit-sensitive areas, we favor an allocation to commercial mortgage-backed securities (CMBS). The underlying fundamentals for commercial real estate continue to be stable overall as employment growth, low interest rates, and a positive GDP trajectory provide a tailwind for the CMBS sector. With concern about the business outlook for retail shopping malls in the news, we anticipate some losses in regional mall-related credit. However, malls are showing some ability to repurpose their space to capture new types of tenants. Ultimately, we do not believe these issues will translate into fundamental losses at the BBB- tranche level.
Within agency credit risk transfer (CRT) securities, we are more cautious on valuations compared with last year, but credit metrics remain very high and underlying collateral performance is strong. Additionally, we continue to find value in the legacy RMBS market. Improving housing fundamentals are helping homeowners, with loan-to-value ratios falling, homeowner delinquency rates declining, and more borrowers staying current after mortgage modifications.
We also continue to find value in areas within interest-only collateralized mortgage obligations (CMO), although we have been more cautious in our allocation relative to mortgage credit. Despite low interest rates, prepayment speed uncertainty is not currently a major concern as we have been in this type of rate environment for quite some time. More generally, we find prepayment risk attractive in an environment where mortgage lending standards have yet to ease materially.
High yield and bank loans: Fundamentals are positive while spreads have tightened
We continue to have a constructive general view on the high-yield asset class. The fundamental landscape continues to be stable and buoyed by solid corporate earnings. There is also cause for optimism that high-yield issuers stand to benefit from pro-growth reforms expected in Washington, including deregulation and fiscal stimulus. However, the timing of policy implementation remains in question. Despite our positive general view, we are somewhat more cautious on the energy sector due to ongoing supply/demand concerns and uncertainty around OPEC production. Also, from a valuation standpoint, although credit spreads are measurably tighter year over year, they continue to look fair on the back of good fundamentals. High yield also benefits from a relatively favorable technical environment due to low net new issuance volumes.
Investment-grade bonds: Fundamentals continue to look solid
We remain constructive on the U.S. investment-grade corporate bond market on account of its improving fundamentals, favorable technical conditions, and fair valuation. Regarding fundamentals, 2Q17 earnings results generally outperformed expectations with notable strength in energy and technology, albeit with continued weakness in telecommunications.
Our outlook is for continued improvement in fundamentals, subject to unknown government policy initiatives. Regarding technicals, our outlook is still for elevated new issue supply, tempered by the decline in pending M&A transactions. U.S. spreads will likely continue to be supported by a solid fundamental backdrop, international flows, and ECB corporate buying programs over the near term. We continue to find current spread levels to be appropriate versus underlying fundamental risk. At the same time, we think it will be challenging for corporate spreads to perform as strongly as they did in 2016.
Emerging-market debt: General improvement offset by risk to U.S.-China trade
The dynamics influencing emerging markets (EM) have not changed much during the third quarter and remain driven by the interaction of global conditions, commodity prices, and local political forces. The majority of the focus has been on North Korea and the rising geopolitical tensions between the reclusive communist state and the developed world. There is still a lot of uncertainty around how North Korea will ultimately affect the global economy, and trade relations between the United States and China in particular, but we can no longer dismiss the possibility of a potentially catastrophic outcome. For now, though, markets do not appear to be too concerned, and EM shows no obvious signs of weakness. Within individual counties, Latin America has seen improvements lately, partly due to an improving economy in Mexico and partly due to Brazil, where the political crisis has eased and attention is returning to the tentative economic reforms that are slowly moving forward.
Municipal bonds: Technicals remain positive
From January to September 2017, investor sentiment generally improved, especially for higher-yielding municipal bonds. The pace of new issuance was generally light, and demand slightly outpaced supply, contributing to rising prices and a narrowing of credit spreads of lower-investment-grade and high-yield municipal bonds. Viewed in a longer-term context, spreads are at or close to the narrowest point since the credit crisis. That said, overall credit fundamentals remain stable, supply/demand dynamics are favorable, and defaults remain low and isolated.
The new administration has stated that tax reform remains a major policy goal. However, we have not seen major tax reform in over 30 years, and we believe it will continue to be difficult to achieve any such reform today given the competing demands on the current administration.
Currency: Tightening policies will contribute to relative strength
The U.S. dollar outlook continues to be most heavily influenced by the Fed and rising expectations that some fiscal policy boost could be expected in early 2018. Beyond that, market pricing for rate-hike expectations remains low as the future composition of the Fed is highly uncertain. What seems likely is that the new chair will keep policy accommodative and the dollar will remain on a weaker footing over the medium term. Over the coming months, Fed nominees should be vetted and appear before Congress for confirmation. As this process resolves uncertainty, coupled with an improvement in sentiment from a fiscal boost, the dollar could become tactically stronger, especially against the yen.
The outlook for the euro remains dominated by relative monetary policy. The ECB continues to balance policy doves, who point to a tame core inflation rate, with hawks, who call for the removal of emergency measures, i.e., tapering, and then ceasing, asset purchases. This balance is likely to persist until October or December, when the ECB will communicate to the market what it will do at year-end when the purchase program expires. The euro has already moved considerably, so much of the near-term direction will be based on perceptions relative to this baseline view. Over the medium term, the euro should continue to appreciate.
In the United Kingdom, the discussions over Brexit remain fluid and quite noisy, contributing significant volatility to the British pound. Unless there is a breakthrough, this should be expected to persist. The statements from the Bank of England (BoE) have been surprising, as the focus has shifted from maintaining accommodative policy in the face of Brexit to treating the impact from a reactionary standpoint. As such, the BoE has set the market up for a series of rate hikes likely beginning in November and continuing throughout 2018, which should keep the pound supported against the U.S. dollar, barring a major political mistake.
Bank of Japan (BoJ) Governor Haruhiko Kuroda continues to underscore that the inflation outlook remains subdued and, as such, the market should not expect any change in BoJ policy, adding that there is no need to raise rates just because global rates rise. With financial market volatility low, the yen should continue to soften as capital leaves Japan to be invested in higher-yielding assets abroad. The continued support of Prime Minister Shinzo Abe is key and should be thought of as a base case. Abe has called a snap election; if his Liberal Democratic Party suffers losses, it is more likely that Governor Kuroda will not be reappointed, and the fundamentally cheap yen will quickly strengthen.