Fixed income: Rising tide of economic growth creates numerous strategy choices
As we consider fixed-income markets in 2017, we are particularly optimistic about two factors. First, we think that the continuing global economic recovery will be positive for a variety of fixed-income sectors. Second, we think increasing levels of market differentiation across the global fixed-income landscape may be highly supportive of active fixed-income approaches. During the last several years of sluggish economic recovery, markets have experienced historically high correlations across a wide variety of asset classes. But as we enter a new political era, amid promises of pro-growth policies and post-U.S. election market exuberance, we expect to see more market, sector, and country-level differentiation — and diversification — which should create opportunities across a range of investment strategies.
As we believe we are entering an investment climate that is healthier overall, we also expect that the trend toward interest-rate normalization will continue, with substantial room for potential rate increases. Considering underlying U.S. economic growth, inflation forecasts, and the typical term premium that we would anticipate for this area of the market, we believe the normal yield on the 10-year U.S. Treasury should be significantly higher than where it currently stands. For this reason, we continue to de-emphasize interest-rate risk in many of our investment approaches, and find greater risk-reward potential across a variety of fixed-income sectors typically found outside of traditional fixed-income benchmarks.
We expect the corporate market to continue to generate attractive returns in an environment of constructive fundamentals and below-average defaults. In 2016, many high-yield issuers repaired their balance sheets and refinanced debt, which lends support to our constructive view across much of the credit spectrum. There has also been meaningful global demand for U.S. corporate credit, which has led to strong spread performance. We also continue to find attractive opportunities among select areas of emerging-market debt, particularly where idiosyncratic stories help differentiate what we consider attractively valued opportunities that can thrive in the evolving interest-rate and policy environments.
In the United States, the presidential election has opened up a set of potentially productive policy variables, particularly in the areas of fiscal spending and tax reform. With the apparent promise of greater cooperation across government, we think the change in the political climate could be helpful for the economy and welcomed by corporates. Simplifying the tax code, especially at the corporate level, could result in a substantial repatriation of capital. That could spell good news for share repurchases, deleveraging, and merger-and-acquisition (M&A) activity. Furthermore, tax reform for consumers should generally be a tailwind for spending, which could be beneficial for a broad range of U.S.-focused companies.
In securitized debt, we continue to like the prospects of commercial mortgage-backed securities (CMBS) and non-agency residential mortgage-backed securities (non-agency RMBS). With CMBS, we think the market will continue to make positive gains on the back of healthy real estate market fundamentals. With non-agency RMBS, we expect that the housing market's continuing recovery as well as the shrinking supply of this security type will support the total return prospects of this area of the market in 2017.
Currency: The dollar appears poised to advance based on growth pace and interest-rate differentials
The Republican sweep in November, spearheaded by President-elect Trump, dramatically changes the distribution of outcomes for growth, inflation, and monetary policy. Many of Trump's policies remain uncertain, in particular the timing and configuration of infrastructure spending and tax cuts. However, looser fiscal policy is highly likely, the deficit will be larger, and the term premium needs to be re-established. The greatest challenge for markets remains around Trump's policy regarding trade.
The potential fiscal boost from the Trump administration has yet to be incorporated into the Federal Open Market Committee's economic outlook. Currently, the Fed appears to be less concerned with the effect of a higher U.S. dollar and rates, and the appetite for running a high pressure economy seems to have abated. So with the market still pricing rates to remain below Fed projections, the potential for pricing in more hikes and a stronger U.S. dollar is greater. If Trump's protectionist rhetoric remains a more benign policy, then one should expect a continued reassertion of the strong U.S. dollar trend that began in 2008 and a more aggressive path of rate hikes by the FOMC.
The outlook for the euro will be dominated by relative monetary policy and mired in ongoing political risk. The ECB has announced a nine-month extension of quantitative easing at a tapered, €60 billion per-month purchase rate from April 2017. By surprising on the dovish side with regard to time horizon and at the same time tapering the purchase rate, the ECB has also bought itself time and side-stepped a series of potentially difficult discussions about further extensions during 2017. This should cap how high the euro can climb against the U.S. dollar given greater expectations for Fed rate hikes. The political risk in Europe is difficult for markets to price since the risk of a eurozone dissolution is not trivial, but in the short run, it is not very large. This will likely cause volatility to the single currency but is unlikely to be the principal driver of its direction.
The outlook for the British pound continues to be driven by the political landscape surrounding Brexit, with more fundamental aspects less relevant. Brexit Minister David Davis acknowledged in the House of Commons that making payments to the European Union in return for single market access was a possible outcome. This softening of tone toward a hard Brexit has and will provide support to the pound on a relative basis. Once positioning has adjusted, the pound should once again follow relative monetary policy that suggests a move lower against the U.S. dollar.
The Bank of Japan, after implementing its "yield curve control" in September, stated that it would ensure the 10-year Japan government bond (JGB) yield will remain around 0% by varying its JGB purchases and offering fixed-rate JGB purchases when needed. Owners of JGBs might watch rate differentials widen to other global bonds, and can sell to the BoJ at the yield cap and send capital overseas, resulting in a weaker yen.