Fixed Income Outlook  |  Q1 2017

Growth acceleration under a new policy regime

Fixed Income Team

Key takeaways

  • We think the combination of positive global economic fundamentals and the potential for fiscal stimulus in the United States provides a tailwind for global economic growth in 2017.
  • The prospects for U.S. interest-rate normalization argue, in our view, for a de-emphasis of rate risk and a continued focus on credit, prepayment, and liquidity risks.
  • While U.S. dollar strength may temper the U.S. Fed's plans to raise rates, the loosening of U.S. fiscal policy could fuel a more aggressive tightening of monetary policy should inflation pressures rise substantially from current levels.

As we consider fixed-income markets in 2017, we are particularly optimistic about two factors. First, we think that the continuing global economic expansion will be positive for a variety of fixed-income sectors. Second, we think greater differentiation in performance outcomes across the global fixed-income landscape may be highly supportive of active fixed-income approaches.

Opportunities to diversify are proliferating

During the past several years, markets have experienced historically high correlations across a wide variety of asset classes, as highly accommodative monetary policy led the performance of risky assets to move in relative uniformity. 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 performance diversification — which should create opportunities across a range of investment strategies.

What's more, we see a variety of investors, across the gamut of size and sophistication, as coming to feel they are under-risked, still positioned as if they were preparing for the next downturn. We believe we will see signs of change in this crisis-induced mindset. As investors start to worry more about the opportunity costs of a defensive posture, that may further propel interest in risk assets across fixed income.

Economic fundamentals improving globally, with some attendant risks

The world economy is picking up the pace of growth. A big part of this has to do with inventories, which were a drag on growth in the first half of 2016 and are now at levels that are allowing economic output to grow more rapidly. In the United States, we believe that destocking ended in the late spring/early summer of 2016, and a rebuilding of inventories is now under way. Globally, we think the change happened at more or less the same time. This has led to positive data reports in the United States, as well as in Europe, Japan, and across much of the emerging markets — with Latin America being a notable exception.

That said, changes in inventories allow the growth rates of supply and demand to diverge, but such divergences cannot go on forever. The current phase of restocking, which is boosting supply growth, will come to an end, and supply growth will ease, unless demand growth picks up. The largest change in demand growth in 2016 occurred in China, where the economy outperformed expectations — or rather, confounded fears of a hard economic landing. For 2017, the China puzzle remains, but the biggest uncertainty concerns the mix of pro-growth and protectionist policy measures that may emerge in the United States.

U.S. rate normalization under way as fiscal policy variables proliferate

As we believe we are entering an investment climate that is healthier overall, we expect that the trend toward interest-rate normalization will continue in the United States, with room for potential rate increases. Considering underlying U.S. economic growth and inflation forecasts, we believe the yield on the 10-year U.S. Treasury should be at least modestly 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.

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 the corporate sector. 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.

But the details of fiscal stimulus, as well as its precise timing, is still open to question. In our view, the Fed has been clear that it would welcome a productivity-enhancing fiscal plan. Such a plan, with meaningful infrastructure development, efficiency-enhancing corporate reform, and well-considered educational and training components, could lift economic growth potential without requiring a more aggressive monetary stance. Of course, we also think the Fed has been equally clear that an inflationary fiscal package — particularly one that stimulates aggregate demand without also enhancing productivity — could prompt more aggressive monetary tightening.

Overall, we think interest rate increases may run up against limits, at least in the short term. Globally, central banks are far from where the U.S. Fed stands today. Stretching to find new ways to be accommodative — from the Bank of Japan announcing new measures to lower Japanese government bond yields to the European Central Bank extending its 
quantitative easing program through the end of 2017 — developed markets continue to resist the pull of U.S. rate normalization. This policy divergence from the United States may help keep a lid on U.S. rates, at least in the near term. Looking further out, however, to the end of stimulus abroad, we do see the potential for substantially higher global rate structures, with the U.S. pulling global rates higher once the shackles of quantitative easing are off.

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