Fixed Income Outlook  |  Q2 2017

Global reflation at a crossroads

Fixed Income Team

Key takeaways

  • We expect global economic reflation will continue to set a positive backdrop for asset markets, including fixed income.
  • We expect a somewhat faster pace of monetary policy change than markets currently anticipate, at both the U.S. Federal Reserve and the ECB.
  • We continue to believe that interest-rate-sensitive areas of fixed income hold fewer opportunities for investors than sectors reliant on prepayment, credit, and liquidity risks.

While the post-U.S. election rally appeared to exhaust itself late in the first quarter, the global economic reflation story seems to be very much alive. On the basis of broadly positive macroeconomic data in the United States, Europe, Japan, and a variety of other markets, we maintain an optimistic outlook for a number of fixed-income sectors in the quarter ahead, particularly those sectors that are not heavily exposed to interest-rate risk. That said, as market participants monitor the interest-rate backdrop, as well as the transition from high expectations for growth-friendly policy to actual policy implementation in Washington, we expect volatility and risk aversion are likely to return periodically.

Impressive growth, but no new catalysts in view

We have been impressed by the pickup in global growth across numerous regions, with only a few reservations. We doubt, for example, that Russia is as strong as it looks, and Mexico is not quite as weak as it may appear on the surface, either. Latin America is the only region that appears to be lagging — and that, we think, is because Brazil's recovery has stalled and Mexico, while not as bad as the data suggest, is certainly not doing well.

In some cases, the composition of growth is quite encouraging. In Europe, for example, the fourth-quarter 2016 national accounts show a balanced pattern of growth with investment moderately picking up. In Japan, there has also been a rise in investment and a further increase seems likely, in our view.

However, we are hesitant to look at the recent bounce in growth and get excited about a new era of faster global growth overall.

The dynamics driving the global pickup are, we think, nearing their natural end. Chinese policymakers' overreaction to the slowdown in the winter of 2015–2016 pushed up the Chinese growth rate, allowing commodity prices to strengthen. At the same time, the inventory cycle in global manufacturing turned. These factors are beginning to reverse: China is now tightening policy, and we think the inventory cycle is coming to a close over the next quarter or so.

These dynamics are also at work in the case of U.S. growth. For industrial production to move onto a much stronger path would require a large upward shift in the ratio of new orders to inventory, which we do not think is likely in the near future. We also do not find evidence of a significant acceleration in global demand growth on the horizon. And finally, after seeing the Trump administration in action for a couple of months now, our near-term conclusion is that nothing in terms of fiscal policy — whether that means tax reform or large-scale infrastructure initiatives — will happen early enough to have a meaningful impact on growth in 2017.

Central banks on the move

With respect to interest rates, we have thought that the Fed could indeed accelerate its rate hikes faster than the market expected, and the Fed's March meeting minutes confirmed this view. The Fed hiked the federal funds rate by a quarter point on March 15, and it has projected that two more hikes are likely this year. For the time being, we think the Fed's anticipated plan does not depend on anything the Trump administration may or may not do in terms of policy. Instead, we observe that today's sustained backdrop of stronger commodity prices is adding to inflation in other segments of the economy, and this may induce the Fed to remain more explicitly on a path toward interest-rate normalization.

In addition, as the minutes of the latest Fed meeting also confirm, the time for making adjustments to the Fed's balance sheet may be fast approaching. We think that the potential unwinding of the Fed's multi-trillion-dollar balance sheet represents a far more important development for asset markets than incremental steps to rate normalization. And importantly, President Trump will have a significant opportunity to reshape the Fed as vacancies on the Fed's board of governors open up over the next year. In our view, there is clearly a risk that the individuals Trump may appoint to the Fed could view the Fed's balance sheet as evidence of undesirable government "interference" in markets. This is something we will be watching very carefully in the coming months.

Turning to Europe, we also think that markets may currently may be underappreciating the possibility of monetary policy changes at the European Central Bank (ECB). The ECB, unlike the Fed, takes its policy cue from headline inflation rather than core inflation. Headline inflation has risen rather substantially in Europe on the back of higher prices across the global commodity complex. While the ECB has said it will continue its quantitative easing program through the end of 2017, that does not mean the bank cannot raise interest rates. Indeed, it is likely to face increased pressure from the financials sector to leave its negative-rate policies behind.

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