Capital Markets Outlook  |  Q3 2017

As the U.S. recovery matures, Europe offers new potential

Fixed income and currency insights

Fixed income: Despite late-cycle signs, mortgages and high yield offer potential

In the United States, we see an increasing amount of evidence pointing toward late-cycle economic conditions. In our view, the key problem the U.S. economy faces is that the tightening labor market is constraining corporate profits. Firms attempted to regain healthier margins in the first quarter of 2017 by raising prices, but households rebelled, and consumption growth eased. This is most clear in the auto market, but it has happened in other areas, including residential real estate. That said, we continue to find value in various areas of the real estate markets, and we continue to prefer various forms of credit and liquidity risk to interest-rate risk across fixed income.

For example, within the securitized debt sector, we continue to find attractive opportunities within interest-only collateralized mortgage obligations (CMOs), although we have been more cautious in our allocation relative to mortgage credit. 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. Nonetheless, we believe the growth in property prices experienced over the past few years will be difficult to maintain going forward.

Turning to high-yield credit, we acknowledge that the market has had a good run year to date — and a strong 18-month record — but our outlook is for continued strength and further yield compression. While this asset class outlook is positive, we are slightly more cautious on the fundamentals due to the complexity of comprehensive policy implementation in the current political environment. With respect to high-yield valuations and "technicals," or the balance of supply and demand, our view is neutral.

For the emerging markets, we maintain a bias toward dollar-denominated sovereign debt and have a greater sense of caution with respect to emerging-market local debt and foreign currency exchange risk. U.S. rates have largely fallen in 2017, and we do not see inflation rising to a level that would prompt more aggressive Fed action. That is good news for emerging-market sovereigns with dollar-based debt obligations.

Overall, we believe a variety of forces are aligned that may enhance the attractiveness of emerging-market debt (EMD) for many investors. Across the developed markets, we think political risk has declined. The recent elections in Europe support this view, and we think these election results suggest the region will maintain its commitment — in the near term, at least — to accommodative monetary policy. Europe typically lags the global cycle, so if normal global dynamics hold, it would not be surprising to see Europe staying strong when the rest of the world slows.

Currency: Major currencies may be more stable, with the euro showing relative strength

The U.S. dollar outlook continues to be most heavily influenced by the Fed, as expectations for fiscal policy have been pushed beyond the investment horizon. The Fed's recent stance is relatively hawkish compared with market pricing and our own beliefs. With no urgency to hike rates aggressively, it is likely that the Fed will start to pare back its balance sheet gradually, but economic data and financial conditions will play a larger role in determining the pace, leaving the expensive dollar as more of the laggard than the leader.

The outlook for the euro is dominated by relative monetary policy and political risk. The ECB continues to balance the doves, who point to tame core inflation rate, with the hawks, who call for removal of emergency level accommodation and tapering of asset purchases. This balance is likely to persist until September or October, when the ECB will communicate to the market what it will do at year-end when the purchase program expires. Over the medium term, the euro should continue to appreciate.

In the United Kingdom, the results of the snap election have left the Conservative government in a much weaker position as they are forced to form a minority coalition with Northern Ireland's DUP (Democratic Unionist Party). The market has taken this to mean that the Conservatives will be forced to take a softer stance and remain in the single market and customs union, but in actuality, the likelihood of a hard Brexit has increased. In this context, the Bank of England kept rates unchanged, but three dissents in the vote suggest that its tolerance of inflation is limited. Since currency weakness caused much of the recent U.K. inflation spike, it is likely that the currency will not be allowed to fall much further. Given the risks associated with Brexit, the pound should be weak, but not excessively.

Bank of Japan (BoJ) Governor Kuroda continues to underscore that the inflation outlook remains subdued and, as such, the market should not expect any change in BoJ policy for the foreseeable future. This will keep the dollar-yen rate a function of Fed policy and the pace of policy relative to market pricing. Over the medium term, however, the return distribution is asymmetric because the yen is fundamentally cheap. A more dovish Fed stance could cause the yen to appreciate more swiftly.

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