Fixed income: Short-term dynamics favor Fed rate move in DecemberU.S. economic data remained positive in the third quarter and consistent with an economy growing steadily at around 2.0% to 2.5%. The major issues as we enter the fourth quarter continue to be the geopolitical confrontation over North Korea's missiles and nuclear weapons program and its potential to disrupt trade and growth; the persistence of low inflation and its implications for central bank policies; and the developing debate over U.S. fiscal policy and, more specifically, possible actions on the debt ceiling, tax reform, and the federal budget.
Given the positive global economic growth profile, both the Fed and the European Central Bank (ECB) seem set to move — the Fed by beginning balance sheet reduction in October and increasing rates again in December, and the ECB by outlining its plans to taper its bond purchasing program. The Fed has been clear that it views the recent negative inflation surprises in U.S. data as temporary and transitory. Although we find it difficult to be confident in this view, we expect inflation will move higher in the short run. Looking toward 2018, however, we expect core inflation to remain in a narrow range, at a level that's consistent with the Fed's target, and which therefore may not warrant the three rate hikes that a majority of Federal Open Market Committee (FOMC) members projected at the September Fed meeting.
Multiple fixed-income sectors continue to offer opportunityWe remain constructive on the U.S. investment-grade corporate bond market on account of its improving fundamentals, favorable technical conditions, and fair valuation. Our outlook is for continued improvement in fundamentals, subject to unknown government policy initiatives.
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. 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.
We continue to have a constructive general view on the high-yield asset class. The fundamental landscape of U.S. high-yield issuers 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. From a valuation standpoint, although credit spreads are measurably tighter year over year, they continue to look fair on the back of good fundamentals.
Currency: Central bank tightening and leadership uncertainty create new concernsThe 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 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 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.
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The market appears to have little confidence in tax reform, and little concern about North Korea or Fed policy.