2017 Fixed Income Market Outlook
The surprise victory of Donald Trump in the 2016 U.S. Presidential election is an appropriate starting point for laying out our 2017 Outlook. To a large degree, it is too early to tell what the market impact of a Trump presidency ultimately will be. Details of the President-elect’s economic plan have been sparse, but early indications are for growth-oriented policies that involve tax cuts, infrastructure spending, and a tax holiday for repatriation of cash held abroad. Trump’s protectionist stance on trade is a potential offset to growth. Regardless of his policies, we believe that the uncertainty created by the Trump Presidency will drive market volatility higher. As we have consistently demonstrated over time, we will seek to take advantage of that volatility.
- Prior to the election, we began to rotate our multi-sector portfolios from high yield to bank loans based on relative value and increased expectations for rising rates; however post-election, the relative value between loans and high yield has narrowed. In general, our overweight to credit sectors should perform well in a growth-driven, rising-rate environment given the excess yield over Treasuries and expectations of further spread tightening.
- We continue to maintain our up-in-quality bias in leveraged finance based on current valuations, and seek to take advantage of market dislocations as increased volatility should create greater opportunities for alpha generation.
- We continue to be favorable on valuations in non-agency residential mortgage-backed securities (RMBS) and out-of-index asset-backed securities (ABS). These securities tend to be less sensitive to rates given lack of extension risk in RMBS and the short duration nature and excess spread of ABS.
We continue to believe that the Fed’s rate increases will be gradual and transparent and that the central bank will remain cautious and data dependent throughout 2017. Increased infrastructure spending, regulatory relief in certain industries, and potential tax cuts have all contributed to expectations for higher inflation, as evidenced by the 24 basis point spike (as of 12/14/16) in the 10-year U.S. Treasury yield breakeven rate post-election. Fiscal spending should translate into higher growth and increased borrowing at both the federal and municipal levels. The potential for expansionary fiscal policy is offset by the expected contractionary impact of Trump’s proposed trade restrictions on global GDP. As expected, the FOMC raised the Federal Funds target rate 25 basis points at the December meeting in response to improvements in labor market conditions and a “considerable” increase in market-based inflation expectations. Together, the stimulus-driven boost to growth and the risk of increased inflation have accelerated the assumed pace of rate hikes over the next few years though we continue to stress that these hikes will be gradual. We believe that two or three rate hikes potentially may happen in 2017 but it will be dependent on the markets, the economy, and Trump’s policies. Worthy of note, Trump has been critical of Fed Chair Janet Yellen and has taken a fairly hawkish tone on monetary policy. Whether this posture changes now that he is President-elect is yet to be determined.
As we look ahead to 2017, what does this mean for the fixed income markets? We believe opportunities exist and, consistent with our 2016 Outlook, effective credit selection is of the utmost importance and will drive returns for 2017.
While we do not bet on or anticipate interest rate movements as part of our investment process, we do have an opinion as to where we see rates going over the next 12 months. We expect that the 10-year U.S. Treasury yield will be range bound between 2.25-3%, with rates approaching the higher end of the range if President-elect Trump gets some of his pro-growth policies through early and these policies help push GDP growth to the 3-4% range. If this were to happen, we would expect rates to eventually pull back some as higher rates start to slow the economy. The pace of Fed rate increases and messaging will be particularly important to spread sectors going forward. Other factors that will influence the credit markets in 2017 include oil prices, China and overall global growth, and the U.S. dollar.