Performance in the bond market in the first half of 2017 was characterized by a lack of inflation, optimism about economic growth reflected in both equity markets and credit spreads and a seemingly insatiable demand for yield. The Fed raised rates twice on the belief that the economy was strong enough to move inflation up to the 2% target level and has introduced a plan to begin shrinking its balance sheet. The ECB has also expressed the view that inflation will move higher but stay below its 2% target, however, it will continue to require substantial support from the European bank.
In the first quarter, it appeared that inflation in the US would indeed move up. The labor market continued to show signs of strength and job creation remained strong. Economic growth in 1Q was weaker than full year forecasts, however, markets have come to expect weak first quarter growth. The yield curve flattened as short rates moved higher and long rates moved lower on demand for yield and on the belief that the Fed will continue to normalize rates, reducing the risk of inflation.
But not everything has worked out as planned. The US consumer, while employed and enjoying modest wage increases, has failed to spend enough money to drive growth in our consumer led economy at a fast enough pace to move inflation higher. In addition, the glut of oil supply continues to put downward pressure on prices and investment spending has yet to pick up much.
Looking forward, at Allianz Investment Management, we believe that the labor markets will continue to strengthen and support economic growth and inflation. We believe the Fed will continue to normalize monetary policy at a very gradual pace. The recent drop in inflation may alter the timing of rate increases and may put more emphasis on Fed balance sheet reduction than Fed Funds rate increases. That shift will cause the yield curve to steepen short term, but longer term we expect a continued flattening trend. With economic growth continuing in both the US and Europe, we expect equity markets to move up modestly and expect credit spreads to stay around current levels. Both equities and credit continue to trade at elevated levels limiting the upside, however, we believe valuations are justified given growth prospects in a low inflation environment. If the administration can successfully move its tax and infrastructure policies forward, we see better upside potential for both equities and credit, but the runway for passage of both appears quite long.