Regarding central bank balance sheets, the market has so far taken in stride the Fed’s plans to begin the process of normalizing its balance sheet in October as well as the European Central Bank’s (ECB) hints at tapering its bond purchases next year. But don’t forget that there is virtually no historical precedent for major central banks actively reducing their balance sheets. Thus, the impact of the Fed’s balance sheet unwind on the term premium and other risk premiums is unknown, especially as it will coincide with a period of uncertainty about the future Fed chair and the composition of the Board of Governors. This is one reason for us to be slightly underweight duration and to expect a steeper yield curve.
As regards China, our forum debates centered on the implications of the more centralized and concentrated leadership that is likely to result from the party congress in October. One view, as stated above, is that the new/old leadership will focus on further suppressing economic and financial volatility through a combination of continued leverage expansion, financial repression including tight capital controls and imposition of supply discipline in commodities industries. If so, unlike in 2015–2016, China would not be an exporter of volatility to global financial markets. While this is a possible outcome, another distinct possibility is that the likely consolidation and concentration of power opens the door for significant and surprising policy changes, including major reforms affecting state-owned enterprises (SOE) and forced deleveraging, which would weigh heavily on growth and could lead to more tolerance for currency depreciation. This could potentially be signaled by a highly symbolic shift, such as the leadership dropping the growth target. Such changes, or the fear thereof, have potential to disrupt global markets. In addition, a more assertive China in foreign affairs under a “paramount leader” President Xi Jinping raises the risk of an escalating trade conflict in case the U.S. administration decides to get tough on trade policy.
Regional economic forecasts: around the globe in five minutes
And here’s our 2018 outlook for the major economies:
As previewed above, in an environment in which the macro climate is about as good as it is going to get and where valuations are tight, we will emphasize capital preservation in our portfolios. The considerable uncertainty in the outlook, including the aging U.S. expansion, tapering of central bank balance sheet support and China-related risks we think necessitates a cautious approach to portfolio construction, generating income and grinding out alpha with a broad set of small trades rather than taking large concentrations in generic corporate credit.
While the baseline for the Fed’s balance sheet unwind and the ECB’s ongoing tapering – and broader central bank tightening – should be broadly priced in, the fact remains that full valuations and low volatility leave little margin for error. In the later stages of the corporate credit cycle, as active managers, we think it makes sense to emphasize portfolio liquidity and to avoid less liquid positions as a rule and focus on those bottom-up opportunities where we are truly paid for the risk.
While staying fairly close to home in the overall positioning versus the benchmark, we can aim to generate above-market return from a range of positions:
- U.S. non-agency mortgages
- U.S. agency mortgages
- Other select structured product opportunities
- Curve positioning
- Instrument selection
- Bottom-up credit positions
- Emerging markets (EM) foreign exchange positions
- EM local rate and external bond positions
- Optimization of bottom-up positioning with a high quality/income-focused bias more generally across specialist sectors
We expect to be slightly underweight duration overall, anticipating fairly range-bound markets but with the potential for a shift higher in yield across market levels that are low even in the context of our New Normal/New Neutral framework. In the U.S., as discussed above, we think the Fed is likely to hike more often than the extremely shallow path priced in by the market.
That said, while U.S. duration is in the lower part of our expected range, it continues to look attractive versus most other global alternatives. We continue to favor Japan duration underweights based on the asymmetric return profile at current levels. Over the medium term, we expect the BOJ to adjust the yield cap on 10-year bonds higher and see only modest risk of significantly lower yields. Moreover, while our baseline is for global duration to be broadly range-bound, we see Japan duration underweights as a low-cost hedge against rising global rates. In the event that we see yields rising in the U.S. and elsewhere, we would expect this to force the BOJ to relax its yield curve targeting regime over time.
We reduced corporate credit risk already across our portfolios and will continue to avoid generic investment grade and high yield corporate credit, looking to our credit specialist teams for bottom-up analysis, with a focus on high quality “bend-but-don’t-break” credit positions. U.S. non-agency mortgages and other high quality securitized assets where we see remote default risk offer defensive qualities in addition to reasonable risk premia for liquidity, complexity and uncertainty over the timing of cash flows. While we see a more balanced outlook for European macroeconomic and political risk, we do not see European peripheral sovereign spreads as offering compelling risk/reward at current levels.
We do not see significant imbalances at present in G-10 currency markets. We will continue to favor a diversified basket of EM currency overweights to generate income where it makes sense within our overall portfolio construction, alongside other income-generating opportunities.
In asset allocation portfolios, we expect to be broadly neutral on equities and commodities. Global equities have had a good year supported by a robust synchronized recovery in earnings. While fundamentals at the global level broadly underpin performance, valuations are full. Japanese equities stand out, screening as relatively “cheap” among developed markets, with the possibility of earnings upside versus relatively subdued expectations.
In commodities markets, while fairly neutral overall in terms of the broad beta of the asset class, we will continue to exploit bottom-up opportunities. We expect oil prices to be fairly range-bound with natural stabilizers on both the upside and downside thanks to OPEC spare capacity and the relatively quick responsiveness of shale production to price changes.
The terms “cheap” and “rich” as used herein generally refer to a security or asset class that is deemed to be substantially under- or overpriced compared to both its historical average as well as to the investment manager’s future expectations. There is no guarantee of future results or that a security’s valuation will ensure a profit or protect against a loss.
All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be suitable for all investors. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. Swaps are a type of derivative; swaps are increasingly subject to central clearing and exchange-trading. Swaps that are not centrally cleared and exchange-traded may be less liquid than exchange-traded instruments. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested.
There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.
This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
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