The slow but steady global recovery since the great financial crisis made good progress through the end of 2017, with interest rates remaining underpinned by central bank accommodation, inflation staying low but steadily awakening from rock-bottom levels, and the recently passed Tax Cuts and Jobs Act set to improve US competitiveness relative to the rest of the world.
We were surprised by the volatility index (VIX) remaining under 10 for most of 2017, but think this is a reflection of the ongoing accommodation of central banks—specifically their collective efforts to be cautious, deliberate and completely transparent.
Looking ahead, we expect the US growth outlook to be another 2%+ growth year in 2018, and perhaps better with the new tax law taking effect almost immediately. We also remain optimistic that global growth above 3% is sustainable and inflation will continue to improve from its current low levels. The fundamental investment backdrop is exceptional, but prices are high so sector and security selection remain key.
- The best performing sectors were outside the US, confirming our view that the global environment is actually healing. Emerging markets (EM) was again the best performing sector.
- In both investment-grade and high-yield, spread compression is behind us so our focus is on name selection even more than industry selection.
US Economic Outlook
- The Tax Cuts and Jobs Act, which lowers the US corporate tax rate to 21%, stands to improve US corporate competitiveness relative to the rest of the world.
- Given the tax cut and other pro-corporation moves, such as further deregulation, we expect positive upward pressure on GDP growth. However, we feel the greatest benefits from the tax cuts will be realized in the first few years.
- Despite better growth in 2017, long-term rates did not increase much. Our expectation is that growth in the US is going to be solid and above-trend this year.
- If growth does improve as we expect, then we believe the Federal Reserve (Fed) will continue to inch up the fed funds rate and the yield curve will likely flatten further.
- We think we’ll get a federal spending boost on two fronts as the Trump Administration wants military spending increased, and will likely give Democrats the domestic spending they desire.
- Low inflation has been persistent and pervasive. Our view of inflation is in line with the Fed’s, and while the Fed has missed its 2% inflation target for the last several years, we are optimistic that inflation will at least get close to 2% this year.
Global Economic Outlook
- Global debt-to-GDP ratios are actually higher than they were during the crisis, but have moved from private to public balance sheets and suggest the need to keep central bank policy rates low.
- EM inflation is improving, especially relative to developed markets; the real yield rates in EM less the real rates in developed markets are still at a 10-year wide.
- Energy prices, specifically oil, is still healing; as global growth continues to improve, it helps energy’s supply and demand; as a result we expect to see gradually rising prices.
- Europe: Growth continues to improve but inflation remains stubbornly low. Our expectation is that core inflation will begin to improve, but very slowly. Further, we think Brexit negotiations may be more difficult than anticipated so we are skeptical there will be any meaningful tightening in the UK.
- Japan: Despite a pickup in growth, the inflation outlook is extremely subdued, and continues to be barely above zero. We expect very accommodative policy to continue for quite some time.
- China: With improved growth in 2017, there is still optimism around China but at some point policy may begin to tighten. Looking ahead in 2018, we expect growth to moderate.
- Most spread sectors performed well over the quarter, with European Banks and EM Local Currency leading the way.
- Investment-grade: We continue to focus on industries that are deleveraging, with specific care to avoid the underperformers. With investment-grade credit at tighter valuations in 2018, we expect sector positioning to be much more important than the overweight/underweight decision.
- High-yield: Relative value around the world augurs well for US high-yield compared to other parts of the world.
- Agency mortgages: The combination of a meaningful decline in volatility (VIX) and the transparent and gradual moves by the Fed has enabled MBS to post strong returns.
- EM: Despite very good returns in 2017, EM is the sector we feel still has the best opportunity with EM countries well-positioned for long-term growth relative to developed markets.
- If we’re right that inflation is turning up, even if it’s slow, then over time interest rates will also increase. As we often say, the story of long-term interest rates is the story of long-term inflation.
- Our portfolios are generally positioned in line with our overall outlook of an improving global environment. However, we are cognizant of the possible risks such as systemic shocks, a rise in protectionism or a spike in inflation. As a result, we have some portfolio strategies that seek to provide an offsetting ballast to contrast with our growth positioning.
- We think the flattening of the yield curve is a yellow flag, and not quite red. While a flat or inverted yield curve traditionally can predict an economic recession, we think the flattening curve will help guide the Fed and may prevent it from tightening monetary policy too quickly.