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CIO Ken Leech

2Q18 Market & Strategy Update

Ken Leech
Chief Investment Officer

2018 began with substantial market enthusiasm and optimism for “synchronized global growth,” but it also raised the fear that inflation and interest rates might rise precipitously and cause other problems. Since then, however, we’ve seen a fairly meaningful downshift in growth and inflation as both failed to meet the earlier expectations.

The world economy now faces powerful headwinds in the form of global debt loads. The US, Europe, China and Japan all have much greater levels of total debt than they did in 2007 leading up to the great financial crisis. The upside here is that this will impede the global economy from picking up too much steam too quickly.

We still believe that the global recovery will be ongoing but could take a very long time to gain traction even with the help of continued accommodative monetary policy.

Market Review

  • Global growth and inflation continue to improve, albeit from very subdued levels.
  • Central banks continue to be very cautious as they signal their path to normalization.

US Economic Outlook

  • US interest rates currently have a meaningful yield advantage compared with most of the developed world.
  • Optimism about US growth from earlier in the year has abated; although GDP growth jumped above 3% in 2Q17 and 3Q17, this was due to one-time improvements in foreign trade and inventories.
  • The foreign trade balance has since resumed a relentless deterioration, and inventories are uncertain at best.
  • With unemployment down, the Fed expects inflation to return but that has yet to materialize.
  • We are hopeful that the Fed’s forecast this year for 2% inflation will come to fruition, but it has been nine years of recovery so far and that rate has yet to be achieved.
  • There is currently no evidence that wages are rising meaningfully.
  • New Fed Chair Jerome Powell is continuing with the policies pursued by both his predecessors, Janet Yellen and Ben Bernanke, with a keen eye on persistent long-term growth challenges.

Global Economic Outlook

  • Fears of “runaway” global growth seen earlier in the year have been tempered by disappointing results throughout the world. We see this as merely a downshift from very high expectations.
  • We are cautious, but continue to believe global growth is strong.
  • The ability of the global economy to accelerate is limited by the long-term global debt headwinds (much higher than in 2007) and demographics (working-age populations continue to decline).
  • Moderate growth is the reasonable expectation going forward; global inflation has barely risen above zero.
  • Europe: Growth remains firm and broad-based yet down from the higher levels expected by the market at the start of 2018; inflation should rise gradually as economic slack diminishes.
  • Japan: Core inflation ex-energy is barely above zero, but moving in a positive direction; growth rates have improved. We think reaching the Bank of Japan’s goal of 2% inflation is many years in the future.
  • China: Growth is supported by a tremendous amount of stimulus in an effort to make growth resilient. At some point policy will turn back to neutral and growth will likely downshift to a more moderate pace.

Investment Themes

  • Bank loan spreads look attractive relative to high-yield spreads.
  • High-yield: Spread sectors should outperform but margins are thin.
  • Investment-grade: Investment-grade credit has marginal negative excess return in 1Q18. We maintain our select subsector overweights.
  • Agency mortgages: Consumer and housing fundamentals appear to be on solid footing; we are constructive on residential credit, specifically securities backed by prime-jumbo loan collateral.
  • EM: Inflation is extremely subdued, which can provide EM countries the latitude for further rate cuts to support growth (and positive bond returns).

Q&A Highlights

  • We think the front end of the yield curve has been so depressed relative to Fed expectations that there’s now an opportunity there, so we are shifting some of our assets from the long end to the front end. We still think it’s very important to have a strategy that could help the portfolio if growth were to disappoint or systemic problems arise.
  • We are strongly attentive to the inflation environment both in the US and across the globe. The fact that we think it’s moving up is an optimistic forecast. The globalization of the world has meant that inflation rates around the world aren’t as divergent as they use to be. We believe that we will see higher inflation, but it will take more time.
  • The US/China trade issues represent a very small fraction of overall trade, so we are not overly concerned about the potential for a trade war. We think the trade-war rhetoric is likely for negotiation purposes.
  • We continue to be optimistic on Mexico, Brazil, and the entire region of Latin America.

View the presentation slides.
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