Market Commentary

He that waits upon fortune, is never sure of a dinner. ~Benjamin Franklin
Ken Leech
Chief Investment Officer

Executive Summary

  • The US and global economies are healing against a muted inflation backdrop that is unlikely to change anytime soon.
  • While the Fed’s models predict rising US inflation, we believe that inflation is in a bottoming process that is going to be both long and slow.
  • If short-term policy rates don’t need to move much above the inflation rate, then fears of a taper tantrum or a Fed policy mistake will be greatly reduced.
  • Very attractive valuations, improving growth fundamentals and powerful cyclical and secular disinflationary forces are strong arguments for investing in EM debt.
  • US spread sectors have performed exceptionally well over the course of the recovery, but their gains should be more limited going forward.
  • In this environment, spread products should still continue to outperform government bonds.

The US economic recovery continues. US unemployment is back to pre-crisis levels at 4.3%, the global economy is finally perking up, the Federal Reserve (Fed) is holding steady on its gradual path to normalization yet core inflation in the US is still refusing to bounce. One might even make the case that inflation is still declining (Exhibit 1). Core CPI is running at 1.7% for one year and 1.3% for six months. Fed Chair Janet Yellen has declared much of the decline to be “transitory,” due to one-off factors such as wireless pricing, but looking at the broader array of core inflation indices, particularly the service CPI, the same downward trend is in evidence.

Exhibit 1
Core CPI Inflation
market-commentary-2017-08
Source: Factset, Bureau of Labor Statistics. As of 30 Jun 17

New York Fed President Bill Dudley reaffirmed his confidence in the Fed’s inflation forecast on August 14. The Fed’s models predict rising inflation. (The Fed’s preferred measure is core PCE.) This suggests the Fed needs to continue gradually increasing policy rates to more “normal” levels. The challenge here, though, is that the Fed has been predicting inflation above 2% ever since 2012. The core PCE has yet to get anywhere near the Fed’s target of 2%, as shown in Exhibit 2. Indeed, the Fed has missed its inflation forecast each year of this expansion. And if 2% inflation is a target and not a ceiling, as the Fed often mentions, then perhaps the notion of interest rate hikes—not just the pace—needs to be questioned.

As anyone familiar with our economic and market commentaries over the last 25 years is aware, we have been deeply skeptical of the Fed’s Phillips curve models, the usefulness of the Taylor Rule and the Fed’s confidence in a terminal 2% real funds rate.

Exhibit 2
Core Personal Consumption Expenditures Deflator
market-commentary-2017-08
Source: Bureau of Economic Analysis. As of 30 Jun 17

Our theme has been and continues to be that the inflation bottoming process, in the US and globally, is going to be both long and slow, yet even we have been struck by the truly molasses-like nature of core inflation this year.

With global growth picking up, emerging markets (EMs) in particular healing readily, and European optimism growing, there should be few headwinds from abroad to impede US growth. Our base case presumes US growth continuing at a rate just below 2%, as we have seen in recent years.

Fed researchers have been publishing on the possibility that r* (the real equilibrium short rate) has fallen meaningfully from 2%. This is a welcome development. If short-term policy rates don’t need to move much above the inflation rate, then fears of a taper tantrum or a Fed policy mistake are greatly reduced. From an investment perspective, this suggests spread products will benefit due to both a higher carry and reduced risk of spread widening.

In this environment, spread products should still continue to outperform government bonds. While we may not get the meaningful benefit from spread compression that we did in 2016, this environment remains supportive of successfully clipping coupons. That is the challenge of a low-growth, low-inflation environment. Returns in high-quality fixed-income products should be expected to be modest. The demand for income and yield—with diminishing prospects for an imminent, significant rise in interest rates—provides the possibility of spreads tightening further. Still, we have reduced our overweights in US credit sectors due to the less compelling valuations presently available.

Emerging Market Yields—Poised to Fall Further

Quite simply, in a world where investors are desperate for yield, EM has plenty of it. Exhibit 3 shows the real yield spread between developed market and EM debt, which stands at a decade wide. Also displayed are the core rates of inflation. The sluggishness of developed market inflation to resume an upward trend is clear to see. More pronounced is the sharp fall in EM core inflation. The fall in EM inflation has meant that despite recent declines in EM yields, the decline in real yields has lagged. Very attractive valuations, improving growth fundamentals and powerful cyclical and secular disinflationary forces are strong arguments for investing in EM debt. Investors not only earn the greater carry, but can benefit from the prospect of significant spread compression versus developed market debt.

Exhibit 3
Real Yield Differential and Core Inflation Rates for Emerging and Developing Markets
market-commentary-2017-08
Source: Bloomberg, HSBC., J.P. Morgan. As of 30 Jun 17,

One of our highest-conviction views this year has been the belief that EM debt, particularly local currency debt, would be an outstanding performer. The bear market of the last five years left EM yield spreads near their 2008 wides. More importantly, as one needs to invest in local currencies to get the most benefit from EM debt, the valuation levels were very compelling.

The risks that drove EM currencies down over 2012-2016 were fears of global recession, commodity price weakness, Chinese growth/recession fears and broad global deflation risks. This year, fears of imminent Fed (and perhaps ECB) tightening and Trump Administration protectionism dominated the narrative for staying out of EM. But if global growth is sufficiently robust to induce the broad-based removal of central bank accommodation, then the growth fundamentals for EM would be turning quite positive. With commodity prices at a minimum stabilizing, and in our view on an upward trend, combined with improvement in Chinese growth, the case for a bull market in EM continues to be compelling.

Excellent valuations combined with improving fundamentals mean rate hikes and protectionism are merely risks rather than integral drivers. Fortunately, our views of the Fed inching up the fed funds rate and a high degree of difficulty in the administration’s ability to implement destabilizing protectionist measures have also come to fruition.

Of course, this opportunity comes with risks. The previously enumerated list of concerns that drove the five-year bear market for EM debt may resurface. Perhaps central bank tightening can re-accelerate should global inflation manage to re-emerge. Or geopolitical risks, as evidenced by North Korean tensions, may lead to challenging risk-off periods. But the opportunity here is not just earning the higher coupon. It is also the possibility of gaining from further compression between developed market and EM yields and/or benefiting from appreciating currencies.

Summing Up

The global economy is healing against a muted inflation backdrop that is unlikely to change anytime soon. Central bank policy should remain benign. US spread sectors have performed exceptionally well over the course of the recovery, but their gains should be more limited going forward. The more substantial opportunity lies in EM debt, where both growth and inflation fundamentals are favorable.

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