- We think the moderate pace (2%+) of US growth will continue, and the Fed will continue providing meaningful monetary accommodation.
- Systemic risk has diminished greatly; now we are in the more traditional data-dependent world of fixed-income. However, investors are still challenged by judging the timing and speed of the GDP recovery, inflation, and Fed policy rates.
- Following the Fed’s removal of thresholds required for raising policy rates, the rise in Treasury rates was short-lived. In our view, meaningful rate declines from this point would be dependent on weakening economic growth.
- We are also witnessing the continued narrowing of yield spreads between spread sectors and Treasury bonds. Growth shortfalls can still occur, and valuations need to be monitored closely.
- We are experiencing some breathing room from a recurrence of systemic risk, and are witnessing some spectacular returns. Today’s valuations are no longer demonstrably cheap but the economy is healing, and policy accommodation will remain the order of the day. Investors needing income have to either go down the credit spectrum, or out the yield curve. Both present challenges.
Our thesis that the US and global recovery would prove a very long and drawn out affair persists. The good news is that we are now further from the conditions threatening systemic risk emanating from the financial crisis. The challenging news is that the normalization of economic conditions will still take more time.
We think that the moderate pace (2%+) of US growth will continue, and the Federal Reserve (Fed) will still have to provide meaningful monetary accommodation. Inflation should stabilize but rebound exceptionally slowly. Global growth of perhaps 3%+ may be better than last year, but only marginally. Again, monetary accommodation will need to be persistent, and global inflation trends will also suggest a very mild uptrend. This growth pattern of two steps forward, one step back, has been pretty challenging for investors. The normalization of risk premia has provided stupendous total returns over the last five years, but not without some prospects of the return to systemic risk. Those prospects of a possible return of systemic risk have impressed upon asset managers the need for vigilance in monitoring and managing portfolio risk. One particularly useful strategy for both providing return and reducing aggregate portfolio risk has been combining long Treasury bond exposure with meaningful overweights to spread sectors.
Systemic risk has diminished greatly. The Fed boldly signaled something of an “all clear” when, after its program to unwind quantitative easing, it further removed the thresholds required before policy rates could be raised. In essence, the Fed has said, emergency monetary policy should be used only for emergencies. It has decided that time has passed. Now we are in the more traditional data-dependent world of fixed-income investing. Carry and roll down is no longer guaranteed the benefit of endless Fed patience, and the yield curve has duly flattened (Exhibit 1).
As this path to normalization proceeds, though, investors are still challenged by judging the timing and speed of the GDP recovery, inflation, and Fed policy rates. In removing the thresholds, the Fed was implicitly showing substantial confidence that its growth rate of 3%+ GDP growth for the rest of this year and next would be realized. In this world, inflation would move up toward the 2% target late next year and policy rates would start to rise next spring or summer. This optimism is similar to that shown last spring, when the Fed announced its tapering considerations, and to last fall when it instituted the tapering program. In each case rates rose at first, but then fell as the Fed’s forecast proved overly optimistic (this has been predominantly the case in the five years of the post recovery period as well).
This time, following the Fed’s removal of the thresholds, the rise in Treasury rates was very short-lived. We have believed that moderate US and global growth, and concomitant low inflation, would keep interest rates low and mostly range-bound. While the trend would eventually be to higher rates in line with the normalization process, this would be a very long path. We lengthened durations meaningfully last summer and again last winter after the Fed induced sell-offs. Now, with 10-year notes nearing 2.5%, roughly in line with our expectations, we have reduced our duration position. In our view, meaningful rate declines from this point would be dependent on weakening economic growth.
Another aspect of the moderate growth we’re seeing in conjunction with policy accommodation is the continued narrowing of yield spreads between spread sectors and Treasury bonds. In many sectors, yield spreads have moved to the tightest spreads since the crisis, though still meaningfully wider than in the economic recovery periods of 1992–1997 or 2002–2006. Spread widening is driven by expectations of weaker growth, most often precipitated by monetary policy tightening. We continue to believe we are still on a very long path. We do not expect policy preemption until a distant horizon. But growth shortfalls can occur nonetheless, and valuations need to be monitored closely. Our bias remains to hold overweights to these sectors.
One fixed-income sector that saw marked widening last year was emerging markets (EM). Here, the storyline of diminished growth expectations in conjunction with the fear of higher US and developed market rates led to sharp price declines. Investment flows that had been almost straightforwardly positive for many years suddenly reversed. Our view—as presented by Gordon Brown’s "Valuations in EM Have Become More Attractive"—was that the valuation opportunities that opened up more than compensated for many of these risks (Exhibit 2). Additionally, our global growth forecast, while tamer than some, also implies that developed market rate expectations were overdone. Indeed, our Europe and Japan forecasts call for further easing.
The return of the global economy from the brink of the financial crisis has provided the necessary breathing room from a recurrence of systemic risk. It has also provided investors with spectacular returns. Today’s valuations are no longer demonstrably cheap but the economy is healing, and policy accommodation will remain the order of the day. Investors needing income have to either go down the credit spectrum, or out the yield curve. Both present challenges. We continue to believe that spread sectors offer the best chance for success. If interest rate expectations diverge meaningfully from our forecasts, though, we will also opportunistically adjust our duration exposure.