With key French elections behind us, term premium in European risk-free rates, which had been excessively low, should rise barring any other global shocks. We reduced our duration underweight going into the second quarter but, as political risks faded, we have since begun to shorten duration once again. In the U.S., leading indicators and surveys have been strong and, as such, we expect second-quarter growth to accelerate from a weak first quarter. If this materializes, we believe the Fed would be on track to hike twice more this year, likely starting in June.
In the U.S., we believe the proposed tax plan and regulatory changes have the right ingredients to lift growth, though it is very likely the time frame for tax reform will be slow. If volatility increases due to uncertainties in the fiscal debate, we see it as an opportunity to position for upside surprises later in the year and into 2018.
We think that steeper developed market yield curves warrant the shortening of duration exposures and an overweight to higher-yielding currencies/countries that have attractive characteristics. For EM growth, the benefit of higher U.S. growth is likely to be offset partly by the risks of a potentially more protectionist U.S. trade agenda. Fairly closed economies enjoying limited current account deficits, such as India, are likely to remain rather uncorrelated to global financial conditions and should continue to perform well. The Mexican peso will likely remain the main shock absorber to U.S. trade protectionism shocks, though we believe a renegotiation of NAFTA is the most likely scenario, and Mexico is otherwise on an improving trend.
In U.S. credit markets, we anticipate a continued grind tighter in spreads toward cycle lows. In investment grade, we remain constructive on financials with a bias toward subordinated debt, marginally constructive on BBB non-financials, and we remain less constructive on A-rated non-financial risk. We continue to seek opportunities in the high-yield and convertible bond markets, which are sectors that tend to perform better in the latter stages of the business cycle.
We continue to underweight agency MBS due to their historically tight nominal and option-adjusted spreads as well as the increasing risk that the Fed may decide to discontinue the reinvestment of MBS paydowns.
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