After discounting their probability for much of the year, markets woke up in October to the prospect of a steeper U.S. Federal Reserve (Fed) rate path and the passage of tax reform. With continued growth momentum around the world and possible U.S. tax cuts, we see a quite benign environment for risk assets. Unless inflation picks up faster than expected, we believe many fixed income securities could and will out-carry the current projected pace of rate rises. We also believe security selection will be important, seeking to avoid those bonds most sensitive to rising rates or those with less than sound fundamentals and focusing on those with improving stories.
DEVELOPED MARKET (DM) RATE/FOREIGN CURRENCY (FX): Better economic performance and tax reform prospects led markets to price in higher odds of Fed hikes while a dovish European Central Bank (ECB) anchored European yields, leading the periphery spreads to tighten. Continuing from last month, most major currencies declined versus the dollar.
Though U.S. inflation could stay muted, we believe the Fed will continue to hike rates as long as growth dynamics remain solid. Market expectations may be too relaxed about the Fed’s willingness to keep hiking while inflation remains below target. It will be interesting to see how the new Fed chairperson calibrates policy. A more assertive Fed, better growth and possible tax reform should pressure long-term yields higher. In terms of currencies, we believe risk-reward now tilts toward a more neutral to positive stance on the U.S. dollar. We believe the dollar has fallen further than justified, by relative rate or growth differentials, especially versus the Swiss franc.
EMERGING MARKET (EM) RATE/FX: EM performance was mixed in October. Despite rising U.S. Treasury yields, the external and corporate debt indices generated positive returns, while domestic debt registered its worse monthly performance of 2017. In China, the 19th Party Congress concluded with an emphasis on the quality rather than speed of growth. Adjustments to growth are to be achieved via advanced manufacturing, rural/ financial/state-owned-enterprises (SOE) reforms and the Belt and Road Initiative.
EM fixed income assets have performed well year-to-date, and investors are being selective on the basis of fundamentals and valuations. Going into year’s end, positioning and political risks (e.g., North Korea, North American Free Trade Agreement (NAFTA), U.S. tax reform) could have a greater impact on performance. In addition, the November Organization of the Petroleum Exporting Countries (OPEC) meeting could stoke volatility. We are more optimistic that selective EM currencies will eventually begin to perform again.
CREDIT: Credit spreads in both the U.S. dollar and the euro hit new post-crisis tights in October, with lower-rated bonds performing the best over the month. There was some increased variability within industries as sectors like energy and consumer cyclicals outperformed while consumer non-cyclicals underperformed due to some weakness in pharmaceuticals. At current valuations, we do not foresee a drastic move tighter in spreads; however, we expect spreads to grind tighter into year’s end if the current backdrop persists. We remain long and continue to favor financials over nonfinancials. The high-yield and convertible markets continue to present attractive opportunities, and we remain positive on both sectors, although expected returns have fallen.
SECURITIZED: Agency mortgage-backed securities (MBS) had a flat performance in October, while credit-sensitive securitized assets continued to outperform. Commercial mortgage-backed securities (CMBS) spreads generally tightened in October, but specific CMBS performance remains closely tied to collateral types. Some uncertainty remains over the impacts from hurricanes Harvey, Irma and Maria on Houston, Florida and Puerto Rico properties. European MBS spreads continued to tighten in October and are now 30 to 100 basis points tighter in 2017. Carry remains king in securitized assets. The spread tightening has slowed in recent months and may be coming to an end, but even without further expected spread tightening, we expect that credit-oriented securitized assets should continue to outperform more rate-sensitive assets given the current credit and rates environments.