The market outlook feels more complex than it did a month ago. The economic backdrop remains very positive, but growth surprises have moderated and become more varied across economies, with the strongest growth trajectory still being in the U.S. The path to higher growth is undoubtedly one that will be bumpier. We still think the most likely path is for interest rates to go higher, but not equally across markets. The risks are skewed to the market underpricing Federal Reserve rate hikes; underappreciating potential Bank of England tightening, while the European Central Bank could signal this month that it is in no hurry to normalize policy. Valuations also come into play, with U.S. Treasuries still demandingly priced, while German bunds are anchored by very low policy rates and quantitative easing induced scarcity.
The increase in risky asset volatility is also a challenge for spread product. The positive economic outlook continues to provide fundamental support, but higher volatility undermines risk-adjusted return expectations when valuations already look demanding versus history. Our bias is still to think that positive growth fundamentals will prevail, but the ride is likely to be bumpier than it was over the last year. Sharpe ratios will likely deteriorate.