With economic fundamentals and monetary policy stable, political noise has become the main source of market volatility. In the case of the debt ceiling and North Korea, we think political noise could continue to generate volatility, but they will remain just that – noise. At the same time, the environment should continue to support carry - fundamentals are improving yet there’s little pressure for monetary policy to tighten rapidly due to undershooting of inflation. Nevertheless, given strong price appreciation for the past eight months, we think taking some profits on risky assets across the board is reasonable.
Developed Market (DM) Rate/Foreign Currency (FX): Geopolitical noise and risk-off sentiments led risk-free yields to decrease across developed markets. U.S. Treasury 10-year yields fell 18 basis points as did German 10-year yields, while European periphery spreads widened. The dollar continued to weaken. Euro-linked currencies, such as Swedish Krona and Norwegian Krone, were the best performers amongst developed market currencies.
We believe higher U.S. Treasury yields will depend on higher U.S. inflation. Until then, they are likely to remain in a range and the yield curve will continue to flatten. We do expect the Fed to announce its balance sheet reduction in September and hike rates in December, although the probability of the latter has been steadily decreasing. In currencies, we think the dollar’s travails will not abate as long as dovish U.S. rate expectations persist and the non-U.S. global economy performs well.
Emerging Market (EM) Rate/FX: Emerging Markets fixed income asset returns were positive in the month with higher-yielding assets outperforming investment grade credits, currencies strengthening versus the U.S. dollar, and sovereigns outperforming corporates within dollar-denominated debt. U.S. President Donald Trump’s political rally rhetoric created headwinds for Mexican assets as he reiterated threats to withdraw the U.S. from NAFTA. The U.S. administration announced additional sanctions on the Venezuelan government. However, trading in most of the existing outstanding debt is still permitted
We remain optimistic about the prospects for EM fixed income in 2017 as country fundamentals and the macro environment remain supportive, with those countries that rely most on global trade potentially challenged. The various factors both pushing and pulling investors into EM fixed income remain in place: developed market yields remain very low, economic data in EM appears to be recovering, EM real rate differentials with the U.S. and European yields are at multi-year highs and Fed rate hikes are likely to remain gradual
Credit: In both European and U.S. investment grade credit markets, spreads widened and was broad-based, impacting all rating categories and sectors, a phenomenon we have not seen in some time. Across markets, higher-beta credits, and lower-rated issues underperformed.
Our overall stance on credit remains largely unchanged, as spreads have not moved drastically enough to warrant a re-evaluation of risk. We remain long risk and carry and have continued to moderately de-risk portfolios to reflect tighter valuations and more balanced upside/downside. We anticipate, however, that if equities continue to trade weaker, we may see a re-allocation into convertible bonds in the coming months, as convertibles have historically provided comparable returns to stocks with far less volatility.
Securitized: Agency MBS continued to perform in-line with expectations, while credit-related securitized assets maintained their trend outperformance. Retail shopping centers remain a major area of concern. Mall vacancy rates inched up 0.2% to 8.1% during the second quarter of 2017, and the leasing of vacant retail space fell to the lowest rate since 2011 during the quarter.
After the significant tightening of credit spreads over the past year, we are becoming more cautious on credit-sensitive securitized assets. We remain positive on European securitized credit opportunities. Home prices have been steadily improving across Europe over the last couple years, buoyed by historically low mortgage rates and the improving economies. The buoyancy of the global economy keeps us long.