- Quarterly Outlooks
- Q4 2016 Market Outlook
- Q3 2016 Market Outlook
- Q2 2016 Market Outlook
- Q1 2016 Market Outlook
A PGIM BUSINESS
4th QUARTER OUTLOOK
Bond Market Outlook
We remain positive on the bond market, especially the higher-yielding sectors. Although yields and spreads are a bit lower, the sluggish economic backdrop and hyper-accommodative central bank motifs continue to point towards “low and lower” as the operative theme for government bond yields and spreads on non-government securities. As we've seen over the past quarters, however, a world of slow growth and low inflation and interest rates—combined with high leverage—leads to intermittent market volatility. Whether it is caused by the U.S. election, the Fed, the new BoJ policy, the Italian referendum in December, a shift in the trajectory of energy prices, deterioration in China's economy, or something still unforeseen, we can't be sure. But in the end, investors will resume their search for yield, generally allowing bonds, especially the higher-yielding sectors, to continue outperforming cash. Meanwhile, as Fed rate-hike expectations continue to moderate, the dollar appears likely to underperform.
Going forward, we expect a continuation of exceptionally loose monetary conditions in developed markets over the near and medium term. Global economic conditions are unlikely to be robust enough to give policy makers sufficient comfort to embark on a significant tightening cycle. However, it is unlikely that monetary policy will prove any more effective in boosting growth than it has been heretofore. The calls for additional fiscal stimulus are therefore likely to get louder. However, Abenomics as well as China’s combined fiscal-monetary stimulus offer a cautionary tale about the effectiveness of stimulus. Moreover, with public debt sustainability already stretched in some countries, additional fiscal stimulus runs the risk of undermining investor confidence. To some extent, easy monetary conditions may have allowed policy makers to avoid tough structural measures—an issue the ECB has consistently raised. Be that as it may, the political environment for such reforms is unlikely to become easier and political risks, especially from upcoming elections, are considerable. However, without reforms, low and further reductions in growth rates could be the result.
|Upcoming Political Events of Note|
|U.S.||Elections for President, House of Representatives, Senate||November 8, 2016||Republican nominee Donald Trump has positioned himself as an alternative to the Republican and Democratic political establishment.|
|Italy||Economic Reform Referendum||December 4, 2016||A vote to reject PM Renzi's economic and constitutional reforms could force early elections and open a window for the anti-EU Five-Star Movement.|
|Austria||Presidential Election||December 4, 2016||The Freedom Party, which is considered on the far-right of the political spectrum, has been polling well prior to the re-vote.|
|Germany||Merkel's Campaign Decision||December 1, 2016||After losing ground to the AfD in local elections, Chancellor Angela Merkel will decide about running for another term before federal elections in the fall of 2017.|
|Netherlands||Second Chamber Elections||March 1, 2017||The Party for Freedom (PVV) is considered far on the right of the political spectrum and has been polling well ahead of legislative elections.|
|France||Presidential and National Assembly Elections||April and June of 2017||Marine Le Pen, member of what is considered to be the far-right National Front party, is in the running. The party will also be a factor in parliamentary elections.|
Source of voting dates: ElectionGuide.org
U.S. and European Corporate Bonds
We are overweight BBB-rated long-maturity corporates due to the steep spread curve and issuers’ efforts to maintain the investment-grade status. Likewise, we are underweight A and higher-rated industrials in light of increased event risk and tight spread levels. We still favor U.S. money center preferreds given their attractive yields, higher capital ratio requirements, and relative immunity to event risk. We are less favorable on life insurers as low rates continue to stress their income statements. We continue to look for opportunities in the energy and metals/mining sectors and favor taxable revenue municipal bonds given their low propensity for credit deterioration and event-driven risks.
Given the sharp compression in Euro spreads so far this year, we believe Euro industrials are fairly priced and are likely to remain near current levels given central bank buying. We are also keeping a close eye on front-end spreads, which may come under pressure as negative rates push spreads wider and credit curves flatten. In this environment, we have reduced our overweight in euro spread risk and hold a more constructive view on non-euro issuers. We remain focused on reverse yankee issues that are priced at discounts to where they trade in U.S. dollars and have spread levels that compensate for the lack of name recognition. We remain underweight European financials and prefer Northern European issues over peripheral country debt. Within euro-area industrials, we are focusing on regulated companies with solid balance sheets, such as electrical grids and airport operators. We find value in certain corporate hybrids from stable, well-rated utility issuers and are avoiding hybrids issued to uplift ratings, including those in the telecom industry.
In global corporate portfolios, we reduced our overweight in euro spread risk in favor of other opportunities, including U.S. spread product and reverse yankee issuers. Within the financial sector we continue to hold an overweight to U.S. money center banks and an underweight in euro-zone banks. As in U.S. portfolios, we remain focused on BBB-rated issuers and U.S. taxable revenue municipals. We continue to take advantage of price dislocations and yield discrepancies between U.S. and euro bonds of the same and/or similar issuers.
Overall, we believe U.S. and non-euro-zone spreads remain attractive and have room to tighten, while euro spreads appear fairly priced. Key risks in the short term include uncertainty over the U.S. election and Fed policy. Longer term, risks include increased leverage in China and uncertainty surrounding the long-term effects of Brexit across the UK and Europe.
Global Leveraged Finance
Despite another quarter of solid performance in high yield energy, we maintain our underweight as we believe that the market is undervaluing the downside risks associated with high yield commodity credits. We prefer the longer-duration, BB-rated, non-commodity portion of the market, as it offers more upside given the attractive spread and price levels. While U.S. high yield appears to be fairly valued to slightly cheap, and the ex-commodity default rate should remain manageable, our outlook for spreads is muted with the expectation that they end Q4 similar to current levels, with slight tightening in 2017.
We have a constructive view on the European high yield bond and loan markets given low default expectations and strong technicals supported by ongoing asset purchase programs from the ECB and BOE. We will continue to maintain our overweight to B-rated credits and will seek to increase our allocation to BBs, while also pursing secular growth stories as opposed to cyclical ones.
Emerging Markets Debt
Although most EM currencies have appreciated year-to-date, real effective exchange rates remain cheap, particularly in LatAm, EMEA, and parts of Asia. Improving EM growth, significant adjustment observed in many countries’ external balances, attractive nominal and real yields, and status quo in developed markets with accommodative monetary policies and low yields could drive further positive performance in EM currencies over the medium term.
We have a positive view on EM as a whole, with improving fundamentals supporting hard currency spread compression and EMFX. In countries where economic conditions have stabilized, rate cuts are expected, supporting an attractive view on local bonds.
Increased volatility is expected as technicals weaken early in Q4 before turning positive towards year end. While positive fund flows into the asset class have created a supportive environment over the past year, the back-up in rates in Q4 could negatively impact this trend. Given the attractive taxable-equivalent yields, any weakness in tax-exempts should provide attractive buying opportunities. We anticipate an increased focus on unfunded pension obligations as investment returns fall well below expected returns. The outcome of the U.S. Presidential election could heighten the risk of tax reform. We expect taxable municipals to perform in line with corporate bonds, with the potential to outperform if corporate M&A activity persists.
Once JGB yields stabilize, we believe investments in the 20-year sector offer the best carry and roll down opportunities. We remain constructive on extending duration in the U.S. given the curve’s elevated risk premium and expect Treasuries to post positive returns in the Fourth Quarter. Swap spread wideners (versus overnight indexed swap rather than LIBOR) remain one of our favorite positions given its attractive carry opportunities. While Bunds remain range bound in the current quarter, the extension will likely keep downward pressure on yields given the general lack of supply and the relative steepness of the curve. We believe investors’ reach for yield will continue to exert downward pressure on yields in the 10- to 15-year segment of the Bund curve. Yields on UK Gilts appear rich at this point, and we believe Gilts will generally underperform the other G4 rate markets.
While mortgages may continue to benefit from the current low volatility environment, we will remain underweight in favor of other spread sectors given that volatility could actually increase in Q4 given the potential for a Fed rate hike and higher net supply despite elevated mortgage rates and the fall/winter seasonal. We are tactically rotating Freddie Mac and GNMA2 positions versus Fannie Maes. We prefer 30-year coupon exposure versus intermediate maturities and have reduced TBAs versus specified pools.
We remain very positive on top-of-the-capital structure bonds. Negative yields in Japan and Europe could tighten AAA CMBS and CLO spreads as investors seek more yield in high-quality bonds. We remain positive on GSE credit risk mezzanine cashflows, while we are negative on CMBS and CLO mezzanine tranches.
Please see Important Disclosures.