- Quarterly Outlooks
- Q3 2016 Market Outlook
- Q2 2016 Market Outlook
- Q1 2016 Market Outlook
- Q4 2015 Market Outlook
A PGIM BUSINESS
3rd QUARTER OUTLOOK
Bond Market Outlook
While we could go on endlessly with the detailed causes and possible implications of the Brexit vote, we would be at risk of diving into the details while missing the big picture: globally, not just in the UK, there is not enough growth, voters are dissatisfied with its distribution, and policy makers are at a loss to fix the situation. The result: voter protest and political fragmentation that is causing strains within and across national boundaries. Intra-country, we’ve witnessed the rise of The Donald in the States, the emergence of nationalist/populist parties across Europe, and intensifying breakaway situations, i.e. the Catalans and Scots. Inter-country, a host of EU countries will undoubtedly muse about following the UK's lead (so far only the President of the Czech Republic has gone public that a referendum, in his view, should be held).
As we've pointed out in our previous outlooks (click here to view the Q2 2016 Outlook) and thought pieces focusing on the interest-rate outlook (click here to view The Totally Mad World of Low Rates), the feedback from the global economy remains the same: hold your disbelief in abeyance—despite all the stimulus, the world economy remains soft, suggesting NIRP and aggressive QE will be with us for some time. Against that backdrop, yields seem fated to remain quite low, and there will undoubtedly be bouts of volatility—perhaps especially so over the less liquid summer months. But over the long haul, investors that take a long-term view in their bond market positioning should continue to reap the benefits.
U.S. and European Corporate Bonds
We currently favor issuers in the auto, chemical, health insurance, paper, and select pharmaceutical industries. We remain focused on U.S.-centric issuers over multinationals or exporters that are vulnerable to a strong U.S. dollar. We also favor financials, primarily money center banks, given their generous spread levels and relative immunity to the event risk that is weighing on the industrial sector. We continue to look for select opportunities in the energy and metals/mining sectors. We continue to overweight lower-quality issues in shorter maturities and favor taxable revenue municipal bonds given their low credit migration risk, although this sector has generally low liquidity.
In Europe, our strategy remains broadly unchanged. We are looking for opportunities to invest in issuers we believe are oversold, as well as in new issues with attractive concessions. We are focusing on reverse yankee issues that are priced at significant discounts to where they trade in U.S. dollars and have spread levels that more than compensate for the lack of name recognition. We remain underweight European financials and prefer Northern European issuers 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 continued to hold an overweight in euro spread risk but within this bucket we are now overweight reverse yankee issuers. Our decision to reduce direct European exposure is due to the fact that many credits have experienced significant spread tightening following the ECB’s corporate bond buying announcement. Within the financial sector we remain overweight U.S. money center banks and underweight European banks. We remain focused on BBB-rated shorter maturities 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.
Global Leveraged Finance
Considering the extreme outperformance of CCC issues in Q2 and our revised outlook for slower global growth amid geopolitical risks and rising populist sentiment, we feel the fundamentals are less supportive of CCCs going forward. In addition, more dovish central banks means that market technicals will likely become even more favorable, which we believe will benefit the BB portion of the market in this low-rate environment. Therefore, at the margin, we are shifting our preference to BBs from CCC issues. Furthermore, despite 2016’s recovery in crude oil prices, we’re maintaining our underweight to the energy sector.
Looking forward in Europe, as risk appetites return, we expect the BBs to outperform at the outset with the lower-quality components eventually following suit.
Emerging Markets Debt
We continue to believe that in a world of low G3 interest rates, the mean-reverting aspect of EM will continue to dominate. This means that generalized market selloffs related to Brexit-type scenarios or Fed concerns are likely opportunities to capitalize on our judgment to time the purchases. With respect to individual countries, we will continue to lookout for potential changes in political or economic policies, which could affect fundamentals and investor sentiment. Official creditor support for countries, such as Sri Lanka (approved) and Mongolia (anticipated), could be harbingers of such a change, as could a potential change of Venezuela’s leadership.
Looking ahead, despite the solid outperformance in Q2, demand for tax-exempts should continue to provide a supportive environment, especially in the context of the global rate environment. Supply is expected to remain manageable, with any supply-driven cheapening representing an attractive buying opportunity. The problematic credits that have dominated the municipal market headlines in recent years have not been resolved. Political gridlock will continue to weigh on Illinois and credits reliant on state funding, thus further rating downgrades cannot be ruled out. We continue to believe that these credit stories, regardless of the outcomes, do not pose a systemic risk to the broader municipal market. We expect taxable municipals to perform in line with corporate bonds, with the potential for outperformance should corporate M&A activity persist.
As the quarter concluded, we continued to see value in a swap spread widener in the U.S. The inverted swap spreads and positive carry profile appears out of line amid the global backdrop. We also favor U.S. curve flatteners amid relatively high term premia that is likely to be reduced. Conversely, the term premia in the JGB market appears too low, and we consequently favor steepeners in the 20-year versus 30-year portion of the curve.
We hold a more positive near-term view on MBS at current spread levels. We have continued to tactically trade Freddie Macs, reduced TBAs versus specified pools, and are focused on lower coupon 15-year issues. Longer-term, we look for MBS spread performance to be driven by the magnitude and duration of the Fed’s mortgage reinvestment program.
We remain very positive on top-of-the-capital structure bonds. These bonds offer positive fundamental returns across a wide range of scenarios. Negative yields in Japan and Europe could tighten AAA CMBS and CLO spreads as investors seek more yield on high quality bonds. We remain positive on GSE credit risk mezzanine cashflows but remain negative on CMBS and CLO mezzanine tranches.
Please see Important Disclosures.