- Quarterly Outlooks
- Q4 2017 Market Outlook
- Q3 2017 Market Outlook
- Q2 2017 Market Outlook
- Q1 2017 Market Outlook
PGIM FIXED INCOME |
4th QUARTER OUTLOOK October 2017
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Global Macroeconomic Outlook
The global economy is firing on essentially all cylinders. While overall growth rates remain somewhat below those recorded before the financial crisis, the expansion has become increasingly balanced across regions, with the United States, the euro area, Japan, and China all growing in tandem at above-potential rates, as seen in the following chart. Although the ongoing recovery has been characterized as “lackluster” and “the new mediocre,” perhaps these very features will allow it to live longer. The more restrained pace of growth through this cycle, while disappointing when taken by itself, may have limited the scope for imbalances to emerge.
Bond Market Outlook
While it's true that the monetary policy backdrop is becoming a bit less accommodative, we believe that the back up in rates since the middle of 2016 has probably more than compensated for modest increases to the Fed funds rate and major central banks’ general shift from expanding their balance sheets to stabilizing or contracting them. All said, the cautious approach taken by the world’s central banks to remove accommodation, combined with a lack of the financial excesses often seen at the end of an economic cycle, suggest a positive environment for both government bonds as well as spread products. As for currencies, the dollar bull market of 2011 to 2016 has given way to a volatile, but weaker dollar on balance. While there is the potential for a near- to intermediate-term rise in the dollar should a tax package encourage repatriation of foreign profits, longer term, however, with the Fed presumably past its point of maximum rate-hike velocity, the dollar is likely to continue to underperform, with relative value continuing to favor a range of emerging market and developed country currencies. No doubt, spreads are tighter and yields lower than they've been at various points in time. And the markets are likely to continue to be intermittently buffeted by the flow of policy, economic, and geopolitical news. But in the end, it continues to look like this bull market in bonds and credit has a ways to go, with moderate growth and inflation keeping long-term rates low and range bound and a search for yield that is likely to drive outperformance by spread products.
Global Rates
While developed market monetary policies generally appear to be on a tightening trajectory, market reactions to various pronouncements may come in fits and starts. The resulting idiosyncratic mispricings that occur will continue to mean revert, leading to numerous tactical opportunities.
Agency MBS
Looking ahead, several positive factors may affect the market in Q4 and beyond. The base of underweight investors remains and could provide a backstop for the sector should spreads widen. Although overseas buyers appear to be waiting for higher yields, banks and REITs may continue buying with the 10-year Treasury yield in a trading range of about 2.15-2.30%. In addition, prepayment speeds should also stay contained unless primary mortgage rates decline at least 0.25-0.375 percentage points from their current levels. Some substantial negative factors will be in play as well. First, the pending tapering of the Fed’s MBS reinvestments (an initial $4 billion monthly roll-off to increase quarterly at $4 billion increments over 12 months until reaching $20 billion per month) is set to reduce the role of the market’s largest non-economic buyer. Even when excluding the effects of the Fed’s withdrawal from the market, which is slated to start on October 13th as the New York Federal Reserve already announced its MBS purchases through October 12th, net supply is expected to increase in 2018, and any increase in implied volatility would tighten option-adjusted spreads from their current levels. We remain underweight MBS vs. other high-quality spread sectors. We anticipate the Fed’s balance sheet normalization process will ultimately widen spreads by the second quarter of 2018.
Structured Products
We remain positive on top-of-the-capital structure structured products, especially AAA CLOs and AAA CMBS. While we remain positive on the fundamentals of GSE credit risk mezzanine cashflows, we are cautious at current spread levels. We are negative on CMBS mezzanine tranches and continue to look at financing trades rather than exposure to the underlying assets.
U.S. and European Corporate Bonds
We are overweighing better-quality financials and electric utilities over industrials that may be subject to event risk and “late cycle” risks. Financials are relatively immune to event risk and should remain subject to higher capital requirements even if other post-financial crisis regulations are relaxed by a pro-growth administration in the U.S. Within industrials, the chemical, health insurance, paper, and pharmaceutical (selective) sectors appear attractive. We are also selectively adding European banks due to stabilizing fundamentals and wide spread levels. We remain overweight lower-quality bonds in shorter maturities as well as BBB-rated, long-maturity corporates due to a steep spread curve and potential uptick in demand from pension plans. Within euro-area industrials, we continue to favor regulated companies with solid balance sheets, such as electrical grid and airport operators, although finding attractive opportunities has been increasingly difficult. 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 hold a risk overweight that is roughly balanced across currencies. We do, however, hold a mild preference for U.S. companies given ECB tapering risk and tight European spreads. We are reducing exposure to companies with potential tail risk, such as Italian corporates that trade through the sovereign and are prime candidates for spread widening. Within the financial sector, we remain overweight U.S. money center banks and insurers. We are 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.
Global Leveraged Finance
While improving fundamentals and favorable technicals—given limited net supply and strong offshore institutional demand—leave us with a constructive view on U.S. high yield in the near term, we are not as bullish in the long term given tight spreads and elevated tail risks. That said, we continue to see relative value opportunities in selected higher yielding CCC-like issuers, however if CCC spreads continue to tighten from current levels, this view could change. We remain cautious on commodities and auto-related names, while maintain an overweight to electric power companies and U.S. consumer-related credits. Overall, we remain constructive on European high yield with expectations that spreads may continue to tighten modestly from current levels on improving fundamentals, reduced political risk, and a fair macro environment. The lack of material recession risk in Europe in the near term, as well as expectations that the ECB will remain accommodative for now, further supports our outlook. We remain overweight B-rated issues amid expectations for spread compression—driven by continued ECB support—in the higher-rated buckets that could filter down the risk spectrum. We will also look to tactically increase our BB allocation through the primary market. Additionally, we continue to seek out attractive relative value opportunities between sterling-denominated and euro-denominated bonds.
Emerging Market Debt
Within EM hard currency assets, there is still room for spreads to tighten in sovereigns, quasi-sovereigns, and corporates. For example, value remains in select quasi-sovereigns that trade at attractive spreads relative to the sovereign, such as Pemex, Petrobras, and Eskom. These issuers trade at levels that range from +130-170 bps relative to similar-maturity sovereign bonds. Likewise, a number of EM countries continue to reprice in anticipation of rating upgrades, including Argentina, Ukraine, and Russia. EM corporates also present opportunities for asset managers capable of conducting thorough credit analysis. The relatively healthy fundamental backdrop in EM—supported by rebounding growth, inflows, and attractive valuations—will likely help assets end the year with strong returns. Selloffs are likely to be buying opportunities in lower-rated, hard currency assets, EMFX, and local bonds.
Municipal Bonds
While technicals have the potential to soften early in Q4, we would expect the environment to become more supportive by year end as we approach the January reinvestment period. We, therefore, view any weakness as a buying opportunity. A range bound interest-rate environment should continue to be supportive of mutual fund flows. Tax-reform discussions will be closely monitored; however, preliminary proposals indicate that municipal bond tax-exemption will not be marginalized. We also continue to believe that the events unfolding in Puerto Rico will not impact the broader municipal market. Looking ahead, we expect taxable municipals to perform in line with corporate bonds with the potential for outperformance should corporate M&A activity pick up.
Please see Important Disclosures.