Constructive but Cautious for 2018Dec 1, 2017

2018 OUTLOOK: “Against a backdrop of a generally healthy global economy, one could argue that many fixed income sectors looked fully valued as of late 2017. However, we believe value can still be found in an approach that moves past headlines and focuses on discrimination and underlying fundamentals.”

Global Growth Is Healthy but Many Believe Fixed Income Valuations Look Full

Our view of the coming year is informed by the backdrop of a global economy that has been performing quite well, particularly in the United States. The consumer-led US economy has continued to show strength aided by continuing improvement in employment and rising household wealth. Moreover, consumer sentiment also has indicated optimism over economic prospects. Measures of corporate wellbeing add to this picture, as revenue and profitability growth suggest a generally steady outlook. And while we continue to carefully observe the potential for political developments in Europe to disrupt economic growth, there has been an uptick in economic activity in the region that bodes well for 2018. Overall, we are reasonably optimistic that this backdrop could remain intact over the coming year. At the same time, we cannot ignore the tremendous amount of liquidity that has been injected into the global financial system during the last decade, nor the view of many market participants that fixed income markets appeared fully valued on a number of traditional metrics as of late 2017.

Inflation, Monetary Policy and an Aging Business Cycle Bear Watching

With this framework as a starting point, there are a number of key issues that we believe will prove important in determining investment outcomes in 2018. Perhaps most important among these is inflation, given its status as a driver of US Federal Reserve (Fed) policy, interest rates and other key variables. While persistently high core inflation could spur rates to climb faster than anticipated, we think the more likely scenario is a modest uptick in inflation, particularly over the coming year. We believe inflation has been persistently low as a consequence of several factors, primarily globalization and technology. Globalization has made a vast pool of labor available that has helped keep a lid on wage growth globally. At the same time, improvements in technology have resulted in the automation of various traditionally manual tasks. While the pace of globalization may have slowed recently, technology has not. If anything, further advancements in artificial intelligence have made even some non-repetitive tasks and occupations additional candidates for disruption. We do not see these impacts easing materially over the near term, so while core inflation may tick up, we think it unlikely to increase in dramatic fashion within this timeframe.

Along with inflation, the Fed’s efforts to reduce its balance sheet (even as it continues to hike short-term interest rates) also bear close watching. It is the first time anything of this scale has been attempted, so care must be taken by policymakers not to unintentionally trigger an adverse reaction. While the Fed has just started this normalization process, the European Central Bank has announced that it will continue buying assets for a longer period than originally planned (albeit at a reduced pace) while the Bank of Japan has continued its quantitative easing program unabated. Nonetheless, we think the Fed and other central banks have done a reasonably good job communicating their intentions to market participants, although we recognize they are still in the early stages of what promises to be a long campaign. For these reasons, we believe that while interest rates are biased to rise, they are likely to do so at a generally measured pace over an extended period.

We also remain cognizant of the age of the current economic cycle. This cycle is notable in the lack of excesses that normally accompany a late stage cycle. For instance, we would expect somewhat higher levels of US inflation with unemployment at current levels, or somewhat higher levels of corporate leverage that could be interpreted as the first indications of excess. Instead, while we continue to believe that the cycle will end eventually, we have found little evidence so far that is suggestive of broad-based excess.

A Time for Discrimination

Within specific sectors, corporate credit continues to be an area bolstered by reasonable levels of growth and generally healthy levels of cash flow. Though credit spreads as of late 2017 were skewed toward the tighter side of their historical averages, we would also note that these conditions could persist for some time. In past cycles, conditions permitting, spreads have managed to maintain such levels and have even narrowed further. As a result, we believe reasonable risk-adjusted opportunities remain in all corporate sectors, including investment-grade and high-yield bonds as well as floating rate bank loans. Historically, we would be seeing some reflection of increasing credit risk this late in the economic cycle in metrics like corporate leverage levels, debt service coverage and credit quality. By and large, however, while we have seen a slight pickup in some of these metrics, the indicators we look at show little to incite concern. Nonetheless, given the age of the current cycle, credit quality remains an issue we will monitor closely and could present a headwind were conditions to meaningfully deteriorate.

The housing-related sectors are another area where economic fundamentals have remained generally supportive. They offer a broad set of opportunities from the perspective of sectors, such as commercial and residential, as well as credit quality. Diversity also extends to each sector’s economic cycle, with certain ones more notably mature than others. The range of available investment opportunities provides a broad variety of potentially attractive assets, in our view.

However, even a buoyant economy has winners and losers, and not all credits within these asset classes will benefit equally. As a result, we believe it will be important to differentiate between sectors exposed to some sort of fundamental disruption, such as many retail-related names, versus those that may be undergoing more cyclically dependent shifts, such as many commodity-related credits. The former is an area that we would strive to avoid absent more clarity, while the latter may or may not represent an opportunity. When a sector such as retail is disrupted, the knock-on effects could extend past sector issuers to service providers, such as certain segments of the commercial mortgage-backed securities market.

The principle of discrimination extends to other sectors where we think value can still be found, such as US municipal bonds and emerging-market debt. Within emerging markets, we note that problem areas like Venezuela remain localized and generally idiosyncratic while garnering the lion’s share of headlines. Likewise, state governments and other municipal bond market issuers in the United States have done a generally solid job of managing their liabilities. While there are always a number of issuers that garner the bulk of headlines for their problems, they represent a very small percentage of overall credits. In short, we believe moving past headlines and focusing on the underlying fundamentals is a sound approach for identifying value in the current bond market climate.

Lessons Learned Since the Global Financial Crisis

Ten years have passed since the global financial crisis began, and it seems appropriate to mention a few thoughts. As an investment team, our emphasis has always been on identifying where excesses or bubbles are likely to arise and how they might manifest themselves as problems in the global financial system. In retrospect, we think we did a good job of pinpointing these issues in the run-up to the crisis and managed to steer clear of the major trouble spots. As we cast a glance to the coming year, we continue to be concerned with bubbles and excesses—no more so than within certain areas of the sovereign debt markets. Of all the distortions or bubble-like conditions caused directly or indirectly by unconventional monetary policy, sovereign bond markets exhibiting negative interest rates would certainly be close to the top of our list.

Global Central Banks Have Injected an Unprecedented Amount of Liquidity into Financial Markets

Global Liquidity: Total Assets of Major Central Banks
August 2005–August 2017


Bank of Japan

European Central Bank

Principle's Bank of China

Source: Bloomberg. Dotted line shows approximate rate of increase prior to recession and approximate rate of increase post-recession. For illustrative and discussion purposes only.

Globalization and Technology Have Kept a Lid on US Inflation

Inflation – Secular Downtrend, Core Personal Consumption Expenditures (PCE)
January 1980–September 2017


Core PCE

Cycle Average

Source: FactSet, US Bureau of Economic Analysis. For illustrative and discussion purposes only. Important data provider notices and terms available at

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