Global Chief Investment Strategist
December 19, 2016
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Against a backdrop of Fed tightening, we see various possibilities for investors within fixed income.
Near this time a year ago, investors were getting quite anxious following the Federal Reserve’s first tightening step of the post-crisis period. A plunge in oil and EM currencies - most notably China’s – followed, and dragged global markets down in their largest correction since 2011. While financial markets had rallied on the day the Fed took action, by the time of our January Outlook meetings, it was common to hear investors ask “tell us why shouldn’t we sell everything?”
The actual results of 2016 – with global all-asset market returns near +7% measured in USD - shows why. Extrapolating short-term market performance into longer periods– even as short as a year – can greatly misguide. In this spirit, as Citi Private Bank’s Global Investment Committee (GIC) met this week, it was our task to set aside the recent and even prospective short-term performance of financial markets, and consider their risk and reward potential over the coming 12-18 months.
At this week’s meeting, the GIC maintained near full allocations to global stock and bond markets with large regional divergences and preferences for particular instruments. Overall, though, we were not entirely comfortable with the guesswork now driving markets over expected US policies. We chose not to “chase” equity markets that had performed well with higher allocations. Meanwhile, poor-performing bond markets now offered higher prospective returns as yields have risen. Yet the outlook had changed enough that we chose to make adjustments within particular fixed-income asset holdings rather than raise overall exposures.
Considering Currency Risk in Global Allocations
The dramatic fiscal easing now expected in the US seems somewhat akin to earlier, quantitative easing steps from the Federal Reserve in its market impact, in this case though, negative for bond markets, positive for growth-driven equities and the US dollar. As we discussed in our last bulletin (How Much US Growth Potential Is There and How Fast Can Trump Fill It?), how well the US economy adjusts to easing now, after seven years of solid employment growth, is an experiment that is to be tested. While there is some fiscal “relaxation” coming elsewhere, the rest of the world largely won’t get to enjoy easing policies close in scope to those likely in the US However, many trading partners could possibly benefit from US demand “spillovers” if such is not lost to trade friction.
A second set of experiments is likely on the regulatory front. Donald Trump’s cabinet picks look like the choices one would make to run the country with the interest of business and growth at the very forefront. The choice of business people rather than politicians for many key rolls reinforces notions of dramatic change in policy approach.
Assuming it goes ahead in ways previously proposed by both Congressional Republicans and the Trump Campaign, a U.S. corporate income tax rate cut to 20% from 35% could boost US firm’s profits by roughly 8% in the year following implementation. This is because effective tax rates have been close to 28%. Reflecting byzantine complexity, some US firms pay nothing, with others pay close to the statutory maximum. Overall though, the tax take for business is likely to be less, and incentivize growth, assuming Congress doesn’t find offsetting revenues from the corporate sector, which seems unlikely.
Notably, the post-election rally in the US means a substantial portion of an expected growth acceleration and tax rate plunge is getting quickly priced in (see figure 1). While we would expect more follow through on the realization of economic growth in the coming two years, neither the policies nor their impact on the rate of growth are certain yet.
As figures 2-3 show, the rise in risk assets of late has also tracked the Citi US economic surprise index on data that is still mostly pre-election, and entirely unaffected by actual fiscal policy changes. This index, which reflects positive and negative surprises to economist forecasts, has a upward seasonal bias at the turn of the year, as do markets.
The rise in the oil price means headline US inflation is likely to head towards 4% year/year during the first quarter 2017, as the anniversary of last year’s $30-per-barrel crude oil passes. This is certain to precede tax cuts, infrastructure spending or any other form of fiscal easing. The last time such an inflation spike happened in 2010, US employment simultaneously transitioned from decline to gain and non-energy inflation was far more muted then. This time, US and other consumers will have to absorb a hit (see figures 4-5). While we believe US consumer spending will, in fact, not falter very much, the late 1Q/early 2Q period seems likely to be one where market risks have risen more than the economy has been lifted.
Don’t Forget the Fed
Later winter/early Spring is also a time where European political election risks are acute. Notably, positive economic surprises in the Eurozone have recently been the strongest since the “easy comparisons” of 2010 (see figure 6).
The chance of a catastrophic breakup of the Eurozone next year is a low one in our view, and would take more than the election of a single anti-Euro leader in the region. However, the precedence for global markets to rally on populist election victories during a time of upward growth surprises may be masking the extent of political risk - and even mere fears of it - in markets.
In international equities markets, we see currency depreciation hampering potential returns measured in US dollars, with currency markets volatile looking forward. Our underweights in Eurozone and certain Asian equities are partly a function of currency risks.
Meanwhile, we discussed the Fed’s tightening step of last year at the outset. The petroleum sector is positioned quite differently from this time a year ago amid a two year-plunge in capital investment spending. China’s external vulnerabilities have also been reduced though a variety of controls, while its internal growth outlook has been stabilizing. Yet the Federal Reserve’s potentially more aggressive tightening path in 2017 represents a risk to world markets that should be considered alongside the fiscal optimism.
Gaining positive Fixed Income Gearing to Fed Tightening
Last month, the GIC shifted down duration in US bond holdings to neutral. While yield opportunities are higher now, we don’t feel comfortable as of yet to overweight long-duration bonds on the backup in yield. However, we saw an additional way to play offense with fixed income in a period when US short-term rates are rising. This was to switch some FI holdings to high yield, variable rate loans, as suitable and appropriate. These see rates adjust with movements in LIBOR/Fed funds, which we anticipate to be upward in the coming year.
As figure 7 shows, loans have reduced volatility relative to high yield bonds, which we continue to overweight. While lower in market liquidity and best implemented with a dedicated loan portfolio manager, they sit higher in capital structure than bonds of the same issuers. We see a 5%-6% USD return in this asset class next year, assuming another year of US economic growth and Fed tightening close to what is anticipated in markets. Defaults have historically been lower for loans than high yield bonds, with recovery rates higher.
For U.S. tax payers, we see a budding opportunity in municipal debt, if rates continue to rise into the new year. This is true at the margin even if US income tax rates fall. At a mere 3.5% yield, full-taxable U.S. high grade corporate debt (with median duration) represents a higher yield opportunity than most of the world’s bond market. However, given interest rate sensitivity, we see the lower-rated, variable loans (where suitable and appropriate) as worthy of increased allocation at the expense of high grade corporate bonds. As noted previously, we continue to see Latin America’s fixed income markets as the strongest opportunity in EM despite the surging US dollar’s challenge.