The US equity market has received a shot in the arm since Donald Trump’s election win, but the bond market has not reacted well. What areas of the US bond market should investors be focusing on or wary of under a Trump administration? We asked three US fixed income experts about their game plan for 2017.
Fund manager, MFS Meridian Funds – US Corporate Bond
Our 2017 outlook for the corporate bond market focuses on fundamentals, technicals and valuations.
Fundamentals continue to support corporate bonds. Heading into the election, the job market was stable and corporate cash flow generation was healthy. Since then, we have seen risk markets rally on expectations that Trump's policies will further stimulate the economy.
We aren't convinced that the stimulus proposals will significantly improve overall economic growth. We think cuts in personal income tax rates may have a muted impact on consumer spending, similar to the lackluster impact of falling gasoline prices in 2015, as consumers increased savings instead of spending.
Similarly, corporate tax cuts will likely put more money back into corporate coffers, but free cash flow hasn't been the issue.
Corporations have chosen to use their free cash flow to increase dividends or buy back stock, not invest in productive assets.
Finally, promised infrastructure spending may take years to come to fruition as we find that most projects are not ‘shovel-ready’.
There is some room for the technicals to improve. We continued to see large flows into US investment grade in 2016, with more than $6 billion in the fourth quarter, even as US interest rates were rising. The repatriation of foreign assets could help to improve the technical because companies would be able to use those dollars to tender for bonds or stocks, instead of needing to borrow.
This could improve the supply/demand dynamic in the market. Higher US interest rates will also increase demand for corporate bonds as pension funds look to rebalance their equity exposure. Additionally, US rates now look relatively more attractive to bond investors in Japan and Europe.
Valuations are relatively high. With spreads tight by historical measures, there is not a lot of value to be found.
The asset class remains a stable place to park assets but we are not expecting significant returns given valuations. We view corporate bonds as a relatively safe ballast to offset a portfolio's riskier equity allocation.
We think Trump's proposals are at best marginally positive for the investment grade corporate bond market in 2017 and for the foreseeable future.
Co-fund manager, Loomis Sayles High Income
We struggle with clarity when it comes to new administration in the US. The lack of clarity is playing out specifically in the details versus the direction, foreign policy versus US policy and in the timing of these changes.
I suspect many details will be forthcoming as the cabinet is approved and sworn in, while foreign policy may remain unpredictable, more than likely by design, for some time.
If we step back, what we find are some pretty clear policies developing. On the economic side, we can certainly expect more fiscal and defense spending, more jobs being created by US manufacturers, more protectionist policy, and less regulation and revenue from taxes.
In the short term, this should translate to more growth, more inflation, driven in part by tight labor markets. In turn, this should translate into more rate hikes and continued dollar strength.
This all sounds like a smooth transition, which seems to be what most market participants are focused on. These policies are expected to tack at least another year onto the recovery, promising to take it from quite lackluster to more normalized growth rates, albeit in a somewhat growth-constrained world.
The potential for more volatility in the political arena, both domestically and abroad, is where we need to watch developments most closely. We know it is out there, but we cannot simply put it in an economic model to predict interest rates, inflation and the price of the dollar.
For clues to the important drivers of growth and inflation from a short-term perspective we have to watch the politics.
Fund manager, JPM US Bond
Since 2010, for all but one quarter, our base case has been that the world’s economies were mired in sub-trend growth and inflation. However, post-US presidential election, we revised our probability of above-trend growth much higher. The outlook is supported by meaningful fiscal stimulus, tax and regulatory reform; strong growth in two-thirds of the world’s economies; and an end to the deflationary effects of lower oil prices.
In a scenario of above-trend growth, we believe the Fed will dial down accommodation and deliver three to four hikes in 2017. Similarly, while term yields may experience a near-term pull back from recent highs, we believe levels will ultimately climb and project 10-year US Treasuries will end the year between 3-3.5%.
We consider this backdrop when positioning portfolios and continue to find opportunities in segments of US fixed income that benefit from the prospects for higher growth.
US high yield bonds should be helped by improving growth and higher commodity prices should strengthen fundamentals; we expect a decline in default rates as we move through 2017. The carry provided by the sector remains attractive, and spreads should absorb much of the increase in rates. Technicals also remain constructive, particularly as investors rotate out of more interest rate-sensitive sectors.
US leveraged loans (and CLOs), like their fixed rate counterparts, also benefit from the positive tailwind to credit. Carry is attractive, particularly on a duration- adjusted basis. Flows are positive, an every rise in Libor is accretive to yield. In portfolios where we have the flexibility, we like the option of owning high yield bonds, while swapping out of the duration, creating synthetic leveraged loans.
Shorter-duration securitized credit has been a favorite asset class for some time, but an environment of rising rates makes the duration-adjusted spread and rapid amortization that much more attractive.
Additionally, fiscal stimulus could further benefit already strong consumer balance sheets.
Finally, in the face of rising rates and diminishing central bank support, low yielding duration looks mispriced. Outright shorts in US Treasuries and US agency mortgages are tools to hedge against rising rates.
This article was originally published in the February issue of Citywire Americas. To sign up to receive our free magazine, follow this link.