“While 2016 was full of surprises causing significant volatility, we expect more of the same in 2017.”
Inside This Issue
Economic growth in the U.S., as measured by real GDP, is projected to increase by 2.4% in 2017 based on consensus forecasts. This would be a marginal improvement from the 2.0% growth rate for 2016. The improvement is primarily predicated on an increase in business and residential investment as consumer spending is forecasted to increase at a marginally slower pace. The labor market is expected to continue to improve in 2017, albeit more slowly than in the previous year. A combination of a tighter labor market and fiscal stimulus from the new Trump administration has the potential to increase inflation. Market implied inflation expectations have increased by 27 basis points since the November election. Stronger growth and higher inflation will allow the Federal Reserve to keep normalizing rates in 2017. The Fed raised rates 25 basis points at their December meeting to a 0.50%-0.75% range and provided an outlook which calls for three additional rate increases in 2017.
AAM views the risks to economic growth in 2017 as slightly skewed to the downside as we expect continued weak fixed investment. As such, we don’t believe inflation will move significantly above the Fed’s long-term target resulting in less than three rate hikes in 2017.
|2016 Returns by Asset Class
|Bloomberg Barclays US Aggregate||2.7%|
|Tax Exempt Municipals||0.25%|
Source: Bloomberg Barclays Index Series, S&P 500, Barclay’s Global High Yield Index, V0A1 (Merrill Lynch IG Convertibles Ex-Mandatory)
Fixed Income Outlook
During 2016 the fixed income markets experienced significant volatility. 10 year treasury yields hit a low of 1.36% in July and rose to 2.60% post-election in December. Investment grade Corporate credit spreads widened to 200 basis points over Treasuries in February then rallied to finish the year at 118. The corporate spread volatility was driven primarily by the energy sector caused by oil falling to $26 per barrel in February then roaring back to close the year above $53.
While 2016 was full of surprises, (see Trump, Brexit, lackluster Q1 and Q2 GDP growth) causing significant volatility, we expect more of the same in 2017. The search for yield has driven valuations higher, making credit risk look expensive across all sectors. Security selection becomes key in this environment. We are going to focus on corporate bonds issued by the strongest companies that can weather what may lie ahead, high quality ABS securities issued by strong underwriters and backed by high quality borrowers, and MBS securities with superior cash flow profiles.
There is uncertainty in China and Europe that may cause some bumps in the road here in the U.S. In our portfolios, we will look to sell securities where the risk is mispriced by those buyers focused solely on a small yield advantage. We will target those securities that perform better during volatile times, and expect that we will have opportunities to add risk at more distressed prices during the year.
Fiscal stimulus and a roll back in regulations are expected to propel the U.S. economy, lengthening the credit cycle by an estimated 12-18 months. However, a potential risk factor is higher than expected inflation and specifically, the Fed’s response to that risk. While there is a high degree of uncertainty related to the Trump administration’s policies, companies’ outlooks for earnings reflect higher commodity prices, higher interest rates, an improving manufacturing sector, and a healthy consumer spending. In 2017, we expect firms to continue pursuing mergers and acquisitions and other shareholder friendly actions, keeping leverage largely unchanged. We expect market technicals will remain strong in 2017 with yield oriented investors focused more on investment grade credit and new issue supply similar to 2016, with tax reform a major swing factor.
Despite spreads which are near cyclical tights, given the strong technicals and our marginally positive fundamental outlook, we propose a modest overweight to the Corporate sector. Since we are in the late stage of the cycle, we continue to be selective (credit/sector).
The Federal Reserve reinvestment program continues to distort agency MBS valuations making them particularly unattractive. As the Fed raises rates in 2017, we expect they will address the timing of bringing the reinvestment program to a conclusion. The loss of a consistent buyer of $300 billion or more of mortgage pass-throughs will negatively impact valuations in a fairly dramatic way. In addition, any increase in longer term interest rates make MBS less attractive to banks and foreign investors who have largely supported the market for the past few years. We’ll maintain a significant underweight position in the portfolios until valuations adjust to reflect higher interest rate volatility and the eventual Fed exit. Investments will focus on specified pools with more consistent prepayment profiles to manage prepayment uncertainty and extension risk from higher interest rates. Selecting specified pools with attractive loan characteristics generates higher yields than those earned from investing in generic, TBA securities. We continue to view non-agency mortgage backed securities as a better alternative based upon their more attractive yields and an improving credit profile from rising housing prices.
During the course of 2017, the tax-exempt sector could experience similar levels of market volatility that the sector weathered during the last two months of 2016. Since the presidential elections on November 8th, 10 year municipal yields rose by 89 basis points (bps), before retracing 30 bps of that move during the first week of December. Most of this volatility was a direct result of both massive outflows from municipal mutual funds and the uncertainties surrounding the prospects for tax-reform and its potential to reduce the relative value of tax-exempts versus taxable alternatives.
As we enter 2017, these uncertainties are expected to remain a cloud over the market until President-elect Trump and Congress clarifies the scale and scope of their comprehensive reform efforts. Given these uncertainties, we remain cautious in our outlook for the sector. However, one bright spot for the sector is the expectation that market technicals should remain fairly positive for much of 2017. With 10yr tax-exempt rates now over 103 bps higher versus the lows of 2016, many of the refinancing opportunities that drove record levels of new issuance in 2016 are no longer viable. The market expects issuance to drop by $95 billion to $350 billion in 2017. On the demand side, the market expects very robust reinvestment flows of call proceeds resulting from the record levels of refinancings that have occurred over the past two years. However, the market should see some continued headwinds from mutual fund outflows that have averaged over $2 billion per week since the presidential elections. The combination of persistent fund outflows and market apprehension related to tax-reform will provide some dampening effect to the expected positive technicals this year. Consequently, we are maintaining a neutral bias for the sector.
Consumer credit has performed at or above historical levels the past few years and we anticipate that this will continue in 2017 backed by stronger economic growth and rising income levels. ABS is an important investment option at the short end of the maturity spectrum and we maintain a significant weighting in portfolios relative to most benchmark weights. High credit quality and stable cash flows make them an attractive alternative to shorter maturity corporate bonds, Treasuries and high coupon mortgage pass-throughs.
Improving real estate fundamentals continue to support the CMBS market however valuations tend to reflect this so we remain neutral on the sector in 2017. Both underwritten and stressed LTVs and DSCR have improved as new risk retention rules have forced loan originators to become more conservative since they now bear more of the risk from their underwriting decisions. Prices of properties in non-major markets continue to lag overall national pricing levels however they have finally surpassed levels seen at the height of the market in 2006. Transactions backed by single properties located in major markets with extensive operating histories and conservatively underwritten conduit deals continue to represent the best value.
Treasury yields have moved higher since the election as optimism about tax and regulatory reform has ignited the equity market. The US dollar and US Treasuries remain the standard for global risk reduction. It’s possible that there will be economic challenges in either China or Europe (or both) which will drive yields lower here in the US as global investors seek a safe haven.
We expect defaults in US High Yield to decline in 2017 given the improved outlook for commodity sensitive sectors that drove defaults in 2016. Fundamentally, the continued increase in leverage bears watching, however proceeds of new debt have focused on refinancing rather than acquisition related activity. Accordingly, interest coverage remains favorable and maturity needs are manageable for the near future. Credit spreads are modestly below long-term averages, however there is room for further tightening as
technicals remain favorable given supply was lower for the third consecutive year while demand for higher income securities has been persistent.
A favorable environment for investors in domestic credit and equity markets provided a strong backdrop for 2016 performance within the US convertible market. The sector continues to exhibit limited sensitivity to changes in interest rates as recent upward movement in yields has coincided with higher equity markets. Portfolios are positioned with limited duration risk and, in our view, rising rates are a positive development for future issuance in the asset class. Prospective issuers may view higher borrowing costs in straight debt markets coupled with rising equity prices and improved growth prospects as providing an ideal environment for routing issuance to the convertible market. With redemption activity expected to hold steady, the US convertible market may see meaningfully positive net new issuance which enhances our opportunity set. From a valuation perspective, convertible models indicate that the balanced segment of the market is fairly valued, resulting in the continued opportunity for strong upside capture in rising equity markets with excellent downside risk control.
The five year return for the S&P 500 is over 14% a year. The small cap sector has outperformed the large cap sector, while the value style outperformed growth. With the bull market near the 8 year mark, we believe that the cycle is long in the tooth, and valuations are above long term averages. The trailing P/E ratio is at 21.3x relative to the 50 year long term average of 16.6x. If the new administration is successful in lowering the corporate tax rate, we would expect further gains in the market. At these valuation levels, caution in the US equity market is warranted.
Sources: AAM, Bloomberg Barclays Index Series, S&P 500
Outlook Commentary Written by:
Marco Bravo, CFA
Senior Portfolio Manager
Reed Nuttall, CFA
Chief Investment Officer
Elizabeth Henderson, CFA
Director of Corporate Credit
Scott Edwards, CFA, CPA
Director of Structured Products
Greg Bell, CFA, CPA
Director of Municipal Bonds
For more information, contact:
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Chicago, IL 60603-2405
Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. Registration does not imply a certain level of skill or training. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns.
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