Fixed Income Outlook: Pardon the interruption

07-10-2017

Despite all the political drama over the last six months, or perhaps because of it, we find ourselves pretty much where we were at year-end 2016. The yield to maturity on the U.S. Treasury Index finished the second quarter at 1.91%, a mere basis point higher than the 1.90% on Dec. 31, 2016. Additionally, the 10-year Treasury yield, at 2.31% as of June 30, 2016, has given back roughly 40% of its post-election surge. The yield curve, which steepened extensively post-election on an expected reflation trade, has completely retraced. And the U.S. dollar’s late-2016 run-up has totally reversed. Add it all up and the story remains the same: we believe the bias on rates is up, supporting our short duration position, and the best opportunities are where they have been for some time, investment-grade and high-yield corporate bonds.

There has been one notable change. Whereas rate volatility over the past two quarters was clearly driven by the great disruptor, President Donald Trump, the past few weeks arguably have seen a passing of the baton back to Europe, where Brexit, slow growth and an aggressive European Central Bank (ECB) have given way to an environment of stronger growth and a proposed reduction of fiscal stimulus. Ironically, this shift is being driven by an almost opposite set of circumstances. On the U.S. side, far from making major changes from Day One, Trump faces continuing difficulty with his agenda. We’re into July with no health-care repeal-and-replace, no tax reform and no infrastructure plan. Hence, the fading reflation trade and some corresponding dollar weakness.

Meanwhile, the populist wave that swept the European political landscape, culminating last summer with Brexit and the election of Theresa May as British prime minister in Europe and the election of President Trump in the U.S., appears to be fizzling out. On the heels of moderate newcomer Emmanuel Macron’s surprisingly easy election over the far-right’s Marine Le Pen as France’s president, May failed to secure even a majority of votes in a June snap election that was supposed to strengthen her hand. Moreover, pessimism has given way to optimism as recent economic data reflect accelerating growth across Europe, while the tone from ECB President Mario Draghi has shifted dramatically, as it has at other central banks, signaling accommodation no longer is open-ended.

Rates handoff to Europe
All of this—political quagmire at home, broadening recovery overseas, inflection point in monetary policy—suggests the very strong value component of U.S. rates relative to foreign rates is diminishing. This sets the stage for gradual rate increases—or maybe not so gradual. A 50 basis-point rise in the 10-year Treasury yield by year-end is not out of the question. One fly in this rate scenario is inflation, where core gauges have rolled over. But we tend to agree with the Fed that this is transitory. U6 unemployment—the broad measure that includes underemployed and discouraged workers—has declined aggressively of late, reaching a cycle low in June. This implies just because we haven’t seen wage inflation, doesn’t mean we won’t. Immigration constraints and the building “skills gap” could further add to wage pressures as both unskilled and skilled workers are discouraged from coming to the U.S.

An extended credit cycle
As for credit, we see an extended constructive cycle, fueled by continuing if unspectacular economic growth, constrained energy prices and a Republican White House and Congress that, for all the headlines, is putting forth regulatory reforms and is likely to enact some form of tax reform. The reality is we’re not that far into this new administration—it only feels like it!—so let’s not get too caught up in the optics of losing little battles. They can fail a bunch of times, but they only have to get it right once. Valuations are a bit of concern, as interest-rate spreads relative to comparable maturity Treasuries have fallen below historical medians for both high-yield and investment-grade corporate bonds. But as Senior Portfolio Manager Mark Durbiano always points out with regard to high yield, valuations are a poor timing indicator. We’ve had extended periods inside median spreads, 2004-2006 most recently. With no recession on the foreseeable horizon, it’s unlikely this cycle would be different. So we remain vigilant. But being long credit has worked for a number of quarters and we expect it will work for another quarter or two.