Our 2018 outlook video (below) noted the risk of resurgent market volatility – we think now it's here to stay. Yet, global growth is strong and we expect the Federal Reserve to normalize interest rates cautiously. We favor selling into strength rather than buying on weakness, remaining modestly overweight spread assets.
In our 2018 outlook, we argued that market conditions were likely to lead to a return of volatility. As the saying goes, be careful what you wish for — volatility has returned in a big way. Though equities made headlines, warning signs first emerged in the fixed income market. In December, as the U.S. dollar continued to weaken amid rising energy prices, the 10-year inflation breakeven rate — the difference between nominal and inflation-adjusted Treasury yields — started to increase. Interest rate volatility, which had been declining for more than a year, soon followed suit. This set the stage for the market’s reaction to the strong February 2 payroll report. Volatility accelerated on fears that inflation would rapidly pick up steam, prompting a more aggressive policy stance from the Federal Reserve.
While we saw pockets of turbulence in high yield and emerging market debt, recent volatility was not a credit spread event — it was primarily driven by interest-rate volatility and large swings in short-term equity positions. Years of historically low and largely range-bound interest rates created complacency. The recent rate volatility is a reminder of the fixed income market’s power to send shockwaves across broader capital markets and the economy. We will be paying close attention to the 10-year yield. We think a near-term move to 3% is likely, and that an acceleration through 3%, while unlikely, would intensify volatility. Nonetheless, we believe that yields above 3% represent attractive value and might adjust our tactical positioning to capitalize on what we would view as an opportunity.
Volatility has returned and we believe it is here to stay, however, conditions are only returning to normal following last year’s prolonged, unusual absence. The reappearance of volatility does not change our outlook for strong global growth and a cautious pace of interest rate normalization and balance-sheet reduction from the Fed. We continue to favor selling into strength in spread assets rather than buying on weakness. We remain modestly overweight spread assets, favoring collateralized loan obligations and non-agency residential mortgage-backed securities.
Spreads, Returns and Yields
Source: Bloomberg, JPMorgan, Standard & Poor’s. All spreads are to U.S. Treasurys and are option-adjusted except for emerging markets, which are nominal. All returns are total returns including dividends, expressed as percentages, in U.S. dollars.
Voya Investment Management’s fixed income strategies cover a broad range of maturities, sectors and instruments, giving investors wide latitude to create a new portfolio structure or complement an existing one. We offer investment strategies across the yield curve and credit spectrum, as well as in specialized disciplines that focus on individual market sectors. We build portfolios one bond at a time, with a critical review of each security by experienced fixed income managers. As of March 31, 2016, Voya Investment Management managed $129 billion in fixed income strategies in the United States.
Bond Market Outlook
Global Rates: gradually rising rates in United States, steady in Europe and Japan
Global Currencies: U.S. dollar strengthens vs. euro and yen; steady vs. pound, weaker vs. select emerging market currencies
Investment Grade Corporates: solid fundamentals and continued economic growth drive spreads tighter despite recent pullback
High Yield Corporates: slightly increasing exposure after pullback left attractive entry point; fundamentals remain decent, default risk low
Securitized Assets: maintain a positive stance on CLOs and CMBS while underweight agency RMBS
Emerging Market Debt: remain constructive on EMD but country differentiation still is key
Investment Grade Corporates
The IG market rallied to post-crisis tights before experiencing a pullback of late. The market continues to be broadly supported by earnings, fundamentals and lower supply. Higher rates and a stronger U.S. dollar support foreign buying of U.S. credits. While valuations suggest further upside is limited, favorable fundamentals, strong technicals and a supportive macro outlook mean a grind tighter into year-end is the most likely path. We like the valuation gap of financials and think BBB spreads can still compress slightly.
High Yield Corporates
The backdrop for high yield remains constructive, and we still expect to see an improved pace of growth as we move through the end of 2017. For the market as a whole, credit fundamentals continue to trend positively, resulting in low default expectations. The technical picture remains positive despite recent outflows, as the search for yield continues and new supply remains manageable. Spreads closed in on their post-crisis tights before pulling back recently. We still see the potential for continued near-term outperformance supported by growth, both domestically and abroad, and will look for pullbacks to take advantage of attractive opportunities.
Agency residential mortgage-backed securities (RMBS) finished the month with slightly tighter spreads vs. U.S. Treasurys. At current spread levels, near-term mortgage performance is skewed to the downside as Fed tapering will result in increased supply. Therefore, we maintain our underweight to the sector.
Non-agency RMBS will continue to be driven by a recovering housing market. Upside remains as credit availability increases, home ownership bottoms and the burgeoning millennial demographic engages. As a result, we remain constructive, particularly from a fundamental perspective, but note that tight valuations may limit near-term upside potential. Within non-agencies, the outlook for credit risk transfer (CRT) securities has improved as data from hurricane-impacted areas increase the certainty of loss projections. Nevertheless, with valuations close to recent tights and elevated volatility still in the rearview mirror, we have subdued enthusiasm for CRT and have trimmed our allocation to the sector.
Asset-backed securities (ABS) remain well supported by consumer spending and no signs of broad consumer credit degradation. Subprime auto borrowers remain a concern, but we still don’t believe the auto sub-sector’s troubles will spill into other sub-sectors. We remain constructive on spread levels.
We maintain a positive near-term outlook for collateralized loan obligations (CLOs) for their attractive relative value and stable risk prospects. Demand remains strong even with elevated supply. As rates move higher, potential relative total return performance leans towards CLOs.
We hold a positive near-term view of commercial mortgage-backed securities (CMBS), because of favorable technical factors and sustained relative value. Longer term, the fundamental story has somewhat plateaued as concerns remain about property valuations and the vitality of the retail sector.
Emerging Market Debt
Growth momentum and macro fundamentals within emerging markets (EM) remain on an upward trend as external accounts continue to improve and EM corporations enhance their liability management and reduce debt. Country differentiation remains key as valuations are tight. Of late, uncertainty stemming from the anti-corruption raid in Saudi Arabia has produced some volatility in oil prices and subsequently slowed the rally. Nonetheless, we remain constructive on EM as global growth continues to improve.
Global Rates and Currencies
U.S. rates gradually increased in October, with the long end slightly lagging the short end, resulting in modest flattening of the yield curve. We see this trend of higher yields continuing, driven by prospects of improving growth – manufacturing levels continue to remain elevated – and stronger inflation – the October CPI print should give the Fed comfort as inflation continues to trend towards its 2% target. In the eurozone, continued dovish policy by the ECB, largely due to lagging inflation, will keep rates low; resulting in an increasing yield differential between U.S. and German government bonds. Across the channel, the Bank of England raised rates for the first time in a decade, but like its Yankee counterpart, stressed that further tightening will be gradual and limited.
The U.S. dollar has slowed after strengthening over the better part of the last two months. We expect it to regain its form and continue to appreciate versus other developed market currencies, but lag select EM currencies tied to faster-growing economies. The euro will weaken largely due to policy decoupling among the U.S., U.K. and eurozone. Finally, we expect the yen to weaken as it remains highly inversely correlated to the global risk rally.
Past Performance does not guarantee future results.
This commentary has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults, (5) changes in laws and regulations, and (6) changes in the policies of governments and/or regulatory authorities.
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