MARKET OUTLOOK / STRATEGY
Third Quarter 2017
The more things change the more they stay the same. Hopes of finding signs of faster economic growth this year have waned. Market forecasts, while initially optimistic, have gradually declined and structural impediments to economic growth remain largely unresolved and unaddressed. Consumer and government spending have seen lower growth rates this year and are unlikely to improve in the near term. In addition, the recent devastating hurricanes will further dampen consumer spending in the short term. We continue to maintain our outlook for a slow growth and low inflationary environment. Consistent with our outlook, current consensus market forecasts for 2017 and 2018 GDP are 2.2% and 2.3% respectively.
The Federal Reserve has been in gradual tightening mode since 2015, well ahead of other major central banks. However, as the global recovery continues to gain momentum particularly out of Europe and Japan, monetary policy tightening is becoming more of a worldwide phenomenon. In fact, earlier this year the European Central Bank hinted at curtailing its bond purchase program soon. The market expects the Bank of England to increase its policy rate next year to fight rising inflation. The Bank of Japan may also effectively be tapering its Quantitative Easing (QE) as it is expected to fall short of its annual buying target. An evolving risk for the bond market is that simultaneous global monetary tightening may lead to tighter financial conditions faster than expected creating negative pressure and less support for risk assets.
The Fed has also communicated its strategy around balance sheet reduction along with its expectation to continue to increase the Fed Funds rate. While not our base case, if Congress were able to pass substantive fiscal reforms, or if U.S. growth and inflation rise faster than expected, the Fed’s projected path of rates would be justified. Currently, the market is not convinced of the Fed’s outlook and is discounting a shallower path. In the event the market and Pugh Capital are wrong, we’re likely to see a higher rate scenario similar to that of the 2013 Taper Tantrum. The most recent FOMC Summary of Economic Projections indicates a rate hike in December followed by three more in 2018. This path is more hawkish than we expect.
With regard to interest rates, we maintain our trading range outlook for the 10-year Treasury of
1.9% – 2.5% for the fourth quarter. We see market risks in addition to the monetary and fiscal issues described above. Fiscally, the deepening divide within Congress has the potential to create further gridlock and exacerbate the debt ceiling issue in December. From a geopolitical standpoint, U.S. and North Korean tensions continue to increase anxiety over a diplomatic resolution. Lastly, inflation has surprised to the downside and may remain low for longer than forecasts suggest. Given the possible crosscurrents and uncertainty with rates, duration will be managed closely to the Index.
Currently, the VIX Index near historical lows indicates the markets are shrugging off much of the aforementioned events. We are cognizant of potential spikes in volatility, but if it stays low in this positive growth environment, there should be near term support for risk assets. We believe credit spreads will be range bound for the rest of the year and therefore we remain modestly overweight. Our strategy emphasizes defensive security selection with a focus on up-in-quality trades while mitigating idiosyncratic risks. The greatest risks to our overweight call include a more hawkish Fed, sustained higher levels of volatility, or a sharp reversal of foreign demand. Given tight corporate spreads, there is limited protection in spread widening scenarios. We remain underweight MBS as the Fed begins unwinding its balance sheet next month. The portfolio continues to be overweight in the high quality CMBS and ABS sectors as part of our lower-risk yield enhancement strategy.
Disclosure – As of September 30, 2017. Source: Pugh Capital, Bloomberg, and Bloomberg Barclays Indices. This market outlook and succeeding pages contains Pugh Capital’s opinions based on the information available at the time of the analysis. Opinions are subject to change without notice. Investors should evaluate their own risk tolerance, time horizon and other restrictions for their investment decisions. Statements concerning financial market trends are based on information available and current market conditions which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions, and investors should evaluate their ability to invest for the long-term, especially during periods of volatility in the market. Please do not redistribute. Refer to Disclosures for forecast, outlook and other information.