Fourth Quarter 2017

As we ring in the New Year, the growth party is approaching a decade without a recession.  We expect this extended recovery to be challenged by accelerating monetary tightening in the second half of 2018.   Economic growth is expanding across both emerging and developed markets.  With synchronized growth, we may also see global Central Banks tightening more broadly. Still, we don’t expect that growth will be sufficient to lift U.S. inflation to meet the Fed’s 2% target.  Our outlook is in line to slightly below the consensus forecasts for GDP of 2.5% and core PCE of 1.8%.

Monetary policy will take center stage this year.  In both 2015 and 2016, the Fed only hiked one time each year.  In 2017, the Fed hiked three times, shifting to a more aggressive tightening mode.  The FOMC dot plots for 2018 project the Fed will raise rates three more times in 2018, faster than the market is currently discounting. While the pace of Fed rate hikes has been more muted during this tightening cycle, we are now in a phase where the pace is accelerating.   In addition to tightening via rates, the Fed began to reduce their balance sheet reinvestment late last year.  The estimated supply of treasuries and mortgages from this shift in Fed policy for 2018 is about $400 billion. The acceleration of Fed tightening through both rates and balance sheet shrinkage will become more impactful as we progress throughout the year.  This combination is unique to the current cycle and while the market anticipates a smooth unwind, we are more skeptical.

Inflation has surprised to the downside and may remain lower for longer than Fed forecasts suggest.  There is a theory that the current causes of low inflation are transitory and as a result, inflation will migrate higher over time.  An alternate theory, and one that we favor, is that the transitory causes that limit inflation are actually rotating to different categories of goods and services over time. While a particular category might prove temporary, disinflationary forces will continue to be in play.  The Phillip’s Curve supporters are calling for wage inflation to pick up given the low unemployment rate.  We are reticent to back this view broadly given the differing education and expertise that exist in the labor force.

Our outlook for the 10-year Treasury is for a trading range of 2.0% – 3.0% for the year.   Given well behaved inflation and low risk premiums, we expect interest rates to exhibit modest volatility around its midpoint.  However, with the Fed tightening we do expect short term interest rates to move higher over the year, causing the yield curve to flatten.  So, while duration will be managed in line to the Index, the curve flattening trend should provide occasions to add value to the portfolio.  The new tax plan may initially cause an increase in long-end rates and perhaps a steeper curve.   However, we expect that the tax cuts will provide little benefit to current economic growth.  Instead, we believe its lasting impact will be an increase in the deficit that will exacerbate the long term debt/GDP problem.

The most important call to get correct for asset allocation will be the portfolio’s credit exposure.  Investment Grade Corporate spreads are trading at levels close to cyclical tights and we are late in the cycle based on a number of metrics.  However, economic, market and technical conditions still indicate credit spreads should remain well-behaved.  We expect the primary drivers of returns in the first part of the year will be carry and curve roll down.  As the year progresses, our outlook becomes more cautious. Global Central Bank tightening will likely negatively impact the liquidity and technical profile of the market. While the macro environment shows no signs of recession, the current valuations indicate caution is warranted.  Our focus will be on downside risk management, as we expect idiosyncratic risk to be a key driver of return variation at the industry, curve and issuer levels as we progress further into the year.

Over the course of the year, the Mortgage sector will be influenced by the Fed balance sheet unwind, as it will increase  net supply that investors will have to absorb.  While we remain modestly underweight MBS over the near term, we expect to increase the allocation as Mortgages cheapen.  We remain overweight both ABS and CMBS for their attractive risk adjusted return profile.

Disclosure – As of December 31, 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.