MARKET OUTLOOK / STRATEGY
Fourth Quarter 2016
The coming year should bring opportunities and challenges. We are reminded in such environments that it is wise to “cross the river by feeling the stones.” The U.S. economy is headed into its eighth year of economic growth, on track to be the third longest period of economic expansion. This trend may receive an additional tail wind from anticipated expansionary fiscal policy, which likely would reduce the role monetary policy has played in the past seven years. However, potential headwinds of de-globalization, demographics as well as anti-establishment political and social movements could derail strong growth. Geopolitical events will also become key risk drivers in 2017. Elections in Europe will be important for the Euro, as will how Great Britain manages the Brexit process. Emerging markets could deteriorate further should financial conditions continue to tighten. Domestically, the market has responded positively to the new regime, and may be underestimating the challenges that lie ahead in implementing the promised fiscal policy changes and ongoing secular stagnation forces.
The Fed increased the Fed Funds rate by 25 basis points in December as expected. Looking to 2017, the Fed is expected to hike 2-3 times. Accelerating inflation expectations could result in a faster hiking cycle. However, continued dollar strength and tightening financial conditions combined with lower potential GDP could result in fewer hikes than communicated. Uncertainty around the path of the fed funds rate could surprise the market, resulting in increased volatility. Outside the U.S, global developed monetary policies continue to be supportive of risk taking. However, the level of support from global central banks could decrease as policy initiatives move from monetary to fiscal and structural.
Corporate bond gross issuance is expected to be around $1.2 trillion in 2017 which would be the seventh consecutive year of over one trillion dollars in issuance. Leverage is expected to continue rising and the market for M&A activity is also likely to be strong, consistent with the later stages of the credit cycle. Tax policies have the potential to reduce issuance if interest deduction is eliminated. Credit spreads are tight and it is not unusual to experience negative excess returns given current spreads levels or during late cycle phases. Liquidity will continue to be challenged. We will actively manage the overweight to Credit as we anticipate periods of volatility resulting in wider credit spreads. Divergences among industries will be large as we expect domestically focused companies to outperform ones that are internationally focused. We favor financials, communications, basics and energy as industries likely to outperform under current conditions. We anticipate an environment where security selection will meaningfully add to performance. Our modus operandi is to continue to be disciplined in managing risk, favoring post-event deleveraging credits and industries that are domestically oriented.
We begin the year with the market expecting economic growth in this new environment will be 2.20%. Pugh Capital sees the 10-year yield between 1.75-3.00%. Yield hungry investors, domestically and internationally, will continue to support the bond market especially if U.S. yields rise further. Given the uncertainties expected to play out during 2017, we plan to keep duration in line with the Index entering the year. We enter 2017 slightly underweight mortgage backed securities which look rich fundamentally. Net supply of mortgage backed securities should be lower in 2017 due to higher rates and less refinancing activity. However, demand from key buyers, such as banks and overseas investors, may decline from last year’s levels. The portfolio remains overweight in CMBS and ABS for their combination of high quality and reasonably attractive spreads.
Disclosures: As of December 31, 2016. 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. Information contained herein should not be considered investment advice for any particular investment strategy or product. 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.