MARKET OUTLOOK / STRATEGY
2016 Market Outlook
The weather outside is gloomy, with torrential downpours and window shaking winds. This stormy environment is consistent with our fixed income market forecast over the next year. We expect challenges that require protective measures to safely weather market squalls, but we also see some rainbows of opportunities.
Market consensus for 2016 is for U.S. growth of 2.5% and core PCE of 1.6%, levels consistent with Fed forecasts. Pugh Capital’s outlook is for weaker than consensus growth and for inflation to remain well behaved. We acknowledge the relative strength of the U.S. economy, which is weighted toward services. However, we are concerned about the implications of a strengthening dollar, tightening financial conditions, weak commodity pricing, increasing geopolitical risks and soft global demand. Given our view, the risks to consensus growth forecasts are to the downside. These factors may also limit the Fed’s ability to raise rates significantly. We will watch for stronger global growth as an indicator that our base case scenario is too pessimistic.
Our slow growth and low inflation outlook, combined with episodes of market stress will translate to periodic flights to quality. The Fed is expected to tighten further, a divergence from most other foreign Central Banks’ monetary policies. Meanwhile, U.S. rates already look attractive versus other developed countries. Economic conditions and attractive valuations should limit higher rates. The 10-year Treasury should trade in a range of 1.75% – 2.75%. Our expectation is that the yield curve will continue to flatten with short rates moving higher. The firm will look to position the portfolio to capitalize on our curve view. Given the unique role that Quantitative Easing played in this cycle, we expect risk assets to have significant performance dispersion as the Fed moves towards normalization.
While recognizing that credit valuations are attractive we remain defensive in our outlook. The credit cycle is clearly in its later stages. Corporations have leveraged their balance sheets, profitability is weakening, and borrowing costs and defaults are increasing. These weakening fundamentals will become more problematic in 2016. Distressed commodity prices and a strong dollar portend turbulence for the corporate sector and the contagion effect is likely to be greater than is discounted by the market.
Corporate bond issuance for 2016 is expected to be around $1.2 trillion, consistent with 2015. However, market liquidity is deteriorating and new issue concessions will need to be wider to attract buyers given the market conditions we expect. This is likely to re-price secondary spreads wider. As issuers come to market that we view as core holdings, these new issues will provide an attractive entry point. One source of new issues will be M & A debt funding. Some of those companies are on our radar as opportunities to invest in deleveraging stories.
The other sectors of the market are higher quality and tend to be domestic in nature, providing safe haven characteristics. We maintain a significant overweight to ABS as they have shorter durations, high quality and relatively wide spreads. CMBS are also reasonably attractive and fundamentals remain strong, although underwriting standards are eroding. We are neutral on agency MBS as they represent a significant asset on the Fed’s balance sheet. In the second half of 2016, we expect the market to become more concerned about the Fed reducing its MBS holdings. This would introduce additional supply to the market and may require spread widening to attract marginal buyers. We begin the year with a larger than normal allocation to Treasuries given our expectations for volatile conditions.