What to Expect in the Bond Market
Three outstanding managers share their outlooks for inflation, interest rates, and the fixed-income market in general.
This analyst blog is part of our coverage of the 2017 Morningstar Investment Conference.
A whirlwind, indeed.
Morningstar's Sarah Bush noted Friday at the 2017 Morningstar Investment Conference that much has changed since we last met for this annual event: Brexit became a reality-- and so did a Donald Trump presidency. Emerging markets and junk bonds staged rallies, and the Fed picked up its pace of rate hikes.
No doubt bond investors in 2017 have different questions and concerns than they did last year. Is inflation back? What's the Fed going to do under a new administration? And what impact might new policies have on the bond market?
Three panelists--Franklin Templeton's Sonal Desai, Blackrock's Rick Rieder, and PIMCO's Dan Ivascyn--shared their opinions on several topics top-of-mind with today's bond investor.
Bush said inflation has been on the minds of some since the election. Desai thinks we could see inflation above 2.5% or 3% in the next 18 months, depending on what policies the new administration puts into place, and when.
"That's very different from what most people are expecting," she said.
"The economy today is extraordinary compared to where we were a year ago," added Rieder. He thinks we've probably peaked where we are inflation-wise, and inflation may drift lower because of energy. Moreover, inflation today is different than it was in the past because technology is pressing down on inflation so aggressively: "Running 2% inflation today is different than the 2% of 10 years ago. If we’re getting 2% today, it’ pretty impressive."
"You don't want to be overly complacent about inflation risk," said Ivascyn. He's watching two factors. Over the short term, the risk lies with fiscal policy in the U.S., where you have a mature economy still growing above capacity, experiencing some wage pressure and labor shortages. Longer term, we still have high global debt levels and low nominal growth rates; at some point the debt will need to be dealt with.
All panelists agreed that China is a risk on the horizon--maybe not this year, but thereafter.
"When you talk about inflation and risk of deflation, it’s going to emanate from China, not from the U.S.," said Rieder. After all, China represents 42% of global growth today.
"China is an area where there's some complacency now," notes Ivascyn. The country continues its transition to a consumer and service economy; Ivascyn expects growth in the 6.25% range in the next 12 months. He notes that the country will continue to experience periods of volatility as the policymakers grapple with the transition. Further, there's a tremendous amount of aggressive lending going on.
Desai, too, has concerns about China--specifically, about China's debt and the ability to use credit as a way to expand itself out of the problem.
"It takes almost 5 times as much credit to generate a unit of GDP in China," she said. In the next few years, an economic slowdown in the U.S. and massive Chinese debt could create the perfect storm.
On the Fed
Panelists expect two to three rate increases this year. The wildcard is, who'll be making the decisions next year?
"It's hard to have a sense of Fed policy, given that," said Ivascyn. That uncertainty may lead to some volatility.
Rieder thinks that the press has overplayed the Trump administration's desire for aggressive tightening.
"No world leader is going to want to see rates move up in a significant way," he noted. Instead, he expects the Fed to continue to take a measured approach, no matter who the new chair is. The debt burden is just too significant.
"If you hike rates aggressively, you create a drag on the economy," Rieder argued. He expects a smoother transition between Janet Yellen and her successor that people may be expecting.
Desai, meanwhile, expressed concern about the liability side of the balance sheet.
"The excess reserves are inflation waiting to happen," she said.
At the end of the day, said Ivascyn: "It'll be hard for rates to rise in the U.S. too much in a world where people are desperately looking for safety."
On Opportunities in Today's Bond Market
The panelists agreed that due to the global pursuit of income, values aren't abundant. There are, however, pockets of opportunity.
"When we look at the market today, we think valuations are fair," noted Ivascyn. That said, he's "cautiously optimistic" about emerging-markets debt. Granted, there was more opportunity a year ago, before the rally. Specifically, Mexico has done well but is still a good long-term value. He cautions that there may be a pause or pullback short-term.
Desai also likes emerging-markets debt, though she notes that "you have to pick your countries very carefully." She's particularly keen on Latin American debt, arguing that the region has had its flirtation with populism: "It's gone there and come out the other side." She's especially encouraged by new leadership in Argentina and likes debt there.
Rieder agrees with the others about emerging markets, and also finds some opportunity in securitized assets--he's looking for things that have high cash flows and are secured, such as commercial mortgages and nonagency mortgages.
Ivascyn likes housing-related investments.
"Areas that withstood the crisis last time might be at risk this time--what causes the last crisis doesn't usually cause the next one," he said. The thinks the housing market is in good shape: It's harder to get loans and build new properties. He's not expecting the eye-popping returns that we’ve seen during previous periods, but he expect these securities to be resilient.
The best advice? When it comes to the bond market, expect the unexpected and hold a balanced portfolio.
"We don't think political risk and panics are behind us," said Desai. "Expect them to continue in an ongoing way."
"We live in an uncertain world," added Rieder. "The only thing you can do is think about balancing your portfolio--creating a stable and durable portfolio."