2017 Review and Outlook
At this time last year investors worried about the end of the bond rally that has been a force in fixed income investing for about as long as many of us can remember – where were you in 1981 when the bond bull market began with interest rates over 15%?
Interest Rates Have Been Falling Since 1981
But as we all know, changes in interest rates are only one part of the bond return equation, with yield (i.e. income generation) being the other component. This is especially true in the intermediate and short end of the curve, where income determines the majority of a bond’s return. When one holds high quality intermediate bonds to maturity, as we often do, then income really determines returns. In looking at 2017, we see this illustrated quite well. Returns were positive in the year considering the 2-year treasury rose 72 bps, the 5-year 30 bps and the 10-year was flat.
2017 Returns BofAML Intermediate Returns (1-10 Yr)
In addition to demonstrating the power of income, this data highlights the impact (or lack thereof) that rate hikes by the Federal Reserve can have on bond returns. The three rate hikes in 2017 caused short-term rates to rise. However, bonds with short-term maturities exhibit limited price sensitivity to changes in rates, and when longer-term rates don’t move much, like we saw last year, bond returns are positive. Alas, these trends combined to produce an environment for bond investors that we have described as “the sweet spot.”
So, will we stay in the sweet spot this year? Let’s look at a few of the factors we expect will have an impact on fixed income markets in 2018.
Fundamentals: The economy is growing nicely in the United States and around the world. The recovery from the great recession has been frustratingly slow and sub-par compared with other recoveries, a real tortoise vs. hare recovery, yet this recovery has the potential to continue for a while longer in the absence of a major central bank policy mistake or a black swan.
Consistent economic growth is a tailwind for corporate bonds and for municipal tax receipts. More people are working, companies’ earnings are very strong, the stock market is hitting new highs and property prices are rising. Adding to strong fundamentals are benefits we may receive from changes in the tax code. We do see much of the benefit going to corporations, which will likely result in higher dividends, stock buy-backs and capital expenditures. Yet there are some consumption benefits to lower personal tax rates. The combination of corporate and personal tax cuts could help extend this economic cycle by pulling demand forward.
Technicals: Supply and demand should favor municipals in 2018. The supply of municipal bonds will likely be lower in 2018 as new legislation takes away the tax shield from some forms of municipal issuance. At the same time, the demand for municipals could grow in 2018 in high tax states where personal exemptions are newly limited. More buyers and fewer bonds could push up prices.
Corporates should continue to be supported, as domestic buyers are still looking for any return in a yield starved environment, and foreign buyers are still investing in U.S. markets as European and Japanese interest rates remain close to zero or even negative.
Valuations: We are not going to say valuations are attractive. After close to ten years of historically low interest rates we should not be surprised that just about all asset classes are rich: treasuries, corporates, municipals, stocks and even Seattle real estate, our hometown.
But these asset valuations got rich due to a combination of low interest rates and a growing economy, and until these factors change the path of least resistance is for the rich to stay rich.
Outlook 2018: The big question in our mind is when will inflation pick up enough for central banks to raise rates at a faster pace and tip this recovery into a recession. As economists often note, economic expansions don’t die of old age – they are murdered by the Fed! At some point the Fed will get behind the inflation curve and be forced to more aggressively raise rates.
Still, we are not worried about inflation and aggressive Fed interest rate hikes at this time. Inflation remains stubbornly low in the U.S., with wages held in check by the powerful twin forces of globalization and automation. In addition to these factors, high government, corporate and personal debt levels tend to moderate growth and, therefore, inflation. We have a ways to go before the Fed acts decisively. As for Europe and Japan, we do not see pressure to raise rates in 2018 or even in 2019. Europe is still in recovery mode and Japan’s battle with disinflation is at best fighting to a draw.
The final part of this forecast is the possibility of black swans, or the unknown-unknowns, as Secretary of Defense Donald Rumsfeld so famously quipped in 2002. Black swans are even more difficult to forecast than interest rates, but we do know they regularly occur, especially when the world is rapidly changing. In anticipating these unknowns, we feel we are structurally insulated from their worst impacts by duration neutrality; by holding high quality assets; by diversifying asset classes, industries and issuers; and through the benefits of separate account management.
We trust 2018 will be another decent year, whatever comes our way. Happy New Year!
Source: Bloomberg, BofAML