- Against a politically sensitive and inflationary backdrop, Western Asset identifies Investment Grade Corporates, High Yield and Mortgage Backed Bonds as good opportunities
- While Western Asset considers potential policy experimentation to be ‘enormous’, it does not see a surge in interest rates
- Western Asset believes fears of Chinese recession are overblown
London, 1st February– Fixed income markets face a number of challenges this year as a political shift in the US, potential changes in interest rate policies, and the likelihood of inflation returning with a vengeance impact the asset class.
Against such a backdrop, there will be also be opportunities across the bond market, according to Legg Mason affiliate Western Asset.
The group’s chief investment officer, Ken Leech, said while the headline is for “steady but unspectacular growth,” in 2017, the picture is actually nuanced.
“The good news is that the global recovery is on a firmer footing than last year,” he said. “However, it’s going to be tougher to make money, and you still need to be cautious, particularly given the extraordinary nature of the policy and political changes we may be seeing,” he said.
So where can investors find the best opportunities, and watch risks are prevalent, as we head through 2017? Below, Leech identifies what themes may play out as we work our way through 2017.
Investment Grade Corporates
Leech said the investment grade segment of the market looks attractive, despite having seen valuations climb recently, with a number of sectors presenting opportunities.
“The sectors we are in are metals, mining and energy,” he said. “We have also been big believers in the banking sector and the election of Donald Trump helped that process along.
“Markets are now anticipating a better economy, the possibility of higher short-term rates, and the possibility of losing regulations, all of which are good for banking. Subordinated bonds could be a particularly attractive sector.”
In 2016, high yield recovered from much of the troubles of the previous year, as fears over defaults subsided. But Leech said investors needed to tread carefully this year.
“There was a real fear that high-yield defaults were going to move up on a sustained basis,” Leech said.
“However now high yield defaults have been falling again, our focus is on issue selection and positioning, and less about an overweight being carried along by the kind of major bull market of spread normalization we saw last year.”
Improving fundamentals have been boost the housing market and Leech is positive the sector can see the trend continuing this year.
“House prices are moving up,” Leech said. “The fundamentals in terms of people being able to afford them are very positive, and delinquencies are collapsing.
“Therefore, if we get continued growth, let alone improvement in growth, the demand for housing could be a positive. That speaks well for the risk transfer market as well as those issues securitized by the housing market.”
Leech expects US growth and inflation to rise in 2017 as the Federal Reserve becomes less accommodative, but he warned there remained much uncertainty as the political shift under Trump plays out.
“In the US we obviously have the possibility of enormous policy change, not just on the economic side, but perhaps even on the foreign policy side, and there remains unbelievable policy experimentation globally,” Leech said.
“However, the Trump proposals are not a surprise and governmental policy changes will take time to implement, while policy continues to be accommodative around most of the world.
“Given it’s a global marketplace, it means government bonds will continue to be underpinned by low policy rates, and therefore we do not see the huge surge in interest rates that perhaps some others do.”
China has had a major impact on credit markets around the globe over the last two years, with the world’s engine of growth slowing having spent years at full tilt.
“Fear of a potential Chinese crisis or recession, in addition to the commodity price declines, led to a 20-month credit bear market,” he said.
“While people talk about the credit cycle in the U.S. being the same as the business cycle, what we really saw was a bear market in the credit cycle – not because the U.S. business cycle had problems, but because the global environment was so challenged.”
However, Leech said many fears over the health of the Chinese economy were overblown, and he added markets were starting to recognise this now.
“You really have to be thoughtful about the policy levers that China has,” Leech said. “As a country, they do not have some of the impediments a messy democracy has, and this means they can move macro policy levers very aggressively when needed.
“In late 2014 to 2016, even as growth was slowing, policy was moving from a very accommodative level. That’s why our thought was the reasonable prospect that Chinese growth would not only stabilize, but would actually turn up, which in fact happened.”
Brexit has created uncertainty for the UK but also for Europe, according to Leech, with the UK’s exit creating an “uncertainty premium”.
However, he said Europe’s improving growth rate had changed the outlook, with the region on more solid ground in spite of the threat from Brexit.
“Growth steadied last year and 2017 growth looks to be about 2%,” Leech said. “Of course there is uncertainty around the Brexit process, and there are downside risks not only for the UK but for Europe.
“However, risks have been mitigated by the fact that growth in core Europe has really improved.”