By Randy Myers
Bonds have long had a reputation as the staid and conservative corner of the investment markets. It was probably never true, except, perhaps, for pensioners “clipping coupons.” It’s certainly not true today. Speaking at the SVIA’s 2017 Spring Seminar, Matthew Kaiser catalogued a list of macroeconomic and political developments that are impacting the bond market. They include an uptick in populist sentiment at the expense of globalization, a shift in the U.S. toward fiscal policy rather than monetary policy as the vehicle for stimulating the economy, the prospect for reflation rather than secular stagnation in developed economies, and a move in the U.S. toward deregulation rather than regulation.
Against this backdrop, Kaiser said, the bond market is likely to see increased volatility over time, which should provide opportunities for active managers—including those who manage stable value portfolios—to squeeze value from their portfolios. Specific areas addressed follow:
The economy. GSAM expects U.S. growth of about 2 percent a year. However, if the Trump administration is successful in implementing many of its policies the economy could do better. While consumer spending hasn’t yet responded to improvements in income and wages, inflation is signaling that the economy may be shifting into a higher gear. GSAM now expects the Fed’s preferred inflation measure—the core Personal Consumption Expenditures price index—to reach or exceed the Fed’s target of 2 percent by year- end 2017. That doesn’t necessarily mean the Fed will tighten monetary policy, as the Fed has been hoping for inflation to move higher. GSAM also expects U.S. wages to move higher now that the labor market is close to full employment levels, and start to approach the Fed’s stated goal of 3 percent to 4 percent growth. Overall, Kaiser called the economic backdrop “pretty constructive” for the bond market.
Interest rates. Kaiser doesn’t see much room for Treasury yields to sustain significantly higher levels this year as long as yields on non-U.S. sovereign bonds remain extraordinarily low, as is currently the case. While GSAM isn’t betting on yields moving one way or another, it is trying to identify the range in which yields will move and trade accordingly, shortening the duration of stable value portfolios as yields in the U.S. fall toward 2 percent and lengthening duration as yields climb to 2.75 percent to 3 percent. GSAM Is anticipating the Fed will raise short-term interest rates two more times in 2017—in June and September— after last doing so in March. After the latest hike, investment markets responded by easing financial conditions, making it easier for the Fed to continue on the path of more increases. Following through on this opportunity should allow the Fed to start shrinking its balance sheet in the fourth quarter.
Headwinds. Among the potential headwinds to an improving U.S. economy, would be the imposition by the federal government of protectionist measures, such as new tariffs on steel or aluminum imports aimed at reducing U.S. trade deficits. Attention should be paid to what’s happening with possible reforms in the market for bonds issued by government-sponsored entities, which have come to account for a large amount of the debt backing the U.S. housing market. On a positive note, a number of the president’s senior advisors, including Treasury Secretary Steven Mnuchin, understand this market well and are focused on the possible dangers it presents.
Investment considerations for stable value. Kaiser noted that consumer balance sheets are healthier today than corporate balance sheets, arguing for more exposure to the consumer and less exposure to corporate credit. He also said the long end of the U.S. yield curve looked particularly expensive. Assets held in the stable value portfolios GSAM manages, include high-quality, short-term corporate bonds; short-term agency debt; commercial mortgage-backed securities and asset-backed securities, including many backed by consumer debt. GSAM likes floating- rate debt at the moment, as well as collateralized loan obligations—floating-rate, securitized assets backed by bank loans. In the CLO market, GSAM has moved almost exclusively into the most senior- rated bonds.
In summary, GSAM sees global economic growth improving amid a shift to fiscal rather than monetary policy. Although market sentiment may be racing ahead of hard improvements in economic data, GSAM thinks the Trump administration ultimately will be successful in pushing through its pro-growth agenda. The administration’s target of 3 percent to 4 percent economic growth is aggressive, but Kaiser added that even 2.5 percent to 3 percent growth would have an enormous impact on federal budget finances.