The global economic environment is improving. Growth is running modestly above trend across many countries and regions, a phenomenon that has not occurred in many years. We have to look to periods before the global financial crisis of 2007-08 to find an expansion this broad-based. However, fixed income markets may be too optimistic that these favorable conditions can continue for an extended period.
In our view, the global economy must continue to operate in this narrow band of "just right" to support current credit market valuations that remain elevated. Should growth momentum accelerate and break out above recent ranges, this would likely trigger more aggressive policy responses by global central banks. The resulting tighter monetary policy, delivered via higher policy rates and a faster withdrawal from quantitative easing, would likely hamper growth.
The global economy has recovered post crisis.
Monetary policy is becoming less expansionary.
Credit markets are becoming stretched and complacent.
Rethink your high yield with munis.
Now may be the time to upgrade your bond portfolios with three key actions.
After years of uneven and sluggish growth, the global economy has entered a period of synchronized recovery. Nearly every major developed and emerging economy experienced economic expansion in 2017, a trend that the International Monetary Fund expects to continue through 2018. GDP growth will likely be particularly strong in the developing world, with China, India, Indonesia and the Philippines all producing 5% or greater growth, according to IMF projections.
Europe's surprising turnaround is also likely to continue, with the euro-zone economy expected to grow nearly 2% in 2018, according to the IMF. As the world's economies strengthen, unemployment rates have declined. In the European Union, the jobless rate has fallen from a post-crisis high of 11% to 7.3% as of December 2017, the most recent data available. In the U.S., the unemployment rate has declined from 10% to 4.1% as of December 2017.
Since the financial crisis, central banks have expanded their balance sheets to unprecedented levels. These banks became the largest buyers of bonds and other securities as a way of increasing money supply to boost struggling economies. The three major central banks increased securities held on their books from around $4 trillion at the beginning of 2008 to more than $14 trillion in 2017.
Now, as the global economy improves, some of them are beginning to move in the other direction. The Fed began shrinking its balance sheet in October. The European Central Bank began trimming its purchases of securities in January. With the Fed stepping away from its role as the largest buyer of securities, the risk of a modest rise in yields cannot be ruled out.
The recent strength across global markets has translated into higher valuations across most asset classes. Many of the world's equity markets achieved or neared multiyear highs in 2017, pushing valuations toward their highest levels in 15 years. But stocks aren't the only asset class whose valuations appear stretched. High-yield and corporate bond returns too have been robust, leaving credit spreads at their tightest levels in years.
As market levels have risen, complacency appears to have settled in. Equity market volatility, as measured by the VIX index, has fallen to historically subdued levels, as has volatility across fixed income markets. In fact, heading into the start of 2018, volatility was lower in the post-crisis period than pre-crisis. While subdued volatility may be welcome, it cannot continue indefinitely.
With the global economy warming up and the Fed tightening monetary policy, long-term interest rates are likely to rise in 2018, though perhaps more modestly than many investors anticipate. Indeed, history shows that rates can remain lower for longer.
Following two previous significant economic dislocations, long-term yields remained below 4% for more than 30 years. During the current cycle, 10-Year Treasuries have only been that low for 10 years. What's more, higher yields in the U.S. relative to other developed markets should continue to support demand for U.S. Treasuries, restraining the pace of any rise in rates.
As the Fed continues on a path of gradually raising interest rates, many investors are moving to cash, short-term bonds and floating-rate securities. But the view that bonds have to suffer losses when short-term rates rise is a myth. Looking at the past seven periods of interest rate hikes, including the current period, investment-grade bonds (BBB/Baa and above) have generally delivered positive returns in five of those periods, as can be seen from results for the Bloomberg Barclays U.S. Aggregate Index.
If rate hikes are gradual, interest earned by bonds can overcome the price impact to deliver a positive return. Indeed, since the Fed began on its current course of rate hikes, the index has gained more than 6%, even as the Fed funds target has risen by 125 basis points. The Fed has signaled that it will maintain a gradual pace in raising rates and tightening monetary policy. Against this backdrop, interest rates will likely remain range bound. Core bond returns have been positive in five of the last seven periods of Fed hikes.
Municipal bonds are sometimes viewed as vulnerable amid rising interest rates. And yet, the past two years have shown that the asset class can provide solid returns when rate increases are modest and gradual — an environment that appears likely to persist. Also, demand for tax-advantaged income is unlikely to diminish. That said, valuations have been elevated. Greater emphasis on bonds of higher credit quality is one way investors can prepare for more mixed market conditions.
The asset class offers diverse income opportunities across sectors. For instance, toll roads are an area where research can uncover value by assessing prospects in a way that reflect risks associated with financing, operation and the regional economy. Consolidation among not-for-profit hospitals is creating great return potential. Look out for opportunities if uncertainty around the future of health care reform or the Trump administration's infrastructure plans prompts volatility and creates favorable entry points.
To help your bond investments successfully diversify your broader portfolio from equities and provide capital preservation, consider upgrading the majority of your fixed income investments to true core bond funds. These include high-quality funds with modest credit and interest rate risk run by managers who do not engage in style drift and consistently aim for low correlation to equities. This should help to stabilize your portfolio when equity volatility hits.
Income is an important function of a bond allocation. However, not all types of fixed income funds that aim for higher yield are equally effective in all environments. With credit valuations stretched and the U.S. well into its economic cycle, high-yield corporate bonds pose outsize downside risk when an equity correction hits. Funds that focus on other bond sectors like emerging markets debt and high-income municipal bonds could be better alternatives in this environment with higher credit quality and lower correlations to equities.
Owning inflation protection can preserve purchasing power. Inflation protection securities that are government issued trade one-for-one with the Consumer Price Index. So, as inflation rises, you have that protection, and it is a government security. This can provide good diversification from the equity market. Although inflation has been low in recent years, after nearly $15 trillion of quantitative easing over a decade and increasing wage pressure, it could finally begin to rise as the U.S. economic cycle advances.