The fixed income markets have delivered surprisingly positive returns year to date, leaving many investors somewhat perplexed. To help shed some light on the market, we asked John Flahive, head of fixed income for BNY Mellon Wealth Management, to share his views on the current economic environment, what we may see from the Federal Reserve in 2017 and what lies ahead for the bond market.
Before we dive into the fixed income market, what is your perspective on the most important macro factor influencing the capital markets in 2017 and beyond?
In my view, there has not been a time in which politics were so intertwined with the capital markets. Since the U.S. presidential election in November, the markets have been extremely sensitive to the possibility of new policies and reforms.
Immediately following the election, we identified six major reforms, three of which would likely be good for the economy and equity markets: tax reform, infrastructure spending and deregulation. But, if the administration focused on health care, immigration and trade reform, there would likely be some negative impact, particularly depending on which order Congress and President Trump chose to tackle these policies. Specifically, I felt that taking on health care first, as opposed to tax reform or infrastructure spending, would be too time consuming and controversial, especially given the focus of repealing and replacing the Affordable Care Act.
The ongoing struggles to push health care reform through have created more uncertainty regarding the administration’s ability to accomplish some of its other policy initiatives. Even if Congress focuses on those policies expected to be more positive for the economy, the complicated nature of this type of legislation will most likely delay passage until late 2017 at best, and possibly even 2018.
Consequently, our expectation for U.S. real GDP is for only a slight increase to 2.2% for 2017 and 2.5% for 2018, up from 1.6% for 2016. We received a weak reading on first quarter GDP, which was somewhat anticipated, but we continue to expect a modest increase in economic activity as the year plays out. This influences how we think about monetary policy, interest rates and the fixed income market at large.
At the March meeting, the Fed increased short-term interest rates by 25 basis points, with many projecting another two or three increases this year. What are you forecasting?
I would not be surprised if the Fed only increased rates twice in 2017, which is a bit controversial as most people expect three or even four increases by the end of the year. I did not expect the Fed to increase rates as early as March; however, in retrospect, I believe this was a good move. If an event in Europe or Asia had impacted global growth, the Fed could have missed its chance to increase short-term rates.
Looking ahead, the Fed may very well raise rates again in June, but I would not be overly surprised if it holds off until later this year. Regardless, the Fed will continue to reiterate its policy of gradual and moderate increases in short-term rates, thereby transitioning from extremely accommodative monetary policy to just accommodative.
Given the recent increase in short-term rates, what are the ramifications for intermediate- and long-term interest rates?
I have long believed that as the Fed increases short-term rates, yields across the curve will not move higher by the same amount. Short-term rates have risen, while longer-term rates are lower or about the same as where they were a year ago. Typically, longer-term bonds are more sensitive to a change in interest rates. But currently, in an environment where the yield curve is flattening, investors would be better off owning long-term securities, or a combination of long- and short-term bonds, compared to owning just intermediate-dated securities.
Our expectations for interest rates this year are not much different than 2016 or 2015. The path of least resistance is for slightly higher interest rates going forward, although potentially moving in a broader range than we have seen in recent years. With that being said, we try not to be overly predictive because there are many factors that can cause intermediate- and longer-term interest rates to stay low, or move even lower. I believe U.S. intermediate- and longer-term rates are tethered to global rates. Therefore, any geopolitical event or global economic disruption that drives global rates lower will pull our domestic interest rates lower again, similar to what happened last summer with Brexit.
What are your views on some specific sectors within fixed income?
We have long recommended a diversified fixed income approach that combines core fixed income holdings with more targeted satellite strategies. For upper tax bracket investors, the core portion typically consists of intermediate maturity, high quality and tax-free bonds. However, we also believe investors should incorporate a variety of strategies (satellites) that add sources of diversification and income. Satellite strategies include high yield, emerging market debt or more flexible strategies. They are typically more risky than the core strategies, and thus, it is important to actively manage their exposures, sometimes adding to, trimming and even eliminating strategies as market conditions change.
In the current environment, our favored satellite strategies are floating rate high yield loans and “go anywhere” strategies because they both can provide additional income with less interest rate risk. Unlike other bonds, the interest rate on high yield loans is tied to short-term rates, such as U.S. Treasury bills, three-month Libor rates or the federal funds rate. So, if the Fed continues to increase the fed funds rate over the next few years, the yield on floating rate high yield loans should capture those higher rates and act as a hedge to core fixed income holdings.
Another strategy we are considering is local currency emerging market debt. The dollar’s strength has softened somewhat this year Should the dollar weaken further, emerging market debt may emerge as the best performing asset class in fixed income. Because local emerging market debt has already delivered strong returns over the last year, I would advocate buying on weakness. Additionally, opportunistic funds, by definition, are benchmark agnostic and they too can provide low interest rate sensitivity and low correlation to an investor’s core fixed income holdings.
Despite having a somewhat challenging 2016 overall, particularly a very difficult fourth quarter, we still believe municipal bonds are appropriate for the core position for upper tax bracket investors. Although some are concerned about credit deterioration from underfunded pension liabilities, this problem is not widespread. It does raise the need for an actively managed approach that includes researching the underlying municipalities in order to identify those with stronger credit. In addition, tax reform is another overhang for municipal bonds, but the market has appropriately priced in that risk and I do not believe municipal bonds will completely lose their tax-exempt status.
How do BNY Mellon Wealth Management’s views on interest rates and the broader market environment shape its investment approach?
For the eighth year in a row, our investment committee continues to believe that equities will outperform fixed income. As a result, we recommend an overweight to equities and an underweight to fixed income.
We recognize that interest rates are still very low. Consequently, we expect lower total returns over the next three to five years, as rates move gradually higher. We expect total returns to be around 3%, compared to the roughly 5% annual returns experienced between 1995 and 2010. However, investors should maintain a fixed income allocation (albeit underweight) to help anchor portfolios during times of equity market volatility. In addition, we believe alternative or low-correlated investments, such as long/short equity hedge funds, absolute return and managed futures can also act as buffers and diversifiers for the overall.
The most important message I would give investors is sound diversification. It’s needed across the whole portfolio, as well as within an investor’s fixed income allocation. As we watch for policy changes out of Washington, we will carefully monitor their impact on the economy, the path of interest rates, and the equity and fixed income markets at large. We will continue to rely on our disciplined active management approach, and position portfolios to navigate this challenging environment in order to help investors reach their goals.