Negative interest rates in Europe and Japan and a strong US dollar have provided questionable economic benefits and investors appear increasingly focused on the potential negatives. As a result, we expect a truce in the “currency war” and a transition in the global policy regime toward more emphasis on domestic demand. We think this environment--where policy remains highly accommodative but perhaps less disruptive--is positive for selective exposure to corporate bonds, emerging market debt and other higher yielding sectors of the fixed income market.
Over the next 12 months, our central case is essentially a continuation of recent trends: 1) modest global economic growth with 2) extreme monetary policy measures helping to support gradual improvement in Europe and Japan, against 3) a backdrop of rising US inflation, rising debt in China and unpredictable politics. Over the longer term, we think fundamental risks are growing and the volatility in the first quarter adds to our sense that market sentiment is fragile. As a result, we are biased to smaller, more nimble positioning with an emphasis on higher credit quality.
- We think global growth remains stuck in low gear. After a modestly stronger year for the US, Europe and Japan in 2015, we expect some softening in 2016.
- US domestic inflation risks are growing. The Federal Reserve (Fed) continues to downplay US inflation risks and has lowered its projections for rate hikes. However, with the US labor market nearing the Fed’s estimate of full employment and measures of core inflation rising steadily, we think ;the market is underestimating the path of Fed hikes.
- China’s commitment to growth targets may raise longer-term risks. China appears to be prioritizing its growth target rather than reforms. In the near-term, we think this is supportive for financial markets but liquidity-fueled debt growth seems unsustainable and could create bigger risks over the longer term.
- The oil market could move into better balance later this year. The oil market remains a key driver of financial markets and we remain cautious about the outlook. However, we think US supply and demand are turning more supportive for oil prices and shale producers probably have less ability to respond quickly to higher prices than markets may be assuming.
- We expect more demand for yield and less fear of default. In the environment we foresee over the next few months, we think investors are likely to worry less about rising corporate default risk and focus more on the higher yield potential in corporate credit and emerging market debt. We also see valuations in these sectors as attractive relative to the fundamental risk. However, we are increasingly cautious about the longer-term outlook and more likely to favor smaller, more diversified risk exposures and more nimble positioning.
