Global Investment Strategy
Global Fixed Income Strategy Report June 6, 2017
Analysis and outlook for the fixed income market
Brian Rehling, CFA Co-Head of Global Fixed Income Strategy
» As we enter midyear, the Federal Reserve (Fed) is preparing for more interest-rate hikes, while many developed-market bond yields abroad remain negative. As central-bank policies continue to diverge, we have adjusted our year-end targets to reflect the Fed’s current rate-normalization plans.
George Rusnak, CFA Co-Head of Global Fixed Income Strategy
» Investors should expect more change in fixed-income markets in the second half, and should remain focused on key investing disciplines, including rebalancing and retaining broad geographic, asset class and sector diversification. What it may mean for investors » We recommend positioning portfolios for a rising-rate environment, by moving up in credit quality, maintaining a neutral fixed-income duration profile, and considering the use of premium bonds to help cushion the potential impact of rising rates.
Stay Focused Amid Change Investors may have felt that the bond market was on the precipice of a significant paradigm shift in the first half of 2017. The Fed raised expectations for the number of interest-rate hikes in 2017 and began discussing the possibility of balance-sheet reductions. Swings between fiscal optimism and disappointment toyed with bond investors’ emotions. Bond prices reacted as investors added or reduced risk based on sentiment and economic developments. Extraneous events may continue to provide periods of uncertainty that drive Treasury yields lower during the second half of 2017. However, we look for yields to slowly trend higher over time as the bond market focuses on a more positive forward-looking economic picture. With this outlook in mind, we have fine-tuned our year-end Treasury yield targets and increased our Fed rate-hike forecast. The Fed appears intent on raising shortterm interest rates two more times this year. Our new year-end federal funds target rate forecast is 1.25 1.50 percent. We have increased our 10-year Treasury yield target range by 0.25 percent; our new range is 2.25 - 2.75 percent. We also have increased our 30-year Treasury yield target range by 0.25 percent; the new range is 3.00 - 3.50 percent. Reshaping the Fed’s Balance Sheet The Fed has signaled that it is rethinking its balance-sheet reinvestment strategy, and a change could come later this year. A reduction in the size of the Fed’s balance sheet would be a form of monetary tightening. It also would mark a milestone in the return to a more normalized monetary policy. Although a balance-sheet reduction would generate significant media attention, we do not anticipate lasting bond-market disruptions as a result. We do not expect the Fed to sell securities outright; rather, we expect it to reduce its rate of reinvestment. We also look for the Fed to pause or slow its pace of
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Global Investment Strategy—|—Stay Focused Amid Change—|—June 6, 2017
interest-rate hikes once it begins quantitative tightening. We urge investors to focus on the bigger picture of a maturing economy and normalized monetary policy. Chart 1. Narrower Yield Differential between High-Yield Debt and Treasury Securities Brings Risk
Sources: Bloomberg, Wells Fargo Investment Institute. Dates: 8/15/2000 – 4/19/2017. One basis point is equal to 1/100 of 1 percent or 0.01 percent. One percent equals 100 basis points. Past performance is no guarantee of future results.
Be Wary of Credit Risk Lower-quality bonds have had a great run; the Bloomberg Barclays U.S. Corporate High Yield Bond Index rose more than 17 percent in 2016. In our view, the opportunity for meaningful upside performance in high-yield bonds has lessened, although we believe a solid economy will prevent negative returns in the latter half of 2017. That said, downside risk often materializes with little notice. Given the relative value across the credit spectrum, we favor moving up in credit quality and recommend that investors hold an underweight allocation to high-yield debt. The Risk of Open Positions at the Fed President Trump will have the opportunity to fill three open Fed governor positions this year, giving him the chance to meaningfully reshape the Federal Open Market Committee. In addition, we look for President Trump to nominate a new Fed chair during the second half of 2017 to replace Janet Yellen when her term ends in February 2018. The sheer number of changes could create uncertainty, which is rarely good for the bond market. Clear communication from the administration could help allay fears. There is also the possibility that Chair Yellen might be renominated, which would provide some assurance of continuity. Major Risks to Our Outlook After President Trump’s election, investors traded on the assumption that his policies would reignite growth and inflation—the so-called reflation trade. That trade faced some growing pains, if not outright skepticism and doubt, in early 2017. For example, the Treasury yield curve flattened over the first half of 2017 after previously steepening in late 2016. While not our base-case expectation, additional curve flattening would be a risk not just to our fixed-income targets but also to our call on continued economic growth.
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Global Investment Strategy—|—Stay Focused Amid Change—|—June 6, 2017
Investor Implications As market conditions continue to change in the remainder of 2017, it is especially important for investors to remain focused on the key investing disciplines of rebalancing, globalization and diversification (by asset class and sector). We believe that this is an appropriate time to position portfolios for a rising-rate environment, by moving up in credit quality, maintaining a neutral duration profile for fixed-income holdings, and considering the use of premium bonds to help cushion the potential impact of rising rates. Investors also should be attentive to risk in lower-grade sectors of the market, as relatively tight yield spreads have injected increased risk into the high-yield space. As noted, we prefer higher-quality bonds at this point in the interest-rate cycle, including U.S. taxable investmentgrade bonds and U.S. intermediate-term taxable bonds. We also retain our underweight recommendation for international developed-market debt and our evenweight position for U.S.-dollardenominated emerging market debt. We encourage broad geographic diversification as central-bank policies continue to diverge.
Risk Factors Investments in fixed-income securities are subject to market, interest rate, credit/default and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. Because bond prices generally fall as interest rates rise, the current low interest rate environment can increase the bond’s interest rate risk. Credit risk is the risk that an issuer will default on payments of interest and principal. This risk is higher when investing in high yield bonds, also known as junk bonds, which have lower ratings and are subject to greater volatility. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity. Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets.
Definitions Bloomberg Barclays U.S. Corporate High Yield Bond Index covers the universe of fixed-rate, noninvestment-grade debt. An index is unmanaged and not available for direct investment.
Disclaimers Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company. The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Wells Fargo Advisors is registered with the U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors. Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company. CAR 0617-00723 © 2017 Wells Fargo Investment Institute. All rights reserved.
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