World markets are still reeling from the impact of the U.K.’s decision to withdraw from the European Union. Since the British exit, or Brexit, referendum in late June, investors have been seeking safe havens and pouring money into U.S. government bonds, driving down the yield on the ten-year Treasury notes to its lowest ever daily closing level, 1.37 percent, in early July.
Adding to the sense of uncertainty are conflicting signals about the strength of the U.S. economic recovery. In June the U.S. Federal Reserve lowered its forecast for real gross domestic product growth by 0.2 percentage point, to 2 percent, and opted not to raise interest rates, although Fed chair Janet Yellen did indicate that further rate hikes are likely this year.
The question is, when?
“We assign a 25 percent chance that the next Fed move will be a 25 basis point rate hike at the September meeting and a 40 percent chance that the next move will be a hike at the December meeting,” declares Jan Hatzius, chief economist at Goldman, Sachs & Co. in New York. “With little chance of hikes in either July or November, this means that our subjective cumulative probability of at least one hike by year end is around two-thirds.”
Hans Redeker, Morgan Stanley’s global head of foreign exchange strategy, disagrees. “We expect the Fed to leave rates unchanged for this year and for the entire 2017,” the London-based analyst says. “Inflation expectations have not rebounded, and import prices have come down sharply.”
The central bank will likely miss its implicit 2 percent inflation target, he adds, even though the economy is operating near full employment.
“The worst thing the Fed could do is to engineer an early rate hike, which would push real rates up and undermine investment,” Redeker maintains.
In such turbulent times money managers are understandably eager for advice and guidance on the best ways to position their portfolios, and when it comes to U.S. credit markets, no firm is held in higher regard than J.P. Morgan, which captures first place on Institutional Investor’s All-America Fixed-Income Research Team for a seventh consecutive year. Its analysts claim places in 50 of the 58 sectors that produced publishable results. That’s an increase of one over last year’s total.
Bank of America Merrill Lynch holds steady in second place for a fifth year even though its team total falls by five, to 40. Wells Fargo Securities repeats at No. 3 despite its total jumping from 28 to 33. Rounding out the top five, with 25 spots apiece, are Barclays — its rank and total are unchanged from last year — and Goldman Sachs, which rises one rung after picking up five positions.
Eleven firms appear this year, which marks the 25th anniversary of the survey. Click on the Leaders link in the navigation table at right to view the full list.
To see the top-ranked analysts and teams in each sector, click on the Best Analysts of the Year.
Hatzius, who leads the Goldman Sachs team to victory in Economics for a fifth year running, is less optimistic than the Fed when it comes to U.S. economic expansion. “Our forecast for annual average 2016 real GDP growth is 1.9 percent,” he reports. “We shaved 0.25 percentage points from the annualized growth rate for the third and fourth quarters immediately after the referendum, from 2.25 percent to 2 percent in both quarters, but that did not change the annual average number after rounding.”
But he does believe Treasury yields will recover. “We expect a gradual increase in ten-year yields to around 2 percent by year end as the markets build in a gradual normalization of monetary policy, inflation edges higher and the economy continues to grow above trend,” the economist contends.
In the meantime, money managers will have a tough time finding yield — but there are options, according to J.P. Morgan’s Matthew Jozoff, who co-leads top-ranked teams in Fixed-Income Strategy (with Alex Roever) and Residential Mortgage-Backed Securities Strategy/Agency (with Brian Ye).
“The low-yield environment has been challenging for all investors, whether they’re hedge funds trying to generate attractive absolute returns or insurance companies trying to outperform their own liabilities,” the New York–based analyst observes. “With little yield available globally, spread product has been a magnet for many types of investors, with credit showing some of the best returns year to date despite the volatility from Brexit and other events. In fact, with yields at such low levels, some investors have even discussed looking at spread products as a yield multiple of Treasuries, rather than as a spread over Treasuries.”
Mortgage-backed securities in particular, Jozoff adds, have proved especially popular. “Foreign investors have been surprisingly strong, most likely reacting to the relatively high yields in the U.S. compared to other parts of the world, and spread products have been a beneficiary of this demand,” he explains. “Banks have also been solid net buyers in the first half of the year, particularly in MBS. Despite staying on the sidelines earlier in the year owing to low absolute yields, banks have turned to MBS for incremental spread as well as for liquidity.”
Including taxable instruments in a portfolio is certainly understandable, but there are also plenty of moneymaking opportunities with municipal bonds, according to Jozoff’s colleague Peter DeGroot, who captains the crew at No. 1 in Municipals Strategy for a fifth straight year.
“The surprising results of Britain’s referendum vote drove relative safe haven asset prices higher around the globe, and municipals were no exception,” he notes. “We expect this trend will continue, to the extent that global government yields remain low and central bank policy is supportive, as municipals should benefit from sustained inflows, compressed credit spreads and outperformance in the longer portion of the curve.”
A consistent flow of institutional investment capital is essential for extending the market’s steady compression of risk premiums going forward. “Credit spreads in the longer dated, A-rated portion of the municipal market have tightened by 10 to 15 basis points, on average, over the past year,” the New York–based strategist says. “In comparison to average spreads over the past ten years, current long A-rated benchmark spreads are about 10 basis points tighter or about 0.5 sigma, reflecting only marginally rich valuations.”
Longer-dated triple-B benchmark spreads have contracted even more, DeGroot affirms, narrowing by approximately 30 basis points over the past year, to an average of 70 basis points — roughly 45 basis points below than their ten-year averages. “On balance, we expect further tightening with continued inflows through year end, as the low-yield environment drives investors into lower-rated and longer-dated securities in search of incremental return,” he predicts.
DeGroot and his teammates are urging clients to remain in long-duration and yield-oriented products, at least through the end of the year. “While we all know that markets don’t move in one direction ad infinitum, the fundamental and technical backdrop that resulted in record low ten-year and 30-year investment-grade municipal yields is projected to persist through at least this summer’s heavy reinvestment period and potentially through all of 2016,” he says. “Going forward, the long end will likely benefit from already-high cash levels as well as increasing fund inflows and demand for higher-yielding assets.”
Moreover, supply should be plentiful. Although long-term gross issuance in the first half was about 3 percent less than for the same period last year, at $219 billion, “we expect that supply in the second half will pick up dramatically as the pool of refunding candidates increases, and our forecast for longer-dated tax-exempt yields is well below yields in the second half of last year,” DeGroot points out. “Based on expected increases in both refunding and new money issuance over the second half, our modal projection for full-year 2016 issuance is $435 billion, or 9 percent above 2015 full-year issuance of $398 billion.”
The impact of Brexit is also being felt in forex markets, although Morgan Stanley’s Redeker believes that forecasts of dollar-pound parity by year end are overstated. “We are GBP bears and see GBP-USD testing 1.25,” he says. “We calculate the fair value of GBP-USD at 1.35 and suggest 1.25 offers a sufficient valuation advantage to trigger investment inflows.”
The pair’s rate stood at 1.32 in mid-July.
In the near term, Redeker and his associates — Morgan Stanley rises one rung to finish in first place for the first time in Currency/Foreign Exchange — recommend “buying high-yielding emerging-markets FX as the Fed stays put and trade indicators suggest better EM growth numbers,” he says.
They’re also keeping a close eye on Japan. “We like buying the yen later this month when it becomes clearer what the new monetary-fiscal mix in Japan is going to be,” the team leader explains. “We think the Bank of Japan will rely on old instruments, which are insufficient to boost Japan inflation expectations. Higher inflation expectations are required to weaken real yields — without them, the yen will move higher.”
In mid-July the Japanese currency was trading at 1.05 to the dollar; by year end it will strengthen to 95, the analysts believe.
Likewise, they remain long-term bulls on the dollar despite some trouble on the horizon. “The anticipated 4 percent dollar downward correction over the course of this summer should be followed by another rally, ending in new historical highs,” Redeker insists.
The 2016 All-America Fixed-Income Research Team is based on feedback from nearly 1,900 portfolio managers and buy-side analysts at some 535 institutions that oversee an estimated $9.7 trillion in U.S. fixed-income assets.
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