Political Risk and Returns

Transcription

1 Fixed Income 1st Quarter 2017 Global Fixed Income Outlook Political Risk and Returns Executive Summary The new year offers contrasting perspectives on the global macro environment, starting with exuberance in markets and trepidation on the political front. At this uncertain juncture our strongest convictions are: 1) the US economy has the best potential to strengthen in 2017; 2) divergence is reaching an extreme, driving significant repricing across rates markets; and 3) volatility is likely to trend higher. In our view, these developments point to more opportunity for alpha generation in the coming months, though directional risks have increased. The US policy outlook is reflationary and global rates are responding. Animal spirits John Maynard Keynes term for the confidence to invest that is essential for growth have rebounded since November s election and, in the early days of the Trump Administration, sentiment may have a bigger impact than actual policies. An agenda of fiscal expansion, deregulation and potential trade protectionism, combined with a narrowing output gap, poses upside risks to US inflation. We are biased to underweight US rates and agency mortgages and favor the US dollar and inflation-linked securities. Monetary policy divergence is pushing to extremes. Based on the likelihood of fiscal stimulus, we see the Federal Reserve raising interest rates three times in 2017, provided financial conditions don t tighten too much. Central banks in Europe and Japan are likely to continue looking for ways to extend their easing programs. As a result, we expect to see more opportunities in the divergence of US and European rates, though demand for higher-yielding US assets may limit the differential. This is a supportive backdrop for risk assets, but we believe the risks are balanced. Markets have priced in much of the positive growth outlook, and they still face the challenge of rising rates. We see selective opportunities in emerging markets as we think they are unlikely to decouple from strengthening US and global growth. We also see pockets of value in corporate credit, though we are wary of a pickup in defaults at this late stage of the cycle. The losers in this scenario are debtors most exposed to rising rates and those reliant on external demand. We are cautious on heavily indebted issuers sovereign or private sector with funding cost pressures. More-open economies and current account deficit nations may also be vulnerable, though we believe most emerging markets have become more resilient since the Taper Tantrum. We see risks and potential opportunity in volatility stemming from political and policy uncertainty. France and Germany hold elections in 2017 against a backdrop of rising nationalism. Europe s immigration debate and the process surrounding the UK s exit from the European Union (EU) have potential implications for the political and monetary union. In addition to the policy uncertainty surrounding China, we are now alert to the potential global impact of a more confrontational US stance on trade and international security, and an unorthodox policymaking style. The economic and market forecasts presented herein have been generated by GSAM for informational purposes as of the date of this presentation. There can be no assurance that the forecasts will be achieved. Past performance does not guarantee future results, which may vary.

2 Growth Outlook We expect global growth to pick up in 2017, led by the US and Japan, in line with the recent rise in global manufacturing indexes to a three-year high. The US labor market continues to strengthen, thereby supporting domestic consumption, and we see some additional stimulus from proposed fiscal expansion. In Japan, innovative monetary policy and modest fiscal stimulus will continue to provide a supportive backdrop for growth. In China, debt levels are unsustainable and we see risks rising due to the potential for policy missteps and geopolitical tensions. In Europe we expect political developments to weigh on the growth outlook, as populist forces have risen ahead of a series of elections and the UK begins the formal separation process (Brexit) from the EU. We expect US growth to accelerate in the near term, driven by strong domestic demand and fiscal easing, but we remain alert to geopolitical risk. The US economy was strengthening prior to the election, but proposed fiscal stimulus and loosening regulations present additional tailwinds. We see growth picking up to 2.3% in In the near term, consumption will be underpinned by rising wages amid a labor market close to full employment. We also see scope for marginal improvements in investment, as the strains of last year s commodity price weakness and currency strength begin to fade. That being said, we are alert to policy-related risks and potential geopolitical tensions associated with a Trump presidency, largely arising from his anti-globalization stance. In China we see risks from unsustainable debt growth and uncertainty ahead of the leadership transition. We expect growth to slow to 6.3% in 2017 from 6.7% last year, due to moderation in the property market, a weaker outlook for exports and the expiry of the tax cut on auto purchases. Consumption has stabilized, but at lower levels. We believe that policymakers are prepared to act swiftly to support growth and preserve stability ahead of the November leadership transition, but their reliance on credit expansion could exacerbate existing problems. We also see potential for increased volatility arising from trade and foreign policy tensions with the US. We expect uncertainty surrounding political events to weigh on euro area growth and inflation in We see growth slowing from 1.6% to 0.8% in 2017, though political uncertainty and the impact of Brexit pose additional downside risks. While we think a break-up of the monetary union is unlikely in the foreseeable future, we believe that rising populist influence poses a significant risk to European cohesion. Inflation lacks momentum and although overall unemployment is declining, youth unemployment remains high. As a result, we think the European Central Bank (ECB) is unlikely to withdraw monetary stimulus before Japan s economy appears stronger heading into 2017, though consumption remains weak. Japanese growth has potential to surprise to the upside, and our forecast is for 1%, up from 0.7% in The recent advance has been led by an improvement in net exports and investment in housing. However subdued wage growth expectations and weak consumer confidence are creating headwinds for consumption. Inflation is likely to rise in 2017 due to energy base effects and currency weakness, but it remains well below the Bank of Japan s (BoJ) 2% target. We expect the Quantitative and Qualitative Easing with Yield Curve Control framework, which aims to tether the 10-year yield, to remain in place for some time. We expect Brexit negotiations to weigh on UK consumption and investment this year. Despite its resilience after the referendum, we think consumption could slow if sterling weakness boosts inflation and depresses real incomes. We expect the formal legal process for exiting the EU to start by the end of the first quarter, and uncertainty throughout the negotiations could weaken investment materially. The Bank of England (BoE) faces the prospect of higher inflation due to currency weakness and recovering oil prices, and weaker growth as the implications of Brexit begin to play out. We do not expect additional near-term easing and believe the BoE will tolerate a short-term inflation overshoot. We expect growth of 1.2% in 2017 and we see inflation rising to 2.9%. 2 Goldman Sachs Asset Management

3 Trumponomics: Near-term Gain Markets expect a reversal of the regime of tight fiscal policy, loose monetary policy and expanding regulation that has persisted since the crisis. The broad implications are supportive of the dollar and negative for US Treasuries and agency mortgages, which are particularly sensitive to volatility. The market reaction to Trump s November election victory showed how his policy agenda with its emphasis on fiscal expansion and deregulation lends itself to a positive interpretation. If this robust sentiment translates to stronger domestic demand, we think US growth could surprise to the upside in the coming months. However, the longer-term outlook is clouded by uncertainty over which aspects of Trump s campaign platform will be put into action, and how. As was the case with Abenomics in Japan, we think this initial reflationary trade may be overestimating the near-term economic gains and underestimating potential challenges further down the track. The recent equity index gains point to a revival of animal spirits, similar to the market s initial response to Prime Minister Shinzo Abe s reflation strategy in This risk-on trade reflects expectations for a reversal of the regime of tight fiscal policy, loose monetary policy and expanding regulation that has persisted since the crisis, and arguably constrained growth. The broad investment implications in the near term are supportive of the dollar and negative for US government securities and agency mortgages, which are particularly sensitive to volatility. In risk assets, this investment backdrop is positive for sectors that benefit from less oversight and/or a steeper yield curve, such as energy and financials. High Debt/GDP May Discourage Substantial Fiscal Expansion US Debt Held by the Public (% of GDP) Actual Projection based on Current Law Projection based on Trump Proposals Reagan Tax Cuts Bush Tax Cuts Trump Proposed Tax Cuts '70 '75 '80 '85 '90 '95 '00 '05 '10 '15 '20 '25 Source: Congressional Budget Office for actual and projection under current law, as of August 2016; Committee for a Responsible Budget for projection based on Trump Proposals, as of September We think the potential downsides of a Trump presidency are yet to be priced, such as his protectionist stance on trade. In the near term we see the benefits of a strengthening US economy outweighing some of these concerns. We see value in the Mexican peso given the country s growth prospects. Longer-term Outlook Is Clouded The coming months will bring more clarity on the new Administration s priorities, as discussed in our 2017 Investment Outlook ( Trump s First 100 Days ). We expect a substantial commitment to tax reform, including a lower corporate rate. However, given the GOP leadership s aversion to deficit spending, infrastructure spending may be delayed beyond 2017 and fall significantly short of expectations raised in the campaign. Heavyweight fiscal stimulus akin to President Ronald Reagan s effort in the early 1980s or Bush s tax cuts in 2003, when debt/gdp was around 30% and 60%, respectively, is probably less palatable today with that ratio around 75% 1 (see chart). The proposed regulatory rollback including the repeal of financial and environmental legislation has already inspired rallies in the financials and energy sectors. We think the unwind may take longer than some anticipate, though even a moratorium on new rules could support domestic investment. In the case of the Affordable Care Act, uncertainty over its replacement may weigh on the healthcare sector. Amid the risk asset rallies, the potential downsides of a Trump presidency are yet to be priced outside Mexico at least. We think markets are underestimating the sincerity of his protectionist stance on trade, which poses risks alongside his isolationist stance on foreign policy and his 1. Federal debt held by public, source Congressional Budget Office, as of Goldman Sachs Asset Management 3

4 unconventional leadership style (see p. 6). While we are on the alert for escalating political risks, in the near term, we see the benefits of a strengthening US economy outweighing some of these concerns. We still see value in the Mexican peso, based on our view that it is undervalued given the country s growth prospects. From a US perspective, we see risks to multinational companies if Trump seeks to unwind the regulatory rules that have enabled US firms to operate globally. We also see some idiosyncratic risk stemming from Trump s current strategy of naming and shaming companies whose actions he disapproves of via Twitter. This approach is inconsistent with the GOP s broader business-friendly stance and may create uncertainty that could curb capital expenditure. Reflation and Rising Rates After many years of a lower for longer regime, we see yields on government bonds rising to compensate for a more typical inflation environment. We see more opportunities to generate returns if valuations are responding more to traditional market drivers. We are biased to underweight Treasury securities and agency mortgages, and favor inflationprotected securities and we see further opportunity for relative value trades. Our dominant investment theme of divergence is pushed to extremes this year, with the Fed picking up the pace of hikes, while central banks in Europe and Japan look for ways to prolong easing. One positive development from both an investment and an economic perspective in 2017 is we believe the US recovery and policy tightening has led to a tipping point for global repricing in rates. After many years of a lower for longer regime, we see yields on government bonds rising to compensate for a more typical inflation environment (see our 2017 Investment Outlook, Stagnation to Inflation ). The corresponding normalization of rates should facilitate economic growth and, from an investment perspective, alpha generation. If rates are rising to reflect strengthening growth and higher inflation expectations over time, the resulting curve steepening contributes to a virtuous cycle for the economy. Higher interest rates motivate banks to lend, supporting consumption and investment. And we see more opportunities to generate returns if valuations are responding more to traditional market drivers, and subject to volatility rather than captive to central bank policy. In this environment, we are biased to underweight Treasury securities and agency mortgages, and favor inflationprotected securities. We also see further opportunity for relative value trades in rates and currency markets that align with our expectations for divergence in growth and financial conditions across developed economies. Yield Curves Have Steepened in the Major Developed Economies 30-Year Yield Premium Over 2-Year Yield (basis points) 400 US France Germany Japan UK We see little reason for a sustained upward trend in European and Japanese rates. The contrast in policy, inflation and growth expectations should continue to support relative value trades in European and US rates in '12 '13 '14 '15 '16 '17 Source: Macrobond. The graph shows the difference between two- and 30-year government bond yields. As of January 6, Not the Great Reflate This normalization comes with caveats. First, it is primarily a US story, as we see little reason for a sustained upward trend in European and Japanese rates. While their central banks appear to have averted a deflationary spiral, inflation is still well below target and unlikely to get close in the foreseeable future. The ECB s December forecast put inflation at just 1.7% in 2019, which suggests a commitment to easing for at least two more years. That said, both the ECB and BoJ have found ways to artificially steepen their yield curves: the ECB by dropping the lower bound of eligible purchases from two years to one year, and the BoJ in its experiment with yield curve control, which tethers the 10-year yield at zero. 4 Goldman Sachs Asset Management

5 Second, as has been the case in recent years, we think demand for higher-yielding US assets may curb the increase in US yields. For instance, we anticipate more buying from Japanese investors and in long-dated sectors from liability-driven investors such as pension funds. On balance, though, we believe the contrast in policy, inflation and growth expectations will continue to support relative value trades in European and US rates in Consolidation of Momentum After several years of searching for inflationary signals, we see consolidation in US price pressures in Close-to-full employment, incipient wage growth and recovering oil prices will encounter a policy mix targeting fiscal expansion, deregulation and increased protectionism. Our expectation is for a moderate increase in inflation to around 2% in 2017 in line with the target based on our low expectations for infrastructure spending. We see rates adjusting higher in line with this outlook, and on the prospect of increased supply if the government resorts to heavier debt issuance to reconcile its plan for tax cuts and its spending objectives. While we don t anticipate an aggressive rebound in inflation, we don t think markets have fully priced the moderate scenario. We believe directional exposure to rising rates is among the biggest risks investors face in Some Borrowers More Vulnerable Than Others While we don t anticipate an aggressive rebound in inflation, we don t think markets have fully priced the moderate scenario. As a result, we believe directional exposure to rising rates is among the biggest risks investors face in Broadly speaking we see potential strains for borrowers in general sovereign or private that are highly leveraged and facing funding cost pressures. That said, an orderly pace of normalization shouldn t be disruptive and we see little danger of a Taper Tantrum rerun driving volatility across global markets, or triggering prolonged weakness in emerging markets. Emerging Market Balance of Payments Have Improved Since the Taper Tantrum EM Average Brazil Indonesia India S. Africa Turkey Among the so-called Fragile Five, current account deficits are narrower and foreign reserve coverage is generally better than it was in early The notable exception is Turkey, where we are positioned for further deterioration in the lira and local rates. Basic Balance (%) Source: Moody s, as of December The basic balance is a measure of the balance of payments that combines the current account and foreign direct investment. In our view, valuations in emerging markets heading into 2017 are less stretched than they were in And looking at the Fragile Five countries that were then considered the most dependent on foreign investment to support growth South Africa, Turkey, Indonesia, India and Brazil their current account deficits are narrower and their foreign reserve coverage is generally better than it was in early The notable exception is Turkey, where we are positioned for further deterioration in the lira and local rates. And while the alarming growth and magnitude of leverage in China s non-financials sector is a concerning weakness in the second-largest economy, we note that these companies are also mostly state-owned, so may be able to shift liabilities to government debt, which is still low by developed world standards. Tail Risks Proliferate Judging by market signals the current risk profile is essentially risk-on, but we believe valuations may already reflect a lot of the growth upside, and looking ahead the risks are more balanced. We think stronger growth and continued demand for yield could further extend the credit cycle, Goldman Sachs Asset Management 5

6 though we are selective at this late stage. Emerging markets have tended to be sensitive to risks associated with US interest rates and deteriorating global trade, but it s hard to envisage a total decoupling from strengthening US and global growth. Broadly speaking, we are alert to possible strains in a rising rate environment, and political risks that could offset more-favorable policy and economic developments. The Trump Effect Over the next few months, our positioning is likely to reflect the fiscal expansion theme in the US, focusing on rising government yields, a strengthening US dollar, and selective opportunities in cyclical US corporate credit. Later in the year, however, we think risk appetite could suffer from disappointment over the fiscal stimulus, and the potential for trade disputes and geopolitical tensions as the new Administration redefines US foreign policy and security arrangements. And we see a more volatile period ahead if some troubling aspects of Trump s platform are implemented. We are expressing our strong US dollar view primarily versus Asian currencies we consider most exposed to detrimental aspects of Trump s policies. These include Korea and Taiwan, as smaller open economies with substantial exports to the US and exposure to China s slowdown. Concerns about the stability of the monetary union have reinvigorated our relative value trades in core and peripheral sovereign markets, and we look for French yields to rise versus their German counterparts. In particular, we are less skeptical than some with respect to Trump s inclination to intervene in global trade, such as by imposing tariffs on imports, labeling China a currency manipulator or overhauling NAFTA, as his message on these issues has been consistent and he has some discretion to act via executive orders. Though China is the political focus of Trump s criticism, we don t anticipate much impact on China s economy from a moderate escalation in trade disputes, as it is self-funding, relatively closed and politically stable. We are expressing our strong US dollar view on a selective basis in Asian markets we consider most exposed to detrimental aspects of Trump s policies, including Korea and Taiwan, which are smaller open economies with substantial exports to the US and exposure to China s slowdown. Focusing on his protectionist leanings, while we don t expect a full-blown trade war, which would be punitive for American consumers, we see potential for selective application of tariffs in sectors such as autos and technology. We are also watching the progress of the proposal for a destination-based corporate tax with border adjustment, which could be detrimental for emerging market exporters that are heavily integrated into the production chains of US corporates. Strains in Europe s Union The first half of the year brings elections in the Netherlands, France and potentially Italy, followed by Germany in the second half, against a backdrop of rising hostility to mainstream political views. As discussed in our 2017 Investment Outlook ( Globalism to Populism ) we believe that more power in the hands of Nationalists could threaten the euro area project. While a win for far-right candidate Marine Le Pen in France s presidential election isn t our base case, we would consider it a blow to the monetary union. We think these political risks are underpriced in European markets, which are sedated by ECB policy easing. Though we don t expect a crisis in the near term, risks to the union s stability have reinvigorated our relative value trades in core and peripheral sovereign markets, and we look for French yields to rise versus their German counterparts. Moreover, these polls coincide with the first experiment in a withdrawal from the EU. We expect the negotiations over the UK s exit will be closely watched, and must be carefully handled to avoid further splintering. In light of our concerns over the impact of Brexit, we favor relative value positions anticipating further decline in the British pound versus the dollar and euro, though we think UK government bonds may weaken from expensive levels relative to the German market. We continue to see value in credit protection on China, given the higher risk of policy missteps in the effort to maintain stability in the leadup to the November 2017 leadership transition. China s Struggle for Stability The stabilization in economic activity and rapid policy response to signs of weakness in recent months has helped to allay concerns about a near-term crisis in China. However, we do see more potential for policy missteps in the effort to maintain stability in the lead-up to the November 2017 leadership transition. Policymakers continue to rely on credit expansion, on top of the existing unsustainable pace, to support growth. They are also still struggling to reconcile the competing objectives of opening the capital account, maintaining currency stability and the need for lower interest rates. As a result, we continue to see value in credit protection on China. Details are yet to emerge on many of the key transitions we identified in our 2017 Investment Outlook. We will provide updates of our views on the global policy and political environment as they evolve this year in forthcoming publications, including Macro Insights and our regular quarterly Outlooks. 6 Goldman Sachs Asset Management

7 Risk Considerations Investments in fixed-income securities are subject to credit and interest rate 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. 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. All fixed income investments may be worth less than their original cost upon redemption or maturity. Emerging markets securities may be less liquid and more volatile and are subject to a number of additional risks, including but not limited to currency fluctuations and political instability. The currency market affords investors a substantial degree of leverage. This leverage presents the potential for substantial profits but also entails a high degree of risk including the risk that losses may be similarly substantial. Such transactions are considered suitable only for investors who are experienced in transactions of that kind. Currency fluctuations will also affect the value of an investment. Investments in commodities may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity. One basis point is equal to 1/100th of a percent. General Disclosures This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice. This material has been prepared by GSAM and is not financial research nor a product of Goldman Sachs Global Investment Research (GIR). 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