2018 Global Market Outlook Press Briefing GLOBAL FIXED INCOME Mark Vaselkiv Portfolio Manager, CIO, Fixed Income November 14, 2017 FOR 2018 GLOBAL MARKET OUTLOOK PRESS BRIEFING. PROVIDED TO DESIGNATED MEMBERS OF THE PRESS ONLY, NOT FOR FURTHER DISTRIBUTION.
Global Fixed Income Outlook KEY FIXED INCOME MARKET QUESTIONS Can central banks tighten policy without derailing the recovery? Fed, European Central Bank (ECB), Bank of Japan (BOJ), People s Bank of China (PBOC) Do geopolitical events matter to markets? Potential U.S. trade wars (NAFTA, China), North Korea, Brexit Can expansionary policies like tax reform help? Is there anything left to the Trump /reflation trade? Is volatility like a tightly coiled spring? Quantitative easing suppressed volatility while changes to market structure since the global financial crisis remain largely untested LOOKING AHEAD Casting a wider net with global fixed income diversification Using barbell credit strategies high yield and loans with asset-backed securities (ABS) Capitalizing on transformational change countries (Argentina, India, Indonesia) versus laggards (Turkey, South Africa) Being active with security selection and sector rotation 2
Balance Sheet Central Bank Support Expected to Wind Down As of August 31, 2017 CENTRAL BANKS BALANCE SHEET VS. % GDP (in U.S.$ Trillions) $20 $18 $16 $14 $12 $10 $8 $6 BOE SNB PBOC BOJ ECB FED Total (right axis) 45% 40% 35% 30% 25% 20% 15% Percentile of Global GDP $4 10% $2 5% $0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 0% Although well telegraphed, the unprecedented global monetary stimulus is set to begin to fade: The Fed had been a price-insensitive buyer, the ECB is reaching the limits of its capital key, and the PBOC is trying to reform China s financial markets. Without offsetting fiscal policies, 2018 is likely to see a pullback in demand for financial assets. Sources: Haver Analytics and T. Rowe Price. Based on moving sum of last 4 quarters GDP figures. 3
Annualized Sharpe Ratio Annualized Sharpe Ratio Annualized Sharpe Ratio Balancing Fixed Income Sector Allocations Across Fed Policy Regimes As of March 31, 2017 ANNUALIZED RISK-ADJUSTED FIXED INCOME SECTOR EXCESS RETURNS CURRENT ENVIRONMENT SINCE INDEX INCEPTION 1.0 REMOVING ACCOMMODATION 2.5 TIGHTENING CONDITIONS 1.0 0.8 2.0 0.8 0.6 1.5 0.6 0.4 1.0 0.4 0.2 0.5 0.2 0.0 0.0 0.0 Removing accommodation real fed funds rate is above its 12-month moving average but below the natural rate (R*) Tightening conditions real fed funds rate is above its 12-month moving average but above the natural rate (R*) Sharpe Ratio is a measure for calculating risk-adjusted return, and this ratio has become the industry standard for such calculations. Index inception dates: ABS, U.S. IG Corp., and U.S. High Yield = December 31, 1989; Gov t. Related = January 31, 1994; Agency MBS = January 31, 1992; CMBS = August 31, 1999; Bank Loans = January 31, 1992; EM $-Sovereign = January 31, 1993. Sources: Bloomberg Barclays: U.S. Government Related, U.S. Mortgage-Backed Securities, U.S. Asset-Backed Securities, Non-agency CMBS: Agg. Eligible, U.S. Corporate Investment Grade, U.S. Corporate High Yield, Emerging Markets USD Aggregate; S&P/LSTA: Performing Loan Index. 4
Divergence Between Countries Offers Opportunities As of August 31, 2017 ILLUSTRATIVE INTEREST RATE CYCLE MONETARY POLICY ACTIONS 2016 100 80 60 40 20 87 CUTS 38 HIKES South Africa Brazil Peru Colombia Indonesia India Developed Countries Developing Countries Argentina Egypt Turkey Mexico 0 MONETARY POLICY ACTIONS 2017 YTD 50 Russia Serbia Malaysia China U.S. Hong Kong 40 30 20 10 46 CUTS 21 HIKES Interest rates going down Poland Australia Israel Eurozone Interest rates toward their lows UK Canada Interest rates going up Philippines Hungary Interest rates toward their highs 0 The two columns of cuts versus hikes are the actual number of cuts and rate hikes that have happened across countries worldwide. Sources: CRB Rates and T. Rowe Price. 5
Mean Spread (bps) Spread Volatility: From One Extreme to Another? As of October 27, 2017 MEAN SPREAD VS. SPREAD CHANGE VOLATILITY 700 600 1-Year Spread Change Vol. Regression 10-Year Spread Change Vol. Regression U.S. HY Euro HY Corp. 500 EM USD: Corp. 400 U.S. HY 300 EM USD Sov. Euro HY Corp. EM USD Sov. 200 100 0 EM USD: Corp. U.S. Credit Corp. Euro Credit Corp. U.S. MBS U.S. Credit Corp. Euro Credit Corp. U.S. MBS 0 50 100 150 200 250 300 Spread Change Volatility (bps) Unprecedented monetary stimulus has suppressed volatility. Is the current level of spread compensation adequate if volatility reverts to normal levels? Sources: Bloomberg Barclays and T. Rowe Price. 6
Corporate Credit Markets Are Not All the Same As of October 31, 2017 U.S. Corporates European Corporates Emerging Markets Corporates Bank Loans Market Weight Yield to Maturity Spread Market Weight Yield to Maturity Spread Market Weight Yield to Maturity Spread Market Weight Yield to Maturity Spread AAA 2.1% 3.0% 60 0.6% 0.6% 56 0.1% 2.2% 68 N/A N/A N/A AA 9.4% 2.7% 56 11.0% 0.4% 57 2.6% 3.0% 87 N/A N/A N/A A 39.0% 3.0% 76 36.2% 0.5% 75 17.4% 3.7% 143 N/A N/A N/A BBB 49.5% 3.5% 124 52.2% 0.8% 105 37.7% 4.3% 197 N/A N/A N/A IG Index 100.0% 3.2% 97 100.0% 0.6% 89-4.1% 178 N/A N/A N/A BB 32.2% 4.6% 233 71.4% 2.4% 207 21.3% 5.3% 304 24.1% 4.2% 283 B 31.7% 6.3% 386 23.5% 4.7% 347 13.9% 6.5% 432 45.0% 5.5% 433 CCC and Below HY Index 11.6% 11.0% 865 4.8% 8.5% 738 2.0% 11.3% 935 4.7% 15.3% 1465 100.0% 1 6.4% 408 100.0% 3.3% 266-6.3% 400 100.0% 1 5.4% 418 Past performance cannot guarantee future results. Sources: BofA/ML, S&P, and J.P. Morgan Chase & Co. U.S. Investment Grade represented by the Bloomberg Barclays U.S. Corporate Index; U.S. High Yield represented by the J.P. Morgan US High Yield Index; European Investment Grade represented by the Bloomberg Barclays Euro Aggregate Corporate Index; European High Yield represented by the BofA/ML European Currency High Yield Const. ex Sub. Fin. Index; Emerging Markets Corporate Index represented by the JPM CEMBI Broad Diversified Index; and Bank Loans represented by the J.P. Morgan Leveraged Loan Index. 1 May not sum to 100% due to split ratings. 7
Negative-Yielding Assets (%) Yield to Maturity The Subzero Yield Landscape and Average Yield to Maturity Falling While Duration Risk Increases As of October 31, 2017 BANK OF AMERICA/MERRILL LYNCH GLOBAL FIXED INCOME INDEX 30 25 20 15 10 5 BLOOMBERG BARCLAYS GLOBAL AGGREGATE BOND INDEX 5% 4% 3% 2% Yield to Maturity (left axis) Duration* (right axis) 7.5 7.0 6.5 6.0 5.5 Duration (Years) 0 2013 2014 2015 2016 2017 1% 2008 2010 2012 2014 2016 5.0 Negative-yielding assets represent approximately 15% of the global fixed income market. Past performance cannot guarantee future results. *Modified adjusted duration. Sources: BofA/ML Global Research; source for Bloomberg Barclays index data: Bloomberg Index Services Ltd. Copyright 2017, Bloomberg Index Services Ltd. Used with permission. The yield to maturity (YTM), book yield or redemption yield of a bond or other fixed-interest security, such as gilts, is the internal rate of return (IRR, overall interest rate) earned by an investor who buys the bond today at the market price, assuming that the bond will be held until maturity, and that all coupon and principal payments will be made on schedule. Duration is a measure of the sensitivity of the price the value of principal of a fixed-income investment to a change in interest rates. 8
High Yield: Percentage of U.S. High Yield Universe by Yield Bucket As of October 31, 2017 30 25 26 28 20 16 15 13 10 10 7 5 0 < 4% 4% 5% 5% 6% 6% 7% 7% 10% 10% Yield to Worst Source: J.P. Morgan Domestic High Yield Index. 9
Yield Over USD Cash (%) Yields and Correlation to Equities As of September 30, 2017 CURRENT YIELD ABOVE USD CASH VS. HISTORICAL CORRELATION Last 10 Years 7% 6% 5% High Yield 4% Emerging Market Debt 3% 2% 1% Sweden Gov t. Germany Gov t. Australia Gov t. UK Gov t. Canada Gov t. U.S. Gov t. Italy Gov t. South Africa Gov t. Brazil Gov t. Poland Gov t. Emerging Market Corporate Indonesia Gov t. U.S. Investment-Grade Corporate Euro. Investment-Grade Corporate Cash 0% Mexico Gov t. -1% -0.80-0.60-0.40-0.20 0.00 0.20 0.40 0.60 0.80 Historical Correlation NEGATIVE CORRELATION TO EQUITIES POSITIVE CORRELATION TO EQUITIES Past performance is not a reliable indicator of future performance. Sources: UBS, Bloomberg Barclays, J.P. Morgan, Bank of America/Merrill Lynch, S&P, MSCI, and T. Rowe Price. Yield shown is on a hedged basis in U.S. dollars. Volatility is based on the monthly returns of each asset class hedged into U.S. dollars. 10
2018 Global Fixed Income Outlook Summary OPPORTUNITIES RISKS Cast a wider net with global fixed income diversification Exploit barbell credit strategies high yield and loans with ABS Focus on transformational change countries (Argentina, India, Indonesia) versus laggards (Turkey, South Africa) Use active security selection and sector rotation Fed and global central banks remove stimulus Economic expansion remains tepid China struggles to manage balanced economic growth Global trade uncertainty Sensitive geopolitical issues Brexit, North Korea 11
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