Friday, July 13, 2018

Outlook 2018: Mid-Year Update

The Mid-Year Update is an opportunity to look back on the year's first half and adjust forecasts for the remainder of it, if necessary, from that which we foresaw in our Outlook 2018 publication released back in December.

A Year of Positive But Shifting Forces


  • Vibrant economic activity should persist through the year, supporting corporate earnings growth at a high level.
  • Volatility has erupted as monetary and geopolitical cross currents shift from last year’s tranquil paradigm.
  • The stock market corrected sharply and will likely remain bumpy, but the macro underpinnings remain conducive for risk assets to flatter balanced portfolios.
  • Fixed income markets had a tough first half, with interest rates rising across maturities in the U.S.
  • Typically, the yield curve flattens and long-term rates begin to decline 18–24 months before an economic downturn.
  • Despite the first half action, we remain modestly bullish on interest rates, a contrarian view reflecting the probability of a downturn in the next several years.
  • Bouts of volatility will persist in the taxable fixed income markets, risking sharp swings in credit spreads.
  • High-yield bonds remain enticing by offering attractive relative returns, but long-term investors may fare better by diversifying across the fixed income spectrum.
  • Along with lower-rated securities, emerging markets debt remains a tricky area for investment and, in certain corners, froth with risk.
  • Assuming the wave of refinancing activity induced by lower rates has mostly passed, mortgage securities present a compelling alternative to other risk assets.
  • Strong seasonal buying interest provides solid municipal bond support, countering the reduced demand from banks resulting from a lower corporate tax rate.
  • Although Puerto Rico remains a headline risk, state and local government credit conditions are stabilizing, with rating agency upgrades exceeding downgrades.

Our Analysis

You can read the full report here. 

Economy & Equity Markets
Mark Luschini, CMT, Chief Investment Strategist

The Mid-Year Update is an opportunity to look back on the year’s first half and adjust forecasts for the remainder of it, if necessary, from that which we foresaw in our Outlook 2018 publication released back in December. In all, there is little change required. We expected a more complicated landscape for investors this year as shifting forces impacted the economy and financial markets. We also believed that the underlying conditions that would facilitate continued positive economic growth would remain intact, and the potential boost from fiscal impulses would serve to augment the pace of activity. Click here to continue reading.

Fixed Income Market
Interest Rates

Guy LeBas, CFA, Chief Fixed Income Strategist

Equity markets had a very volatile—though generally positive—performance in the first half of 2018. For fixed income, it’s been very nearly the opposite. Thanks to a trend of rising interest rates through the first six months of trading (thus far, rates actually peaked in May), returns have been negative for most bond sectors. Realized volatility of bond markets returns, however, has actually been low. The U.S. Aggregate bond market index has posted a total return of –2.2% as of mid-June, while realized interest rate volatility fell to 9% lower than the last ten years’ average. That, along with a range of positioning data, speaks to a very “consensusdriven” market with relatively few dissenting points of view. As of the time of publication, 10-year Treasury yields are higher by 0.55%, while two-year Treasury yields are higher by 0.63%. Click here to continue reading.

Credit Markets
Jody K. Lurie, CFA, Director, Corporate Credit Analyst

Volatility remains ever-present in 2018, a stark contrast to the muted response the market garnered to headlines in 2017. Recent geopolitical risks including those related to tariffs (China, Canada, Mexico, Europe), North Korea, Iran, Eurozone, and various emerging markets, affected the appetite for risk assets, causing credit spreads to move wider rather suddenly, only to reverse when the initial pressures subsided. At the same time, the directional difference seen in investment grade and high yield credit spreads (measures of credit and liquidity premiums over the risk-free rate)—with investment grade spreads creeping wider, contrasting with high yield spreads narrowing after market pressures subside—speaks to a broader market discussion around appetite for risk and fears that we may be at or near the top of this current expansionary phase.  Click here to continue reading.

Municipal Markets
Alan Schankel, Managing Director, Municipal Strategy

The December 2017 passage of the Tax Cuts and Jobs Act (TCJA) set the tone for municipal bond markets in the first half of 2018. The foremost and most obvious impact of the TCJA was the ensuing drop in new issue volume, resulting from the tax bill’s elimination of tax-free borrowing for advance refunding purposes. Through May, total municipal issuance was 22% behind the same period in 2017, marking the slowest start for munis in four years. Partially offsetting this drop in supply is the reduction in demand based on lower corporate tax rates. Although the magnitude was uncertain, most observers believed bank and insurance company appetite for tax-free income would diminish after the tax bill’s reduction of the corporate rate to 21% from 35%. Recently released data from the Federal Reserve confirms that bank holding of municipal debt fell by 2.8% in the first quarter of this year versus the prior quarter, the first quarterly decline in bank holdings of munis since 2009. At year end, banks held 15% of the $3.9 trillion of municipal debt outstanding, which is up from the 7% owned by banks in 2010, illustrating the key demand side role played by banks prior to December's tax reform package. Click here to continue reading.