Fixed Income Macro Outlook
Fourth Quarter 2015
Our Global Macro Strategy Team's Perspective
Moderate growth in face of global macro headwinds
- Moderate Growth in Face of Global Macro Headwinds: Our most likely (61% probability) scenario continues to call for moderate growth, producing near-term annualized economic growth rates of 2.0% to 3.0%. The possibility of an upside breakout of over 3.0% growth has declined to 29%.
- U.S. Fundamentals Support Moderate Growth: The U.S. economy continues to grow at a moderate pace, despite global economic weakness stemming from China and other emerging markets. We see strong bifurcation between the services and manufacturing sectors of the U.S. economy, with services expanding and manufacturing contracting.
Muted in near term but still long-term concerns if economic conditions improve
- Muted in Near Term: A 1.5% to 3.0% increase over 12 months in the overall Consumer Price Index (CPI) appears most likely to us (66% probability). (CPI is a government index derived from detailed consumer spending information.)
- Long-Term Concerns if Economic Conditions Improve: We still believe higher inflation (a 12-month CPI change over 3.0%) could occur in the coming three to five years because U.S. economic growth combined with monetary and fiscal policies enacted since 2008 could eventually spur stronger global economic growth and asset bubbles.
- Valuations on Inflation-Linked Investments Look Relatively Attractive: We believe strongly that some level of inflation protection be incorporated into investor portfolios.
U.S. Monetary Policy
Interest rate normalization depends on data—particularly inflation and wage growth—and market expectations
- QE3 Completed but Other Stimulus Continues: The Federal Reserve's (the Fed’s) third bond-purchase program (quantitative easing, QE) since 2008 ended in October 2014. But the Fed still owns a large portfolio of bonds it purchased through QE, and will continue to reinvest its coupon income. And short-term interest rates remain very low, even if the Fed starts raising them.
- Rate Normalization Expected; Timing, Magnitude Are Data- and Market Expectation-Dependent: The Fed is expected to begin raising short-term interest rates from their near-zero level some time in the next 12 months. But we think global economic weakness and low inflation will allow the Fed to temper the timing and magnitude of possible rate increases. We don’t expect the Fed to raise rates until market and inflation expectations move higher.
U.S. Interest Rates
Range-bound, supported by U.S. economic fundamentals but constrained by global macro headwinds
- Range-Bound: Given our expectations for moderate U.S. economic growth in the face of global macro headwinds, we expect the 10-year U.S. Treasury yield to rise to between 2.20% and 3.00% in the next 12 months. We think this longer-term trend is fundamentally supported, assuming the U.S. economy continues to grow. We expect an eventual normalization of long-term interest rates after years of artificially low levels caused in part by the Fed’s QE programs.
- Global Macro Headwinds for Higher Interest Rates: Weaker global economic fundamentals, aggressive non-U.S. monetary policies, low inflation, a strong dollar, uncertain global geopolitical factors, and demand due to the wide yield disparity between U.S. bonds and those of other developed countries are working together to keep interest rates low in the near term, despite U.S. economic fundamentals that support higher rates.
Divergence from the U.S. in terms of weaker economic growth and more aggressive monetary policies
- Global Divergence in Economic Growth: Outside of the U.S., the global economy is mostly struggling. Europe has required monetary stimulus to fight deflation, Japan is slowly easing out of recession, and Russia, China, and Brazil are slowing.
- Global Divergence in Monetary Policies: While the Fed is contemplating tighter monetary policy, most of the world’s other central banks in developed economies are still considering or implementing additional monetary easing.
- Low Inflation: As in the U.S., inflation is not a near-term threat. However, the amount of monetary and fiscal stimulation that has been prescribed could create longer-term inflationary pressures.
What Our Fixed Income Experts Are Saying
Macro Observations - Changes Since Last Quarter
- China Turmoil, Fed Uncertainty, Market Volatility: Investors faced an unsettling confluence of factors during the third quarter, including sudden, sharp market reactions to China’s economic slowdown and currency devaluation, questions about when the Fed would finally start raising short-term interest rates and by how much, and big swings in the price of crude oil, which tested previous lows, then sharply rebounded. Equity markets declined globally while bond returns were mixed.
G. David MacEwen & Victor Zhang, Co-Chief Investment Officers — China- and Fed-Related Volatility Opens Opportunities for Active Managers
- Market volatility stemming from China’s economic slowdown and uncertainty about Fed interest rate policy ties closely to four themes we’ve outlined during the past year: 1) global divergence between the U.S. and the rest of the world in economic growth rates and central bank policies; 2) normalization—more two-way market risk and higher interest rates as the Fed withdraws monetary stimulus; 3) more volatility as markets normalize, and 4) increased opportunities for active investment managers to add value with security selection as market volatility rises.
- China, the world’s second-largest economy after the U.S., was central in the market volatility. Chinese economic growth, as measured by 12-month changes in real gross domestic product (real GDP, a measure of the total economic output in goods and services for an economy, adjusted for inflation), has slowed from the 10-14% range through the middle of the last decade to approximately 7% this year. This had a deflationary impact on commodities and on the GDP growth of emerging markets that rely on China for exports and imports.
- We do not expect China’s slowdown to change the U.S. economy’s moderate growth pace significantly in the near term. Global growth is weaker than in the U.S., but there are signs of improvement in key developed areas like Europe and Japan.
- The Fed has fostered uncertainty and volatility by postponing rate normalization. This has disrupted capital market movements and financial plans, and put the Fed and its deliberations in the macroeconomic foreground, forcing everyone to watch, wait, and wonder. We believe the Fed should start raising rates.
- A market environment in which volatility is being driven as much by sentiment as by fundamentals opens opportunities for active investment managers to find fundamentally solid issuers whose securities have been beaten down by adverse headlines.
G. David MacEwen — Prepare for Periods of Bond Price Volatility as Markets Normalize
- Market volatility has increased after years of being suppressed by the Fed’s bond purchases. Market volatility can be a favorable factor for fundamentally driven active investment managers seeking value and other opportunities amid the gyrations. However, more volatility means more risk, and a more-pronounced tendency for certain types of bonds and bond portfolios to behave like stocks.
- The third-quarter stock and high-yield credit sell-off served a productive purpose in terms of demonstrating where investors had risk exposure and/or lacked diversification. Many investors thought they owned diversified bond portfolios (or diversified overall portfolios) when they actually didn’t.
- The glaring proof that they didn’t: When the stock market plunged, did they see positive performance in any parts of their portfolios? For average investors, probably not, unless they had high-quality core bond holdings. High-quality core bond sectors tend to be non-correlated to the stock market and are important components of diversified investment strategies.
- In this environment, it’s important to balance opportunistic risk-taking with respect for fundamental credit quality and a diversified investment approach. We suggest a three-step approach for attaining appropriate risk levels for fixed income investments in today’s markets: 1) seek true diversification—bond vehicles that are non-correlated with stock market movements (bond portfolios that act like bonds, not stocks); 2) seek bond vehicles that offer some protection from rising interest rates (by using short-to-intermediate maturities) and from credit-related volatility (by focusing more on credit quality than yield); and 3) seek transparency (visible and comprehensible portfolio positions) and liquidity (positions can be sold in an orderly fashion, if needed).
Duration measures the price sensitivity of a bond or bond fund to changes in interest rates. Specifically, duration represents the approximate percentage change in the price of a bond or bond fund if interest rates move up or down 100 basis points.
The opinions expressed are those of American Century Investments (or the fund manager) and are no guarantee of the future performance of any American Century Investments fund. This information is for educational purposes only and is not intended as investment advice.
Diversification does not assure a profit nor does it protect against loss of principal.