FIXED INCOME STRATEGY - FOR PROFESSIONAL INVESTORS

Fuel for (over)heating and more of my
favourite themes

17-Jan-2018
By Jeffrey Rosenberg

Cold winter weather provides some inspiration for the lead theme for the 2018 fixed income outlook: fuel for (over)heating. The heat of global economic acceleration may lead to this narrative gaining traction in 2018, with significant implications for the global rates outlook.

Fixed income outlook 2018 themes

  • Fuel for (over) heating: Fiscal stimulus from tax cuts and spending plans –on top of a US economy operating at full employment and both the US and a handful of other developed economies operating above capacity –may provide fuel for an overheating debate in 2018. We believe the Fed would likely delay any pre-emptive action, keeping to a moderate pace of rate hikes in 2018. But an inflation acceleration could finally result in an increasing inflation risk premium.
  • Ahead of the curve: Global yield curves flattened in 2017 but we see several reasons for this trend to halt –and perhaps even to reverse. Upside risks to growth may fuel inflation expectations and a steepening in the long end. Factors that have caused excess demand relative to supply in longer-maturity bonds appear to be shifting. Among them, central banks are pulling back on their degree of support just as fiscal stimulus implies rising issuance. This supply shift is particularly significant in the US.
  • Late-cycle blues: Credit valuations reflect dynamics of rising leverage and increased issuer friendliness but also low defaults and low uncertainty. As a result we see credit primarily as a source of income, with limited potential for price appreciation from spread compression.
  • Emerging challenges: Emerging market (EM) debt remains a favoured sector in a world of exceptionally low developed market rates. Local-currency debt appears well supported in an environment of low currency volatility. However, the outlook appears increasingly challenged as more EM central banks move to tighten policy.

Snapshot

The Fuel for (over) heating chart highlights the unusual nature of expanding fiscal support at this stage of the economic cycle: The fiscal deficit is set to widen even as the unemployment rate touches multi-decade lows. This supports our investment views, including a preference for shorter-maturity and inflation-linked bonds.

U.S. fiscal balance vs. jobless rate. 1960-2018

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Chief Fixed Income Strategist
Jeffrey Rosenberg, CFA, Managing Director, is BlackRock's Chief Fixed Income Strategist and a member of the BlackRock Investment Institute.

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