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Bond Market Bumps Ahead

Three top bond managers offer insights into the risks and opportunities.

Sarah Bush, 02/01/2017

Fixed-income investors endured twists and turns in 2016. U.S. Treasuries rallied in the beginning of the year as riskier bonds plummeted along with plunging oil prices and concerns about global growth. By year-end, the tables had turned:

High-yield and emerging-markets bonds rebounded with commodity prices and were among the year’s strongest sectors, while an increase in Treasury yields that started midyear accelerated in response to the U.S. election and the expectation of fiscal stimulus. Today, the extent of further interest rate rises and a new U.S. administration’s policy changes are unknowns with global ramifications.

In the face of the uncertainty ahead, we turned to three of the best bond managers in the business: Dana Emery, CEO, president, and director of fixed income at Dodge & Cox; Laird Landmann, co-director of fixed income at TCW; and Ken Leech, CIO of Western Asset Management. Among them, they oversee a number of Morningstar Medalists, including Dodge & Cox Income DODIX, Metropolitan West Total Return MWTIX, and Western Asset Core Bond WATFX. They and their teams are all also past recipients of the Morningstar Fixed-Income Manager of the Year award.

On Dec. 20, Emery, Landmann, and Leech shared their perspectives. Their conversation has been edited for clarity and length.

What is your view on what we heard coming out of the December Fed meeting, and the likely path of monetary policies for 2017?

Laird Landmann: When we focus on the Fed, we’re focusing on the short term. I think they are also focusing on the short term, which is an important point. The market has pretty much bought into this notion that there will be three hikes next year because that’s where the dots move. But we have to remember that those dots are massively contaminated by a bunch of central bank regional presidents who are always a little more hawkish and always have been. Really, the only dot that matters is [Federal Reserve Chair Janet] Yellen’s, and her dot is at two hikes going forward. We think that the long-term trend is to remove some of this unprecedented central bank intervention that’s gone on for the last seven years. But the markets have jumped to the conclusion that we’re going to move immediately to a much more hawkish bent. As long as Yellen is in that seat, two hikes is much more likely than three.

Dana Emery: In general, we were expecting rates to increase more than the market was. The biggest factors we were considering were valuations and how the forward curve was priced. It was way too flat, and we based that view on the inflationary and growth trends we were seeing even before the election. The election adds to the expectation for fiscal stimulus that a lot of the Fed governors and presidents have been calling for. You can’t just boost the economy with monetary policy, you need some combination of monetary and fiscal stimulus. The market has repriced more quickly than we would have expected. Inflationary pressures are building and unemployment is low, so we think that rates will be rising in the future. For 2017, we are expecting three rate hikes in our base case.

Cloudy Outlook
Ken Leech: We think over time we have a slow path to normalization. But from our perspective, there are two elements that make the outlook for 2017 particularly cloudy. First, there’s the uncertainty with respect to the Trump administration’s fiscal proposals: what they’ll look like, how difficult they will be to implement, the degree of fiscal stimulus are really just unknowns. The market is pricing in a tremendous amount of optimism about that prospect.

Sarah Bush is a senior analyst with Morningstar.

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