Three Top Managers on Their Outlooks for Rates, Inflation

The article was published in the February/March 2017 issue of Morningstar magazine.

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 midyear, 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

On Dec. 20, Emery, Landmann, and Leech shared their perspectives with Morningstar. In the first part of a two-part series, the three discuss their outlooks for monetary policy and interest rates in 2017. Their conversation has been edited for clarity and length.

What is 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.

Second, if you look at the U.S. economy in isolation, it’s doing reasonably well. Inflation trends look like they’re on the upswing, so that the Fed should be moving to normalize rates perhaps more swiftly than they have. But when you look at the rest of the world, you see very weak economies, very weak inflationary trends--no inflationary trends at all in some countries, where monetary policies attempt to keep inflation from falling further. That makes our rates, relative to other rates around the world, pretty compelling. I think this has slowed the pace of Fed tightening from what it otherwise would have been in 2016. Our perspective is that there will be two tightenings, but we would say the range round that is pretty uncertain.

Emery: One thing that is interesting is the repricing of inflation expectations. Even in a slower global growth environment, if inflation expectations increase significantly, the Fed may be compelled to move more quickly. I think they've been able to not move, despite the better unemployment numbers and above-trend growth, because of exactly what Ken was talking about, the overall global environment and inflation expectations being relatively low. But that's been repriced in recent weeks, and I'm sure that's something that they're going to be paying a lot of attention to.

Landmann: Ken brought out this idea that our higher rates are attracting flows, and we're seeing that in the cost of hedging currencies, the Japanese yen and euro. It's going to put a lot of pressure on our trading partners. The strong dollar is probably here to stay as long as the Fed stays on this course, and that's going to create fragilities and unintended consequences around the world. I think that the Trump presidency also is going bring about a lot of volatility. When you read the details of these proposals, to the extent that they have details, you think of unintended consequences. If you do away with the deductibility of interest for corporations, for example, how do you deal with finance-intensive business models like banks or real estate? There are a lot of things that Washington could get wrong here, unfortunately, but the potential volatility caused by some of these policies will most likely be very good for active management going forward, as it will create trading opportunities that weren't as present in 2015 and 2016.

A lot of people have interpreted the election as potentially being an inflationary event, given some of the proposals on the table. Is there a risk of a significant spike in inflation and that the Fed could miss the boat?

Leech: I think we were pretty thoughtful about the decline in inflation expectations over 2016. You heard the Fed talk about whether or not they could take inflation expectations for granted, which is why a lot of the Fed members held back this year. But the change in inflation expectations has been pretty abrupt post the Trump presidency, putting the Fed in a much tougher spot.

We think inflation might rise modestly. But could you still get a bond market reaction that anticipated the inflation trend getting worse and moving upward? That’s not our base case, but I think that that’s a fair concern.

Emery: Various Fed presidents have also been calling for perhaps targeting an even higher inflation rate (above 2%), trying to give themselves some maneuvering room. So, we aren't expecting rampant inflation, but we wouldn't be surprised if inflation pushed up over 2% to 2.5% or more.

Landmann: We're definitely in the camp that thinks we're going to get to 2.5% here, and maybe a touch beyond that. We're not particularly alarmed by that. It's a natural dynamic of the way these numbers work. We've had high core services inflation for a while; that's been baked in here. The oil price dynamics have changed dramatically in terms of the elasticity of supply in that market, so the likelihood of significantly higher oil prices coming into play on the CPI number doesn't seem that substantial to us. We don't think that this Fed will get too hawkish. This is not your father's Fed. This is a Fed that's a lot more concerned about market volatility and international stability than they are about whether inflation is at 2%, 2.5%, or even 3%. If we begin to see some of the types of problems we saw emerging back in February 2016, you're going to see them turning around pretty quickly on the hawkish talk--as long as it's Yellen at the head. Obviously, the wild card out there is what's going to happen in 2018 with the Fed, and what sort of appointees will we get? Undoubtedly, given the history of this administration so far, it'll be a surprise.

We’ve seen a pretty significant sell-off in the longer end of the yield curve in the 10- and 30-year range. Is there a continued risk of a substantial increase in longer-term bond yields?

Leech: It is pretty uncertain, so we're not hanging our hat on it, but given that the market's gone too far, too fast, we would think the chances of a big spike from here are reasonably low.

Emery: I would agree with that. Even before the election, we thought the 10-year would be around 3.5% or so by 2018 in our base case, and now the market has moved toward that view. It really depends on the path of this fiscal policy, how stimulative it is, what happens with inflation, and what that impact is on GDP growth. If the pace is faster, we could see 10-year rates pushing up higher, perhaps through 3.5%.

Landmann: We certainly don't think this is going to be a normal cycle. We are eight years into an economic expansion; there has been unprecedented central bank intervention. This is probably a process that consumes itself in the end, meaning that, as the Fed raises rates in 2017 to balance fiscal stimulus, these high rates, combined with already high leverage, trigger an economic downturn. Other wild cards are also going to come into play. If Trump starts trade wars with various major trading partners, that's not going to be stimulative for growth. A stronger dollar also will not necessarily be stimulative. As we get through 2017, we could see global and U.S. growth prospects weaken. These factors constrain the magnitude of the rise in rates we will experience in 2017.

Emery: If looking at the U.S. in isolation, we would expect the rates to be higher, but you obviously can't do that because of the context that we're operating in--global yields and economic growth outside the U.S. I think it's really important to do simulations when setting duration of portfolios. We don't try to put portfolios together that are just based on point estimates, and I'm sure Ken and Laird don't either. We try to think in terms of ranges and overall portfolio construction and try to generate positive long-term total returns in a safe manner.