With a backdrop of modest global growth, we see some potential for spread tightening in 2016.
Although the global financial crisis of 2008 continues to recede into history, its aftershocks continue today, in the form of extremely low interest rates, excess capacity, slow economic growth and flat inflation. Uncertainty remains elevated as slower growth in China poses a threat to the sanguine global outlook. On balance, we anticipate modest global growth over the next 12 months, as low commodity prices and benign monetary policy will likely combine to support consumers. In such an environment, the low yields on sovereign debt provide little reason for enthusiasm, but certain credit sectors appear undervalued, with the potential for modest spread tightening in the coming year.
Consumer Likely to Support U.S. Growth
We believe the U.S. economy should continue to be driven by the strong consumer, supported by stronger balance sheets, lower energy costs and subdued inflation. As shown in the display below, personal consumption expenditures have been solid, which has helped the U.S. overcome sluggish investment spending and moderating exports due U.S. dollar strength. The picture could turn out to be rosier than we are anticipating. As balance sheet repair peaks and wages firm, consumers may feel comfortable taking their savings rate to a more normal level, which could lead to an unexpected boost in consumption.
U.S. Consumption Has Been on the Rise
U.S. Personal Consumption (year-over-year % change)
Source: Bloomberg, data through September 30, 2015.
Our view that consumption will continue to spur growth is also linked to our outlook for labor markets and monetary policy. While the pace was not as vigorous as in 2014, the labor market improved at a healthy rate in 2015. We anticipate that monetary policy will remain accommodative in 2016. In our view, the Fed will likely be very gradual in its tightening cycle and allow labor markets to strengthen in order to increase its confidence that 2% inflation will be achieved and sustainable. All told, we anticipate three to four rate hikes over the next year, with the middle point of the Fed Funds rate at around 1% - 1.125% by the end of 2016. The forecasted pace of rate hikes would be slow by historical standards.
Despite undershooting the Fed's target for several years, we think inflationary pressures could pick up in 2016. The sharp decline in energy prices has kept inflation muted in 2015, but the base effects of this downward spiral appear set to dissipate, which will likely put upward pressure on the Consumer Price Index. Moreover, in spite of low realized inflation this year, elements of the CPI basket have remained firm, most notably shelter and core services inflation.
2016 Economic and Government Rate Outlook
|GDP Growth||Inflation||10-Year Gov't Rate|
|U.S.||2.5% (+/- 0.5%)||2.0% (+/- 0.3%)||2.8% (+/- 0.5%)|
|Eurozone||1.5% (+/- 0.5%)||1% (+/- 0.3%)||1.3% (+/- 0.3%)*|
|U.K.||2.2% (+/- 0.5%)||1.5% (+/- 0.5%)||2.5% (+/- 0.5%)|
|Japan||1% (+/- 0.3%)||1% (+/- 0.3%)||0.9% (+/- 0.3%)|
Source: Neuberger Berman, data as of November 15, 2015.
In Europe, Easing and Acceleration?
2015 is the year the ECB finally implemented its quantitative easing program, while the region has continued its perpetual "dance" in a political minefield. Cooler heads eventually prevailed and kept Greece from exiting the monetary union. But strains from the refugee crisis remain at the forefront. In spite of these challenges, the economic divergence between Germany and its other eurozone counterparts has started to narrow. Ireland and Spain have cemented themselves recently as Europe's fastest growing economies and, following a prolonged contraction, Italy has returned to positive growth. Unemployment rates in the periphery have also moved lower, albeit from very high levels.
Still, the shadow of a fragile recovery remains hard to shake, as the eurozone has struggled to surpass its pre-crisis peak in output. Downside risks remain elevated both internally and abroad, while leading indicators such as PMI surveys have pointed to a potential slowing of momentum. On the external front, the uncertain emerging markets outlook and the implication for demand for eurozone exports is a material risk.
Eurozone: Exports Reign, Investments in Exile
Components of Eurozone GDP (Dec 2007 = 100)
Source: Bloomberg, Neuberger Berman calculations, data through June 30, 2015. Total Consumption: Final Consumption Expenditure, or FCE; Household: Household and Nonprofit Institutions Servicing Households; Government: General Government FCE; Capital Formation: Gross Fixed Capital Formation.
Against this backdrop, the ECB has remained on high alert. Indeed, in December the central bank extended its asset purchase program by six months, until at least March 2017, including the indefinite reinvestment of QE proceeds, and lowered the deposit rate to -0.3%. These actions should enhance the odds of achieving our real GDP growth forecast of around 1.5% in 2016, with headline inflation of about 1%. The cyclical backdrop and the risk for upward economic surprises as the euro weakness feeds through to output could pressure yields modestly higher. Moreover, we anticipate that Italian and Spanish spreads could gravitate towards 80-100 basis points over German Bunds in the 10-year part of the curve. The reemergence of political instability is the prime risk to our outlook.
Caution in the U.K., Elusive Recovery in Japan
After its deepest recession on record, the U.K. economy has achieved "escape velocity." Similar to the U.S., the labor market has firmed at a rapid pace while inflation has fallen, due largely to declining energy prices. 2015 was earmarked by investors as the start of the movement toward policy normalization in the U.K. However, weakness in global growth and benign inflation have pushed back the onset of the tightening cycle. We believe the Bank of England will remain cautious over the next year as event risks increase the likelihood of economic turbulence. With this backdrop, the central bank will likely raise rates only once or twice over the next 12 months, with the refinancing rate forecast topping out at 1% and real GDP coming in just above 2%. Given the cyclical outlook for the local economy, combined with the Fed hiking cycle, U.K. 10-year bond yields should rise modestly.
U.K. Labor Market Dynamics Continue to Improve
Unemployment Rate and Earnings Growth (%)
Source: Bloomberg, data through September 30, 2015.
For the past few years, Japan's economy, central bank and rate structure have marched to a different drummer. Any discussion surrounding Japan's macroeconomic outlook has been heavily influenced by its QE program and Abenomics reflationary policy. Notwithstanding these extraordinary measures, growth has been volatile without a persistent trend, and headline inflation is now hovering around 0%. Like its G4 counterparts, growth in Japan is likely to be fueled by consumer spending. Despite the sharp decline in the yen since the onset of Abenomics, net exports have generally been a drag on growth in recent few years. The outlook for exports does not appear promising, as China continues to be the country's chief trade partner. Still, a pick-up in U.S. demand could soften the blow. The Japanese economy remains somewhat vulnerable, suggesting that further expansion of QE could be a possibility.
Spotlight on Spread Sectors
Although we believe that developed market government bonds are richly valued in regions such as the U.S., core Europe and Japan, the spread sectors are a different story. Given current valuations and our expectation for modest growth in the U.S., we have a generally positive outlook for the U.S. credit market in 2016. Slower growth in China and weakness in the commodity market have fueled concerns that we are getting closer to the late innings of the current credit cycle, but we think it still has room to run. In the U.S. investment grade credit market, we anticipate modest spread tightening over the next 12 months, with periodic volatility opening up opportunities in mispriced securities. Still, pockets of weakness will likely persist, especially for sectors with direct or indirect commodity exposure. Among sectors, we think U.S. banking is attractive. Its credit cycle is in its earlier days and banks continue to improve their balance sheets and de-risk their businesses. While their spreads have tightened and the upside is more modest, we believe the sector offers attractive risk/return prospects for 2016.
Among non-U.S. credits, we also see some attractive opportunities. In our view, Europe is likely to see an acceleration in growth in 2016 and could exceed low expectations. The eurozone is benefiting from the weaker currency, less fiscal austerity, increased credit flows and lower oil prices . In addition, we anticipate very accommodative policy, as the ECB is motivated to lock in and even amplify the recent weakness of the euro. In such an environment, we would anticipate conditions being favorable for risk assets. Among corporate credits, we find high yield particularly compelling, as valuations are attractive and current spread levels provide an appealing carry over investment grade bonds.
RMBS, TIPS Appear Attractive
Within the securitized space, we believe non-agency residential mortgage-backed securities ( RMBS ) continue to represent solid relative value. In our view, these securities have attractive loss-adjusted yields with very low interest rate risk. In addition, rating agency activity over the past year has been heavily skewed toward upgrades relative to downgrades. Finally, the asset class has had a relatively low correlation with other non-investment grade credit. We are not as bullish on the agency mortgage-backed securities market (MBS), as it continues to trade at historically tight spread levels due to technical factors. However, these tight spreads will likely persist until there is a change in the Fed's involvement in the market and/or a loosening of credit which would likely increase supply. Finally, recent spread widening has increased the attractiveness of the commercial mortgage-backed securities ( CMBS ) market. However, this is tempered by our concerns over the quality of the underwriting in some of the more recently issued CMBS deals.
Elsewhere, over the next one to two years we anticipate a very healthy environment for Treasury inflation-protected securities ( TIPS ). Real yields are now in positive territory and among the highest in developed markets. Moreover, Fed hikes are expected to be slower than normal and we believe the central bank will accept the tradeoff of tight labor markets to ensure that its 2% inflation target is met.
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