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Global Fixed-Income Markets 3Q: Economic Outlook and Interest Volatility


Economic Outlook


FRAN RODILOSSO: Our outlook for fixed income markets in the third quarter is a mixed bag. While we remain somewhat positive on credit markets, given an okay growth story, our concern on the interest rate side is beginning to rise again. Despite a negative first quarter, U.S. growth appears to have accelerated in Q2, or at least become positive again, and has scope to potentially accelerate in the third quarter. Versus a year ago, we're seeing higher consumption numbers, higher consumer confidence, higher loan growth, and also signs of higher inflation by most readings including the ones the Fed watches most closely. Europe, of course, is still experiencing very weak growth and virtually no inflation. The European Central Bank has recently moved one of its target rates to negative territory. Europe is still at least a year, if not two, behind the U.S. in terms of easy monetary policy. The growth outlook for emerging markets remains something below potential. Emerging markets economies overall, however, are expected to grow in excess of 4% in 2014, although most of that growth will be driven by Asia.


U.S. Credit Markets


RODILOSSO: In terms of credit markets, we continue to view a lukewarm growth story coupled with low rates as credit positive, particularly when you add in highly accessible capital markets. Inasmuch as companies are using those markets to refinance or extend debt maturity profiles, we think the news is fairly benign. As more and more issuers seek to use capital markets for other purposes -- either expansion or M&A type activity -- investors will need to be increasingly discerning.


 

U.S. Interest Rates


RODILOSSO: The interest rate question is probably a tougher one than credit at this point. The move thus far in 2014 has caught some people by surprise. But with 10-year yields back around 2.6% in late June, the idea of extending duration -- taking on that added risk to enhance yield in the portfolio -- does not make a lot of sense to us. In fact, whereas the taper continues, the bigger question going forward is when the Fed will start raising short-term rates.


Global asset prices in general -- certainly global fixed income asset prices -- are susceptible to a move higher in treasury yields. We think that is the greater risk to fixed income markets in Q3 and Q4 of this year. Although the scaling back of asset purchases by the Fed has in effect not troubled the market thus far in 2014, we still believe that the Fed will have difficulty navigating an elegant exit to a combination of quantitative easing and zero interest rate policy, particularly as we're seeing some volatility in inflation numbers. That’s really the risk to fixed income markets going forward. It's not so much higher rates -- are rates moving steadily higher? -- its interest rate volatility. If the market starts losing faith in the Fed's ability to navigate way smoothly, you may see higher interest rate volatility.


Emerging Markets Debt

RODILOSSO: Even after outperforming most markets during the first half of 2014, emerging markets debt may still have room to do well in the second half. On the corporate and sovereign hard currency debt side, spreads versus U.S. corporate debt are still above historic averages. On the local-currency side, the index is currently yielding roughly 6%. There could be room for interest rates to come in. The currency volatility has been lower, at least of late. We could expect pockets of volatility going forward, but I think EM was well tested in 2013 in terms of its ability to both withstand and respond to currency volatility.


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