- We expect moderate increases in rates in 2017
- Our taxable positioning protected the downside
- Municipals suffered due to possible tax reforms
- We are focused on more attractive yields levels
Yields rose sharply following the election, exacerbating a gradual increase that began in July after economic data began to firm. The Fed acted in December with its first quarter-point rate hike in a year. We expect two more quarter-point increases in 2017, with the change of a third. While this will push short-term rates higher, we also expect a flattening of the yield curve as long-term rates remain relatively stable. The Fed may move more aggressively with improved productivity and higher labor force participation and wage growth. The Fed is also keeping an eye on the dollar's strength, with Treasury bonds already quite attractive versus other developed sovereign bonds such as German Bunds. Easy Japanese and European monetary policies may keep yields contained despite domestic stimulus proposals.
Our taxable portfolios benefited in the fourth quarter from our short-duration positioning and heavy overweight to corporate credit versus government bonds. Our allocation to Treasury Inflation Protected Securities (TIPS) also helped protect portfolios against the modest rebound in inflation expectations. Our allocation to financials performed well, thanks to a steeper yield curve and the possible rollback of the Dodd-Frank legislation. Municipal bonds were an unusual underperformer, primarily due to the treat of tax reform which would, if enacted, reduce the value of municipals' tax exemption. We expect tax reforms, but believe the total elimination of the municipal tax exemption is unlikely.
Higher rates in the absence of high inflation are good for bond investors, in our view, in spite of short-term declines in bond market values. Cash flows and maturities can be reinvested at higher rates, thus increasing the yield on a portfolio over time. Inflation is the true enemy of fixed income, but we do not believe the recent uptick in inflation expectations is necessarily a harbinger of things to come.
We currently find intermediate bonds attractive for income investors. However, signals from the Trump administration tapering of bond buying by the European Central Bank, and stabilization of the Chinese economy suggest that rate volatility risk has increased. We are thus targeting short to neutral durations relative to our strategic objectives and are continuing to overweight exposure to credit where spreads still offer value.
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Certain statements contained herein may constitute projections, forecasts, and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Certain information has been provided by third-party sources and, although believed to be reliable, it has not been independently verified, and its accuracy or completeness cannot be guaranteed.
Any opinions, projections, forecasts, and forward-looking statements presented herein are valid as of the date of this document and are subject to change.
There are inherent risks with equity investing. These risks include, but are not limited to, stock market, manager, or investment style. Stock markets tend to move in cycles, with periods of rising prices and periods of falling prices.
There are inherent risks with fixed income investing. These risks may include interest rate, call, credit, market, inflation, government policy, liquidity, or junk bond. When interest rates rise, bond prices fall. This risk is heightened with investments in longer duration fixed-income securities and during periods when prevailing interest rates are low or negative.
The yields and market values of municipal securities may be more affected by changes in tax rates and policies than similar income-bearing taxable securities. Certain investors’ incomes may be subject to the Federal Alternative Minimum Tax (AMT) and taxable gains are also possible.
As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money. Returns include the reinvestment of interest and dividends. Investing involves risk, including the loss of principal. Diversification does not ensure a profit or protect against a loss in a declining market. Past performance is no guarantee of future performance.
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The Small Business Optimism Index is compiled from a survey that is conducted each month by the National Federation of Independent Business (NFIB) of its members. The index is a composite of 10 seasonally adjusted components based on the following questions: plans to increase employment, plans to make capital outlays, plans to increase inventories, expectations of the economy to improve, expectations of real sales to move higher, current inventory, current job openings, expected credit conditions, whether now a good time to expand, and earnings trend.
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