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2018 Market Outlook: Fixed Income

Key Points
  • Past the peak of central bank stimulus: Led by the Federal Reserve, major central banks are poised to reduce the amount of monetary stimulus flowing to the global economy. Deflation fears are easing, with interest rates slowly moving out of negative territory in Europe and Japan, a trend we expect to continue in 2018.

  • Potential inflation surprise: Stronger economic growth, a tight labor market and the prospect of tax cuts could mean that inflation in the U.S. hits or exceeds the Federal Reserve’s 2% target in 2018.

  • Markets appear complacent: With rates low, a flattening yield curve and tight credit spreads, fixed income markets aren’t priced for higher inflation or volatility.

Central bank tightening may awaken bond bears

2018 could be the year that bond bears finally awaken from their long slumber, sending 10-year Treasury bond yields above the three-year high of 2.6%.  Economic growth is picking up both globally and domestically and fiscal policy is becoming more expansive. Most importantly, the era of extremely easy money is coming to an end. The Federal Reserve is tightening monetary policy through rate hikes and balance sheet reduction. The European Central Bank (ECB) is planning to gradually reduce its bond buying program. Even the Bank of Japan (BOJ) is seeing some success with positive inflation while focusing on keeping 10-year bond yields at zero or above. As the easy-money era gradually recedes, we see more upside risk in yields than downside.

Bond bears awakening

Bond markets are highly valued

Most segments of the fixed income markets appear expensive relative to long-term average valuations. Yields in the corporate and municipal bond markets are low compared to Treasury yields, providing little reward for added risk. With the economic outlook positive, we don’t anticipate a major increase in yield spreads, but there simply isn’t much room for further narrowing. Since risks rise as credit quality declines, we are most cautious about lower credit quality bonds—like high-yield corporate bonds. 2018 could be a year when the income generated by bonds is the major source of return rather than price appreciation.

With markets priced for ongoing moderate growth and low volatility, the risks we are monitoring include the potential for more central bank tightening than expected and the potential for fiscal stimulus from tax reform.

Takeaways

  • Short-to-intermediate duration: For Treasuries and investment grade bonds, we suggest keeping duration in the 3-7 year range to mitigate the risks of rising rates. Investment grade floating-rate notes should benefit from further Federal Reserve tightening.
  • Stay up in quality: Corporate bond credit spreads are near the post-crisis lows and well below their long-term averages, offering little compensation for their additional risks. Even a modest rise in the yield spread—likely due to increased volatility—could result in disappointing returns for lower-rated bonds.
  • International: Low yields and the potential for tighter monetary policy make international and emerging market bonds less attractive.
  • Municipal bonds: Valuations are high for short-term maturities but near long-term averages for longer maturities. Credit quality remains high in general. Five- to eight-year durations offer better risk/return characteristics.
2018 Market Outlook: Global Stocks and Economy
2018 Global Market Outlook: Three Actions to Take for the Year Ahead
2018 Global Market Outlook: Three Actions to Take for the Year Ahead

Past performance is no guarantee of future results. Forecasts contained herein are for illustrative purposes, may be based upon proprietary research and are developed
through analysis of historical public data.

The information here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation.

Data here is obtained from what are considered reliable sources; however, its accuracy, completeness, or reliability cannot be guaranteed. Supporting documentation for any claims or statistical information is available upon request.

All expressions of opinion are subject to change without notice in reaction to shifting market, economic or geopolitical conditions.

Specific names/titles are for illustrative purposes only.

Indices are unmanaged; do not incur management fees, costs, or expenses; and cannot be invested in directly.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.

While the market value of a floating rate note is relatively insensitive to changes in interest rates, the income received is highly dependent upon the level of the reference rate over the life of the investment. Total return may be less than anticipated if future interest rate expectations are not met.

International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.

Tax-exempt bonds are not necessarily a suitable investment for all persons. Information related to a security’s tax-exempt status (federal and in-state) is obtained from third-parties and Schwab does not guarantee its accuracy. Tax-exempt income may be subject to the Alternative Minimum Tax (AMT). Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.

High-yield bonds and lower rated securities are subject to greater credit risk, default risk, and liquidity risk.

Diversification, automatic investing and rebalancing strategies do not ensure a profit and do not protect against losses in declining markets.

Index and Term Definitions

S&P 500® Index is a capitalization-weighted index of 500 stocks from a broad range of industries. The component stocks are weighted according to the total market value of their outstanding shares.

The MSCI All Country World Index (ACWI) captures large and mid-cap representation across 23 Developed Markets (DM) and 23 Emerging Markets (EM) countries. With 2,484 constituents, the index covers approximately 85% of the global investable equity opportunity set.

The Nikkei-225 Stock Average is a price-weighted average of 225 top-rated Japanese companies listed in the First Section of the Tokyo Stock Exchange.

The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.

The Bloomberg Barclays U.S. Corporate Bond Index covers the U.S. dollar (USD)-denominated investment-grade, fixed-rate, taxable corporate bond market. Securities are included if rated investment-grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody’s, S&P and Fitch ratings services. This index is part of the

The Bloomberg Barclays U.S. Aggregate Bond Index (Agg). The Bloomberg Barclays U.S. Corporate 1-5 Year Bond Index is part of the Barclays U.S. Corporate Bond Index.

The Bloomberg Barclays U.S. Corporate High-Yield Bond Index covers the USD-denominated, non-investment grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.

The Bloomberg Barclays U.S. Floating-Rate Notes Index measures the performance of investment-grade floating-rate notes across corporate and government-related sectors.

The Bloomberg Barclays Global Aggregate Bond Index provides a broad-based measure of the global investment-grade fixed-rate debt markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The Global Aggregate Bond Index ex US excludes the U.S. Aggregate component.

The Bloomberg Barclays U.S. Corporate High-Yield Bond Index covers the USD-denominated, non-investment grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.

The Bloomberg Barclays U.S. Corporate Bond Index covers the USD-denominated investment grade, fixed-rate, taxable, corporate bond market. Securities are included if rated investment-grade (Baa3/BBB-/BBB) or higher using the middle rating of Moody’s, S&P, and Fitch. This index is part of the U.S. Aggregate.

The Bloomberg Barclays EM USD Aggregate Index includes USD-denominated debt from emerging markets in the following regions: Americas, Europe, Middle East, Africa, and Asia. As with other fixed income benchmarks provided by Barclays, the index is rules-based, allowing for an unbiased view of the marketplace and easy replicability.

The BofA Merrill Lynch Fixed Rate Preferred Securities Index tracks the performance of fixed-rate U.S. dollar (USD)-denominated preferred securities issued in the U.S. domestic market.

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