Standish Mellon Asset Management
May 19, 2017
Specialist multi-asset investment management firm

Bond Market Observations: Coping with Climate Change

A few more pieces have fit into place of the economic and financial market puzzle that we have been staring at for so long. It is not that US economic data have been especially encouraging. The first-quarter pothole was a little deeper and more bone jarring than expected, and household and business surveys on the outlook have continued mostly to run ahead of official statistics. The Washington political scene still does not make sense. The atmosphere of antagonism may be short of its all-time worst—after all, no one has been caned on the Senate floor and the president has not yet fired a pistol off the back porch of the White House. Nonetheless, the prospect for cooperation between the two parties seems remote; a lot of oxygen under the Capitol dome is sucked up by pursuing scandals at the cost of framing economic policies and spasms of concern about the viability of the Trump administration trigger bouts of financial market volatility. While the French presidential-election result was reassuring, President Emmanuel Macron will need to pivot from campaigning to governing which, judging by recent US experience, could pose a challenge. In addition, other major risk events dot the European calendar.


Nevertheless, we take some comfort in the observation that investors now seem more resigned that slow economic growth, low real interest rates and compressed risk spreads reflect the climate to come, not the weather of the moment. The lining is silver in this dark economic cloud because this climate allows central banks to renormalize the stances of their policies slowly and to a previously unthinkably low cruising altitude for nominal policy rates. With growth slow, large firms can muscle into a bigger market share in order to raise profit margins. They can do so without stretching their balance sheets, while supporting their share values and while justifying narrow credit risk spreads. In these circumstances, financial-market volatility will mostly remain low in a world that delivers neither economic growth nor drama. This implies that there are selective investable opportunities in corporate credit.

Coping with Climate Change
May 2017
By: The Standish
Investment Committee
A few more pieces have fit into place of the economic and financial market puzzle that we have
been staring at for so long. It is not that US economic data have been especially encouraging.
The first-quarter pothole was a little deeper and more bone jarring than expected, and household
and business surveys on the outlook have continued mostly to run ahead of official statistics. The
Washington political scene still does not make sense. The atmosphere of antagonism may be
short of its all-time worst—after all, no one has been caned on the Senate floor and the president
has not yet fired a pistol off the back porch of the White House. Nonetheless, the prospect for
cooperation between the two parties seems remote; a lot of oxygen under the Capitol dome is
sucked up by pursuing scandals at the cost of framing economic policies and spasms of concern
about the viability of the Trump administration trigger bouts of financial market volatility. While the
French presidential-election result was reassuring, President Emmanuel Macron will need to pivot
from campaigning to governing which, judging by recent US experience, could pose a challenge. In
addition, other major risk events dot the European calendar.
Nevertheless, we take some comfort in the observation that investors now seem more resigned that
slow economic growth, low real interest rates and compressed risk spreads reflect the climate to
come, not the weather of the moment. The lining is silver in this dark economic cloud because this
climate allows central banks to renormalize the stances of their policies slowly and to a previously
unthinkably low cruising altitude for nominal policy rates. With growth slow, large firms can muscle
into a bigger market share in order to raise profit margins. They can do so without stretching their
balance sheets, while supporting their share values and while justifying narrow credit risk spreads.
In these circumstances, financial-market volatility will mostly remain low in a world that delivers
neither economic growth nor drama. This implies that there are selective investable opportunities
in corporate credit.
Given this economic backdrop, only small changes were necessary in our depiction of the
investment landscape this month. We still advise being leery of risk-taking, favoring portfolios with
durations shy of the benchmark in advance of the nominal Treasury backing up as investors get
fully on board with the US Federal Reserve (Fed) firming train. The appropriate place to position for
this Fed firming is to focus on policy makers’ concern—breakeven inflation rates should rise as the
weight of resource use pushes up costs and shows through to headline inflation. Even so, nominal
dollar-bloc rates remain the best houses on a bad block as long as the European Central Bank (ECB)
pins German bund yields at uneconomic levels.
Bond Market Observations:
2
The overshoot of US inflation is modest and contained by the gradual renormalization of the Fed’s
monetary stance, both in terms of the level of the policy rate and the size of its balance sheet,
now unfolding. Slow and telegraphed Fed firming that locks in its dual objectives of maximum
employment and 2% inflation is partly made possible by the relatively steady expansion of the
global economy. The near-term success of Chinese officials in delivering growth according to their
five-year plan sustains a cyclical upswing in manufacturing worldwide; and, Saudi vigor in enforcing
oil production cutbacks, even as US shale oil producers ramp up output, keeps energy prices range
bound. In these circumstances, US economic performance is not much of an outlier, which caps
the foreign-exchange value of the dollar. This provides a favorable backdrop for emerging-market
credit, especially when denominated in local currencies. Nothing in this assessment makes MBS and
CMBS look any better, especially relative to more attractively priced, shorter duration ABS.
The comments provided herein are a general market overview and do not constitute investment advice, are not predictive
of any future market performance, are not provided as a sales or advertising communication, and do not represent an offer
to sell or a solicitation of an offer to buy any security. Similarly, this information is not intended to provide specific advice,
recommendations or projected returns of any particular product of Standish Mellon Asset Management Company LLC (Standish).
These views are current as of the date of this communication and are subject to rapid change as economic and market conditions
dictate. Though these views may be informed by information from publicly available sources that we believe to be accurate,
we can make no representation as to the accuracy of such sources nor the completeness of such information. Please contact
Standish for current information about our views of the economy and the markets. Portfolio composition is subject to change,
and past performance is no indication of future performance.
BNY Mellon is one of the world’s leading asset management organizations, encompassing BNY Mellon’s affiliated investment
management firms, wealth management services and global distribution companies. BNY Mellon is the corporate brand for The
Bank of New York Mellon Corporation. Standish is a registered investment adviser and BNY Mellon subsidiary.
BMO/May2017/5-19-17/BR
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Features of the Economic
Landscape
Fixed-income
Valuation
Investing
Themes
Source: Standish as of May 2017
Maintain the risk budget at current
levels for now.
Remain overweight EM risk, both in
dollars and local currency.
Maintain exposure to corporate credit
and high-quality ABS, emphasizing
security selection.
Remain underweight MBS and CMBS.
Remain long U.S. and dollar bloc rates
versus core Europe.
Overall duration should be slightly
below benchmark.
Economic expansion seems assured as
corporate earnings continue to improve
and oil prices remain range-bound.
Potential output continues to
expand sluggishly;
So, inflation ticks higher.
Public policy will likely buoy confidence,
and central banks would lean against
bouts of financial market instability.
Still, the political process may be rocky
at times, causing volatility to spike.
The scaling back of expectations about
Federal Reserve rate tightening is
overdone, especially regarding the
longer term.
The ECB will signal a tightening of its
asset purchase program this year.
Treasury yields are slightly rich given
our expectations about monetary
policy.
Even so, dollar rates are attractive rela
-
tive to European ones.
Break-evens are modestly attractive.
Corporate fundamentals are improving,
but valuations seem a bit rich.
We expect dollar weakness from
current levels.
Value remains selectively in dollar and
local-currency emerging markets.
Volatility is stubbornly and historically
low.
MBS and CMBS will continue to be
under pressure.
Remain long break-evens.
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