A lot has happened since this time last year. Overall, we have underestimated U.S. growth momentum so far this year. At least temporarily, tax cuts and spending increases have produced a bigger effect than we had initially thought. We also underestimated the potential for Fed action, following the change of leadership. By contrast, European growth has been slower than we expected. We were late in understanding the market consequences of Italy's changing political landscape and did not foresee the speed and extent of the spread widening in emerging-market bonds. On the plus side, our out-of-consensus currency call of 1.15 dollars per euro proved spot on.
As we head into the fall, our outlook remains broadly intact. We remain strongly in favor of the short to medium end of the U.S. Treasury curve. We expect 2-year Treasuries to deliver a total return of approximately 2.8%, which looks quite attractive on a risk-adjusted basis, particularly since we expect the dollar to trade sideways. That said, we remain constructive on corporate credit and see selective opportunities in emerging markets.
To take each of these themes in turn, we continue to see solid economic momentum in the United States. With no recession in sight, Fed tightening remains on track. In addition to the rate hike just implemented in September , we expect three more increases by September 2019. There might be one more, later on in 2019, perhaps marking the end of this tightening cycle. This would translate into a federal funds rate peaking in the range of 2.75% to 3.25% and may well coincide with an even flatter yield curve. For now, we have left our strategic forecasts for 10-year and 30-year Treasuries unchanged, at 3.25% and 3.45%, suggesting returns too low in longer-dated Treasuries to compensate for the corresponding duration risks.
In Europe, we currently tend to avoid core government bonds. Italy may continue to offer some tactical trading opportunities but with a lot of binary risk related to its uncertain politics and ratings outlook. We expect that a downgrade to junk can be avoided. In the short term, spreads will obviously depend on ongoing budget negotiations. Assuming no escalation in Europe's periphery, the ECB looks set to start its hiking cycle relatively slowly and to continue to reinvest proceeds from their various purchasing programs.
All this should provide a fairly favorable backdrop for corporate credit. In particular, we think that European credit markets have overreacted to the admittedly negative news flow we have seen in recent months. Going forward, we believe that spreads in investment-grade credit as well as euro high yield will tighten. In U.S. high yield, we think that it is reasonable to assume some widening but still see positive absolute returns. In contrast to many other riskier credit assets, U.S. high yield has held up very well in recent months. In both Europe and the U.S. credit fundamentals remain solid, and default rates extremely low.
Recent sell-offs have also created selective opportunities in emerging markets. With spreads on emerging-market hard-currency sovereigns at 350 basis points, we see strategically attractive entry levels, for example in Russia. The recent increase in oil prices will help some emerging markets and hurt others. To be sure, there are plenty of risks to watch, including the upcoming presidential elections in Brazil. The rise of populism in both emerging and developed markets as well as the resulting tariff measures and trade tensions may continue to weigh on sentiment. Economically short-sighted U.S. trade policies could increase the scope for instability and could also contribute to slow or misguided policy responses in other countries. U.S. relations with Mexico's new left-wing government may prove more difficult to manage. That said, a lot of all this is already reflected in current emerging-market spread levels. With markets likely to remain volatile, a thorough understanding of country-specific factors will prove essential to correctly assess and time emerging-market opportunities. It is also worth keeping in mind that over the past 25 years, emerging-market bonds have been performing quite strongly, compared to other risky assets.
Despite recent setbacks, emerging-market sovereign bonds have outperformed U.S. equities and U.S. high-yield bonds over the past 25 years.
Sources: Bloomberg Finance L.P., DWS Investment GmbH as of 8/3/18
** S&P 500
High-yield default rates remain very low by historic standards, on both sides of the Atlantic.
Sources: Bloomberg Finance L.P., DWS Investment GmbH as of 9/3/18
* Default rate based on issuers 12 months prior to the date of default
** U.S.-domiciled companies in the ICE BofA Merrill Lynch Global High Yield Index
*** Europe-domiciled companies in the ICE BofA Merrill Lynch Global High Yield Index
The probability that most currency pairs will trade more or less at their current levels for twelve months is, of course, very low. Yet we expect the exchange rates of the most important economic regions to fluctuate in a narrow range of plus/minus 4% – with movements of more than 10% only for emerging-market currencies. Why? There can be two reasons for predicting such low volatility. The first is the belief that all known input factors are adequately priced in, which we believe is the case now for the euro/dollar. The second reason is the certainty of momentous uncertainty. This means that we anticipate decisions during the forecast period that can produce very different results with, in turn, major significance for capital markets. These events include Brexit, the budget plans of the Italian government, the U.S. mid-term elections, and the question as to how far Trump is willing to escalate the trade conflict. Their outcome, or even the probability of the many different possible outcomes, is very hard to predict, and we prefer to take a neutral stance.
China's willingness to manipulate its own currency also falls into this category. In the case of the renminbi, however, we assume that it will continue to weaken even without any intervention and that 7.00 yuan to the dollar is not an obstacle. For the vast majority of the other currency pairs, our positioning remains Neutral. We will adopt a clearer stance again in the coming quarter within the framework of our full-year forecast for 2019 – provided there are good reasons to do so.
The word is probably out that nominal rates are higher in the U.S. than in Germany, so the spread is of little help to predict short-term currency moves.
Source: Thomson Reuters Datastream as of 09/25/18