INSIGHTS

On July 31, 2017

HIMCO Market Outlooks

Equity Market Outlook (as of June 30, 2017)

Strong earnings shrug off the slack in the Trump Trade. Despite slow progress in promises made for lower corporate tax rates, foreign cash repatriation, and reduced regulation, the S&P 500 rallied to an all-time high of 2454 on June 19^th and modestly retreated from there on the back of hawkish Central Bank speak to end the quarter at 2423, a total return of +3% for the quarter. One-third of this return came from improved earnings growth expectations for the year (which now sit at +11%), supported by a strong 1Q17 earnings season (with 47% of companies beating estimates on sales and earnings versus 35% historical average), and healthy management guidance. The other two thirds of returns came from expanding multiples, which have moved from 1- to 2-standard deviations away from historical means.

Outside of the dampened Trump Trade, markets were largely well-behaved despite another rate hike by the Fed in June. There were short-lived bouts of volatility, but the VIX index stayed near all-time low territory for most of the quarter, and 10-Year UST (U.S. Treasury) yields remained range bound between 2.20-2.40%. Within sectors, telecommunication services (-7%) and energy (-6%) were laggards in the quarter. The former has been the victim of a rotation away from it and into banks, which accelerated since the 10-Year hit its trough mid-June, while the latter has seen the first order effect of collapsing oil prices, which declined 9% in the quarter on concerns over U.S. supply growth. Healthcare (+7%) and industrials (+5%) were the best performing S&P 500 sectors.

From a quantitative perspective, growth outperformed again in the quarter, while value and quality lagged. Of note, the year-to-date gap between large growth and small value total return (~22%) is the largest on record, and the gap between best and worst performing sectors is the fourth largest.

Looking forward, we see additional room to run for equities. We expect continued growth in the second half of the year as pro-business policies are expected to be delivered around year-end. Possible factors that could affect this outlook include monetary policy becoming too tight too quickly, before a handoff to fiscal policy is completed, as well as the possible drag to capital expenditures from lower oil prices.

High Yield Fixed Income Market Outlook (as of June 30, 2017)

The High Yield Market continued to grind higher in the 2^nd quarter of 2017 (2Q2017), building off the strong returns of 2016 and 1Q2017 with another quarter of positive performance measured on a total return basis. There were similar themes in play during Q2 (2^nd quarter) that we have been referencing since mid-2016 which have helped the market continue its rally from its February 2016 market lows. These themes include stable to increasing commodity prices which have been supported by OPEC and its members’ desire to stabilize world oil markets. Although WTI (West Texas Intermediate) and Brent Oil have become more volatile of late, the current range of $45-55 remains intact. Also, easy global central bank policy has helped quell market volatility and support continued economic growth as loose/accommodative monetary policy has stimulated demand and economic activity over the past two years. In addition, a pro-business and pro-growth Trump/Republican regime has acted as an economic “shot in the arm” here in the United States as investors have started to price in what this type of presidency could mean for different sectors of the economy as far as growth, expansionary Cap Ex and shareholder returns. Finally, corporate earnings have continued to improve as 4Q 2016 and 1Q 2017 numbers have matched or surpassed most expectations allowing companies to slowly de-lever as top line growth and margin expansion take hold. Given the supportive backdrop described above, risk markets rallied further during the 2nd quarter as the Bloomberg Barclays U.S. High Yield Index returned +2.17%, building upon the market’s strong first quarter performance of +2.70% and 2016’s full year return of +17.13%.

During 1Q2017, the lower quality sectors and capital structures within the High Yield market outperformed continuing their performance trends from 2016. However, in 2Q2017, we saw a bit of a divergence from recent performance trends as investors sought out a bit more safety given recent performance and current trading levels. The double B-rated part of the market was the top performer in 2Q17 returning +2.68% followed by distressed (Ca/D-rated) sectors and securities which returned +2.39% giving the market a true barbell-type return profile during the quarter. Triple C-rated (+1.85%) and single B-rated (+1.71%) securities lagged the overall market return. On a year to date (YTD) basis, the distressed (+11.47%) and triple C (+6.59%) segments of the market have outperformed the double B (+4.79%) and single B (+4.28%) parts of the market while the broad market index (Bloomberg Barclays U.S. High Yield Index) has returned +4.93%.

From a sector standpoint, pharmaceuticals (+5.44%), banking (+4.60%), manufacturing (+3.94%), finance companies (+3.81%) and paper (+3.68%) outperformed the overall market while oil field services (-4.43%), independent energy (-2.24%), industrials (-1.29%), electric (+1.06%) and supermarkets (+1.34%) were the worst performing sectors during 2Q17. On a YTD basis, pharmaceuticals (+8.95%), healthcare (+7.89%) and banking (7.77%) are the top 3 performing sectors while independent energy (-1.40%), oil field services (+.24%) and retailers (+.96%) are the market laggards so far in 2017.

After hitting market wides of +839 option adjusted spread (OAS) in February of 2016, the High Yield market has staged a meaningful recovery as global recession fears have eased as Central Banks have committed and re-committed to accommodative monetary policy. The High Yield market has also benefitted from a strong move higher in oil from $25 to $50 per barrel over the last six quarters as well as further stabilization in copper and iron ore pricing. Also, a Republican regime led by President Trump has been viewed as business friendly and pro-growth. In addition, corporate earnings have stabilized and expanded over the past several quarters which has allowed the market to price in continued and future top line growth, margin expansion and balance sheet de-levering. In our view, all of these factors allowed spreads to rally another 19bps (basis points) this quarter to close at +364 OAS.

Over the next few quarters, there are many factors to consider as we think about relative value in the High Yield market. Currently, given our outlook of slow to moderate economic growth, stable commodity prices and continued supportive monetary policy within the current credit cycle, which we see as peaked as far as credit quality, defaults and recovery rates, we see +350 OAS as fair value for the High Yield market pricing in all of the above. The 2016-2017 commodity-led default wave within the current credit cycle has played out and many lower quality names have been re-structured out of the market. We see defaults returning to their normal 2.5-3% in 2017 with recoveries moving closer to their long term averages. Risks to the downside include policy error (either Central Bank or Trump-induced or a combination of the two) along with slower than expected U.S. and global growth as economic activity wanes and the market begins to question the ability of Central Banks around the world to stimulate global growth and the possibility of a U.S. recession is put back on the table. In this case, we could re-test the 2016 wides of ~+800 OAS. Given that we see the previous scenario as a low probability event, we think the High Yield market OAS range fluctuates between +325 and +425 during 2017 with a floor of +300 and a ceiling of +450. These levels will likely be driven by the global economic picture as well as Central Bank and Government policy, corporate earnings power, commodity pricing and currency shifts.



REIT/Utilities Market Outlook (As of June 30, 2017)



REITs

The Russell 3000 REITs Index returned +2.5% in the second quarter, underperforming the broader S&P 500 Index which returned +3.0%. Most of this underperformance was driven by headwinds in REITs exposed to the retail sector. Retail REIT’s (-7%) fell in line with broader retailers as the market began pricing in the prospect of an endemic disruption to their business models, in light of the Amazon takeover of Whole Foods Markets. Specialized REIT’s provided an offset to the weakness in Retail, as their business models proved resilient. Data centers and Cloud computing continue to be a bright spot in the sector. Outside of the dampened Trump Trade, markets were largely well-behaved despite another rate hike by the Fed in June. There were short-lived bouts of volatility, but the VIX index stayed near all-time low territory for most of the quarter, and 10-Year UST yields remained range bound between 2.20-2.40%.

REITs performance in the 2^nd quarter has been driven more by fundamentals. Retail REITs have been the weakest property sector, due to fears over struggling retailers, closing stores and the long-term viability of real estate. Eight retail REITs were among the worst performers in the index. Each had a total return loss of more than 22%.

Looking forward, we continue to expect security-specific fundamentals to take a back seat to policy anticipation as we believe many investors will reposition for large-scale fiscal stimulus and higher inflation. We believe lower corporate tax rates, inflation, and infrastructure spending could significantly impact U.S. real estate prices. Winners and losers will likely be determined by policy details and timing, with health care REITs (ACA resolution) and industrial REITs (infrastructure spending) being examples of policy-sensitive subsectors. Valuations appear moderately attractive at quarter-end as our analysis indicates adjusted funds-from-operations (AFFO) payout ratios are slightly below historical averages. Fundamentals remain sound in our view as low interest rates have generally allowed REITs to generate strong cash flows to support their dividend payments. We also see balance sheets holding low levels of long-term debt, with low levels of rate-sensitive floating-rate debt.

Utilities

The utilities sector, measured by the S&P 500 Utilities Index, returned 2.0% in the second quarter lagging the broader S&P 500 Index which returned 3.0%. With an improving U.S. economy, gradually increasing inflation, and a corresponding rising-rate environment, utilities are facing challenges as more yield-based options become available to investors. Within the utilities sub-industries, electric utilities (+1.7%) led while independent power producers (-0.1%) lagged. Outside of the dampened Trump Trade, markets were largely well-behaved despite another rate hike by the Fed in June. There were short-lived bouts of volatility, but the VIX index stayed near all-time low territory for most of the quarter, and 10-Year UST yields remained range bound between 2.20-2.40%.

Looking forward, we remain cautious on fundamentals as utilities have historically been particularly susceptible to rising rates. In addition, if higher growth expectations come to fruition, we expect utility multiples to contract on a relative value basis as utility growth rates remain stable. In this backdrop, we note utilities have remained attractive to yield-focused investors as the sector was delivering a 3.4% yield through the second quarter but remind investors of the potential of loss of capital.

Possible factors that could affect this outlook include: fiscal policy under-delivering, monetary policy tightening too rapidly, growth-reducing trade conflicts, commodity price volatility, and heightened geopolitical tension. 

 

Investment Grade Credit Market Outlook (as of June 30^th, 2017)

Q2 Review: The Investment Grade Credit (IGC) market continued its march tighter, as the spread of the Bloomberg Barclays U.S. Credit Index finished the second quarter nine basis points tighter at 103, and now stands just 10bps away from the post-crisis tights. As of quarter end, the index was yielding 3.11%. Supportive Q1 earnings and European election results were the biggest drivers of investor appetite for high quality spread product during the quarter.

2017 Outlook: Looking ahead, we expect IGC spreads to finish 2017 near current levels, and for returns to be dominated by carry and security selection, rather than beta. A stronger global macroeconomic backdrop and improving corporate profitability should be supportive of credit spreads, but need to be balanced with a Fed inclined to hike rates (despite very modest inflation) and commence tapering later this year. Given current valuations, which are approaching first quartile on a historical basis, now may not be the time to reach for risk.

While we don’t anticipate a significant sell-off, we advocate staying “close to home” until either a change in the economic backdrop, issuer fundamentals, or market valuations lead us to say otherwise. In addition to our regular industry and issuer analysis, we are watching closely the details around the Fed’s tapering program, Washington D.C.’s ability to implement tax reform, non-USD interest rates, and OPEC’s desire (and ability) to maintain stable oil prices.

Municipal Bond Market Outlook (as of June 30, 2017)

As the U.S. and global bond markets struggled with potentially restrictive monetary policies, the municipal market outperformed the overall market during the 2^nd quarter as technical conditions remain supportive with healthy demand outpacing lower supply. The market also continues to be aided by the unraveling of President Trump’s pro-growth/reflation agenda and the lessening concerns surrounding tax reform as any proposed reform measures will likely be watered down and thus have a limited impact on the municipal market. The front end performed well with short term municipal yields (2 year, 5 year, 10 year) as a percentage of Treasuries moved lower during the quarter, reaching near term tights before bouncing back slightly in June. Relative value ratios in 5 and 10 years finished the quarter tighter at 71%/86% vs. last quarter at 81%/94%, respectively. The yield curve (5/10s) did flatten slightly as investors began to move out the curve to add some duration risk as policy and headline risks subsided even amid Fed tightening. Municipal supply was lower again for the quarter by 17% compared to last year, while demand picked up with mutual fund flows higher during the quarter (+$5.6Bn v. $1.5Bn 1Q) and reinvestment cash (redemptions, maturing bonds and coupon payments) higher versus last quarter and last year (see chart, +14% quarter-over-quarter and +41% year-over-year). The Bloomberg Barclay’s Municipal Bond Index (BMBI) had a total return of 1.96% during the quarter (v. 1.61% in 1Q) with 5-10 year indices returning 1%-2%.

As has been the case since the November elections, quarterly issuance has been lower with refunding issuance down 46% for the year even as new money issuance has picked up slightly. Despite significant infrastructure needs, municipal issuers still remain hesitant to borrow amid the challenges to state budgets and the uncertain future support from the federal government as well as the subpar growth in the U.S. economy.

Source: TM3 Thompson Financial

Source: Lipper U.S. Fund Flows

Source: Siebert’s - Municipal cash flow report

Source: TM3 Thompson Financial

No major change in credit fundamentals for most municipal issuers during the quarter. In general, the economic growth over the last few years has led to improvements in income, consumption and real property values that support tax-exempt securities. Economic expansion has also been a boon to the more cyclical and essential service revenue sectors like healthcare, transportation, special tax, and education. However, headline risks continue to hover over the sector related to state budget problems, particularly in IL, NJ and CT which were among 11 states without budgets.

Looking forward, we expect municipals to largely follow Treasuries as seasonal demand should remain strong during the summer months despite rich valuations, future policy risk, and recent rate increases. If rates continue to move gradually higher, relative value ratios will likely remain rich as the forward supply calendar looks underwhelming. Plus, higher yields will likely entice more retail investors into the market.

CRN: 2017-0719-6046 R

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

Hartford Investment Management Company (HIMCO) is a SEC registered investment adviser subsidiary of The Hartford Financial Services Group, Inc. SEC registration does not imply a certain level of skill or training; nor does it imply that the SEC has sponsored, recommended, or otherwise approved of HIMCO.

AAM is not affiliated with The Hartford Financial Group, Inc. or HIMCO, and was not involved in the preparation of this article. The opinions expressed herein are solely those of HIMCO, and do not necessarily reflect those of AAM.

The forecasts, opinions and estimates expressed in this report constitute HIMCO’s judgment as of June 30, 2017 and are subject to change without notice based on market, economic and other conditions. The assumptions underlying these forecasts concern future events over which we have no control. The assumptions may turn out to be materially different from actual experience. There can be no guarantee that any target or forecast will be realized.

Investment Risks: All investments involve risk, including the possible loss of principal. Fixed income investments are subject to credit and interest rate risk, as well as inflation risk and default risks. Additionally, fixed income markets, like all investment markets, can be subject to volatility.

Municipal Bonds: Municipal bonds are subject to numerous risks including rising interest rates, economic recession, deterioration of the municipal bond market, possible ratings downgrades, increased volatility, reduced liquidity, calls and associated reinvestment risk, and defaults on interest and/or principal. Certain investors in municipal strategies or products may be subject to state and local taxes. There is no guarantee that the securities held will be exempt from federal income taxes.

HIMCO Market Outlooks

By HIMCO

Equity Market Outlook (as of June 30, 2017)

Strong earnings shrug off the slack in the Trump Trade. Despite slow progress in promises made for lower corporate tax rates, foreign cash repatriation, and reduced regulation, the S&P 500 rallied to an all-time high of 2454 on June 19^th and modestly retreated from there on the back of hawkish Central Bank speak to end the quarter at 2423, a total return of +3% for the quarter. One-third of this return came from improved earnings growth expectations for the year (which now sit at +11%), supported by a strong 1Q17 earnings season (with 47% of companies beating estimates on sales and earnings versus 35% historical average), and healthy management guidance. The other two thirds of returns came from expanding multiples, which have moved from 1- to 2-standard deviations away from historical means.

Outside of the dampened Trump Trade, markets were largely well-behaved despite another rate hike by the Fed in June. There were short-lived bouts of volatility, but the VIX index stayed near all-time low territory for most of the quarter, and 10-Year UST (U.S. Treasury) yields remained range bound between 2.20-2.40%. Within sectors, telecommunication services (-7%) and energy (-6%) were laggards in the quarter. The former has been the victim of a rotation away from it and into banks, which accelerated since the 10-Year hit its trough mid-June, while the latter has seen the first order effect of collapsing oil prices, which declined 9% in the quarter on concerns over U.S. supply growth. Healthcare (+7%) and industrials (+5%) were the best performing S&P 500 sectors.

From a quantitative perspective, growth outperformed again in the quarter, while value and quality lagged. Of note, the year-to-date gap between large growth and small value total return (~22%) is the largest on record, and the gap between best and worst performing sectors is the fourth largest.

Looking forward, we see additional room to run for equities. We expect continued growth in the second half of the year as pro-business policies are expected to be delivered around year-end. Possible factors that could affect this outlook include monetary policy becoming too tight too quickly, before a handoff to fiscal policy is completed, as well as the possible drag to capital expenditures from lower oil prices.

High Yield Fixed Income Market Outlook (as of June 30, 2017)

The High Yield Market continued to grind higher in the 2^nd quarter of 2017 (2Q2017), building off the strong returns of 2016 and 1Q2017 with another quarter of positive performance measured on a total return basis. There were similar themes in play during Q2 (2^nd quarter) that we have been referencing since mid-2016 which have helped the market continue its rally from its February 2016 market lows. These themes include stable to increasing commodity prices which have been supported by OPEC and its members’ desire to stabilize world oil markets. Although WTI (West Texas Intermediate) and Brent Oil have become more volatile of late, the current range of $45-55 remains intact. Also, easy global central bank policy has helped quell market volatility and support continued economic growth as loose/accommodative monetary policy has stimulated demand and economic activity over the past two years. In addition, a pro-business and pro-growth Trump/Republican regime has acted as an economic “shot in the arm” here in the United States as investors have started to price in what this type of presidency could mean for different sectors of the economy as far as growth, expansionary Cap Ex and shareholder returns. Finally, corporate earnings have continued to improve as 4Q 2016 and 1Q 2017 numbers have matched or surpassed most expectations allowing companies to slowly de-lever as top line growth and margin expansion take hold. Given the supportive backdrop described above, risk markets rallied further during the 2nd quarter as the Bloomberg Barclays U.S. High Yield Index returned +2.17%, building upon the market’s strong first quarter performance of +2.70% and 2016’s full year return of +17.13%.

During 1Q2017, the lower quality sectors and capital structures within the High Yield market outperformed continuing their performance trends from 2016. However, in 2Q2017, we saw a bit of a divergence from recent performance trends as investors sought out a bit more safety given recent performance and current trading levels. The double B-rated part of the market was the top performer in 2Q17 returning +2.68% followed by distressed (Ca/D-rated) sectors and securities which returned +2.39% giving the market a true barbell-type return profile during the quarter. Triple C-rated (+1.85%) and single B-rated (+1.71%) securities lagged the overall market return. On a year to date (YTD) basis, the distressed (+11.47%) and triple C (+6.59%) segments of the market have outperformed the double B (+4.79%) and single B (+4.28%) parts of the market while the broad market index (Bloomberg Barclays U.S. High Yield Index) has returned +4.93%.

From a sector standpoint, pharmaceuticals (+5.44%), banking (+4.60%), manufacturing (+3.94%), finance companies (+3.81%) and paper (+3.68%) outperformed the overall market while oil field services (-4.43%), independent energy (-2.24%), industrials (-1.29%), electric (+1.06%) and supermarkets (+1.34%) were the worst performing sectors during 2Q17. On a YTD basis, pharmaceuticals (+8.95%), healthcare (+7.89%) and banking (7.77%) are the top 3 performing sectors while independent energy (-1.40%), oil field services (+.24%) and retailers (+.96%) are the market laggards so far in 2017.

After hitting market wides of +839 option adjusted spread (OAS) in February of 2016, the High Yield market has staged a meaningful recovery as global recession fears have eased as Central Banks have committed and re-committed to accommodative monetary policy. The High Yield market has also benefitted from a strong move higher in oil from $25 to $50 per barrel over the last six quarters as well as further stabilization in copper and iron ore pricing. Also, a Republican regime led by President Trump has been viewed as business friendly and pro-growth. In addition, corporate earnings have stabilized and expanded over the past several quarters which has allowed the market to price in continued and future top line growth, margin expansion and balance sheet de-levering. In our view, all of these factors allowed spreads to rally another 19bps (basis points) this quarter to close at +364 OAS.

Over the next few quarters, there are many factors to consider as we think about relative value in the High Yield market. Currently, given our outlook of slow to moderate economic growth, stable commodity prices and continued supportive monetary policy within the current credit cycle, which we see as peaked as far as credit quality, defaults and recovery rates, we see +350 OAS as fair value for the High Yield market pricing in all of the above. The 2016-2017 commodity-led default wave within the current credit cycle has played out and many lower quality names have been re-structured out of the market. We see defaults returning to their normal 2.5-3% in 2017 with recoveries moving closer to their long term averages. Risks to the downside include policy error (either Central Bank or Trump-induced or a combination of the two) along with slower than expected U.S. and global growth as economic activity wanes and the market begins to question the ability of Central Banks around the world to stimulate global growth and the possibility of a U.S. recession is put back on the table. In this case, we could re-test the 2016 wides of ~+800 OAS. Given that we see the previous scenario as a low probability event, we think the High Yield market OAS range fluctuates between +325 and +425 during 2017 with a floor of +300 and a ceiling of +450. These levels will likely be driven by the global economic picture as well as Central Bank and Government policy, corporate earnings power, commodity pricing and currency shifts.

REIT/Utilities Market Outlook (As of June 30, 2017)

REITs

The Russell 3000 REITs Index returned +2.5% in the second quarter, underperforming the broader S&P 500 Index which returned +3.0%. Most of this underperformance was driven by headwinds in REITs exposed to the retail sector. Retail REIT’s (-7%) fell in line with broader retailers as the market began pricing in the prospect of an endemic disruption to their business models, in light of the Amazon takeover of Whole Foods Markets. Specialized REIT’s provided an offset to the weakness in Retail, as their business models proved resilient. Data centers and Cloud computing continue to be a bright spot in the sector. Outside of the dampened Trump Trade, markets were largely well-behaved despite another rate hike by the Fed in June. There were short-lived bouts of volatility, but the VIX index stayed near all-time low territory for most of the quarter, and 10-Year UST yields remained range bound between 2.20-2.40%.

REITs performance in the 2^nd quarter has been driven more by fundamentals. Retail REITs have been the weakest property sector, due to fears over struggling retailers, closing stores and the long-term viability of real estate. Eight retail REITs were among the worst performers in the index. Each had a total return loss of more than 22%.

Looking forward, we continue to expect security-specific fundamentals to take a back seat to policy anticipation as we believe many investors will reposition for large-scale fiscal stimulus and higher inflation. We believe lower corporate tax rates, inflation, and infrastructure spending could significantly impact U.S. real estate prices. Winners and losers will likely be determined by policy details and timing, with health care REITs (ACA resolution) and industrial REITs (infrastructure spending) being examples of policy-sensitive subsectors. Valuations appear moderately attractive at quarter-end as our analysis indicates adjusted funds-from-operations (AFFO) payout ratios are slightly below historical averages. Fundamentals remain sound in our view as low interest rates have generally allowed REITs to generate strong cash flows to support their dividend payments. We also see balance sheets holding low levels of long-term debt, with low levels of rate-sensitive floating-rate debt.

Utilities

The utilities sector, measured by the S&P 500 Utilities Index, returned 2.0% in the second quarter lagging the broader S&P 500 Index which returned 3.0%. With an improving U.S. economy, gradually increasing inflation, and a corresponding rising-rate environment, utilities are facing challenges as more yield-based options become available to investors. Within the utilities sub-industries, electric utilities (+1.7%) led while independent power producers (-0.1%) lagged. Outside of the dampened Trump Trade, markets were largely well-behaved despite another rate hike by the Fed in June. There were short-lived bouts of volatility, but the VIX index stayed near all-time low territory for most of the quarter, and 10-Year UST yields remained range bound between 2.20-2.40%.

Looking forward, we remain cautious on fundamentals as utilities have historically been particularly susceptible to rising rates. In addition, if higher growth expectations come to fruition, we expect utility multiples to contract on a relative value basis as utility growth rates remain stable. In this backdrop, we note utilities have remained attractive to yield-focused investors as the sector was delivering a 3.4% yield through the second quarter but remind investors of the potential of loss of capital.

Possible factors that could affect this outlook include: fiscal policy under-delivering, monetary policy tightening too rapidly, growth-reducing trade conflicts, commodity price volatility, and heightened geopolitical tension.

Investment Grade Credit Market Outlook (as of June 30^th, 2017)

Q2 Review: The Investment Grade Credit (IGC) market continued its march tighter, as the spread of the Bloomberg Barclays U.S. Credit Index finished the second quarter nine basis points tighter at 103, and now stands just 10bps away from the post-crisis tights. As of quarter end, the index was yielding 3.11%. Supportive Q1 earnings and European election results were the biggest drivers of investor appetite for high quality spread product during the quarter.

2017 Outlook: Looking ahead, we expect IGC spreads to finish 2017 near current levels, and for returns to be dominated by carry and security selection, rather than beta. A stronger global macroeconomic backdrop and improving corporate profitability should be supportive of credit spreads, but need to be balanced with a Fed inclined to hike rates (despite very modest inflation) and commence tapering later this year. Given current valuations, which are approaching first quartile on a historical basis, now may not be the time to reach for risk.

While we don’t anticipate a significant sell-off, we advocate staying “close to home” until either a change in the economic backdrop, issuer fundamentals, or market valuations lead us to say otherwise. In addition to our regular industry and issuer analysis, we are watching closely the details around the Fed’s tapering program, Washington D.C.’s ability to implement tax reform, non-USD interest rates, and OPEC’s desire (and ability) to maintain stable oil prices.

Municipal Bond Market Outlook (as of June 30, 2017)

As the U.S. and global bond markets struggled with potentially restrictive monetary policies, the municipal market outperformed the overall market during the 2^nd quarter as technical conditions remain supportive with healthy demand outpacing lower supply. The market also continues to be aided by the unraveling of President Trump’s pro-growth/reflation agenda and the lessening concerns surrounding tax reform as any proposed reform measures will likely be watered down and thus have a limited impact on the municipal market. The front end performed well with short term municipal yields (2 year, 5 year, 10 year) as a percentage of Treasuries moved lower during the quarter, reaching near term tights before bouncing back slightly in June. Relative value ratios in 5 and 10 years finished the quarter tighter at 71%/86% vs. last quarter at 81%/94%, respectively. The yield curve (5/10s) did flatten slightly as investors began to move out the curve to add some duration risk as policy and headline risks subsided even amid Fed tightening. Municipal supply was lower again for the quarter by 17% compared to last year, while demand picked up with mutual fund flows higher during the quarter (+$5.6Bn v. $1.5Bn 1Q) and reinvestment cash (redemptions, maturing bonds and coupon payments) higher versus last quarter and last year (see chart, +14% quarter-over-quarter and +41% year-over-year). The Bloomberg Barclay’s Municipal Bond Index (BMBI) had a total return of 1.96% during the quarter (v. 1.61% in 1Q) with 5-10 year indices returning 1%-2%.

As has been the case since the November elections, quarterly issuance has been lower with refunding issuance down 46% for the year even as new money issuance has picked up slightly. Despite significant infrastructure needs, municipal issuers still remain hesitant to borrow amid the challenges to state budgets and the uncertain future support from the federal government as well as the subpar growth in the U.S. economy.

Source: TM3 Thompson Financial

Source: Lipper U.S. Fund Flows

Source: Siebert’s - Municipal cash flow report

Source: TM3 Thompson Financial

No major change in credit fundamentals for most municipal issuers during the quarter. In general, the economic growth over the last few years has led to improvements in income, consumption and real property values that support tax-exempt securities. Economic expansion has also been a boon to the more cyclical and essential service revenue sectors like healthcare, transportation, special tax, and education. However, headline risks continue to hover over the sector related to state budget problems, particularly in IL, NJ and CT which were among 11 states without budgets.

Looking forward, we expect municipals to largely follow Treasuries as seasonal demand should remain strong during the summer months despite rich valuations, future policy risk, and recent rate increases. If rates continue to move gradually higher, relative value ratios will likely remain rich as the forward supply calendar looks underwhelming. Plus, higher yields will likely entice more retail investors into the market.

CRN: 2017-0719-6046 R

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

Hartford Investment Management Company (HIMCO) is a SEC registered investment adviser subsidiary of The Hartford Financial Services Group, Inc. SEC registration does not imply a certain level of skill or training; nor does it imply that the SEC has sponsored, recommended, or otherwise approved of HIMCO.

AAM is not affiliated with The Hartford Financial Group, Inc. or HIMCO, and was not involved in the preparation of this article. The opinions expressed herein are solely those of HIMCO, and do not necessarily reflect those of AAM.

The forecasts, opinions and estimates expressed in this report constitute HIMCO’s judgment as of June 30, 2017 and are subject to change without notice based on market, economic and other conditions. The assumptions underlying these forecasts concern future events over which we have no control. The assumptions may turn out to be materially different from actual experience. There can be no guarantee that any target or forecast will be realized.

Investment Risks: All investments involve risk, including the possible loss of principal. Fixed income investments are subject to credit and interest rate risk, as well as inflation risk and default risks. Additionally, fixed income markets, like all investment markets, can be subject to volatility.

Municipal Bonds: Municipal bonds are subject to numerous risks including rising interest rates, economic recession, deterioration of the municipal bond market, possible ratings downgrades, increased volatility, reduced liquidity, calls and associated reinvestment risk, and defaults on interest and/or principal. Certain investors in municipal strategies or products may be subject to state and local taxes. There is no guarantee that the securities held will be exempt from federal income taxes.