INSIGHTS

On May 11, 2017

HIMCO Market Updates

Municipal Bond Market Outlook (as of March 31, 2017)

The municipal market ended the 1^st quarter tighter versus taxable alternatives, as technical conditions (supply vs. demand) were more favorable than expected which drove positive performance. Seasonal technicals that normally weaken during tax season were actually quite supportive. Municipal supply, was up 43% year over year in January, dropped off considerably in the next two months to finish the quarter down 11%. On the other hand, demand remained firm with mutual fund flows positive for most of the quarter (+$1.3Bn)and reinvestment capital higher than last year (+19% qoq). Plus, the market was aided by signs of Trump’s pro-growth agenda beginning to unravel and concerns surrounding his proposed tax reform fading as the tax cut measures are now likely to be watered down and thus have a diminished impact on the municipal market. The Bloomberg Barclay’s Municipal Bond Index (BMBI) had a total return of 1.58% during the quarter with the best performance in the 5-10 year indices. Relative value ratios (Municipal/Treasury Ratio) in 5 and 10 years broke through recent tights in March before finishing the quarter at 81% and 94%, respectively. The front end of the municipal curve experienced a bull steepener (5s and 10s outperformed 30s) for much of the quarter as investors moved shorter on the curve to limit duration risk which ultimately led to outperformance against Treasuries in response to the Fed tightening.

Credit fundamentals across most municipal issuers throughout the first quarter of 2017 continued to be supportive of price performance. The U.S. economic expansion has led to growth in income, consumption and real property values that support tax-exempt securities backed by one or more sources of tax revenue. Economic growth has also been beneficial to the more cyclical and essential service revenue sectors like healthcare, transportation and education.

Looking to second quarter 2017, we still expect municipal performance to remain positive, although somewhat subdued given the strength of the recent rally and potential pushback on tighter valuations. We believe liquidity should remain healthy, technicals governing supply and demand should remain favorable, and stable fundamental conditions should afford investors’ further confidence in investing in the municipal market. However, the pivot to tax-reform by the Trump Administration after a failed ACA repeal coupled with the potential pickup in supply due to infrastructure needs could lead to further steepening. Therefore, we remain cautious in going out longer on the yield curve.

REITs (As of March 31, 2017)

The real estate investment trust (REIT) sector underperformed in the first quarter of 2017 as all retail exposure significantly underperformed, with the Russell 3000 REITs Index returning +3% as the broader S&P 500 Index returned +6%. Retail REITs (-5%) fell in sympathy with broader retailers as a soft holiday season for brick-and-mortar businesses exacerbated the long-term negative sales trends. Outside of retail, specialized REITs (+10%) outperformed as growth sectors (e.g. data centers, towers) did well while hotel & resort REITs (-2%) were the second softest subsector as many investors expected a slowdown in tourism as a result of the election of President Trump. Elsewhere, markets were largely well-behaved despite another rate hike by the U.S. Federal Reserve in March. Volatility remained relatively muted (VIX-CBOE Volatility Index trading largely between 11 and 13) and the 10-Year Treasury yield traded around 2.40 for the majority of the quarter.

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.

In this backdrop of sound fundamentals and post-election macro uncertainty, we look to add REITs opportunistically on pull-backs as the sector continues to deliver a robust 4% yield through the quarter. We also continue to caution against viewing the asset class as a fixed-income proxy and 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, heightened geopolitical tension.

Utilities (As of March 31, 2017)

The utilities sector performed on par with the broader S&P 500 Index in the first quarter as measured by the S&P 500 Utilities Index which returned +6% after a strong February as income securities rebounded after post-election softness. Within utilities sub-industries, independent power producers (+16%) led while multi-utilities (+5%) lagged. Broader markets were largely well-behaved despite another rate hike by the U.S. Federal Reserve in March as volatility remained relatively muted (VIX trading largely between 11 and 13) and the 10-Year Treasury yield traded around 2.40 for the majority of the quarter.

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 3.6% yield through the first 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, heightened geopolitical tension.

Investment Grade Credit Market Outlook (As of March 31, 2017)

The Investment Grade Credit (IGC) market began the year on a strong note, as the option adjusted spread of the Bloomberg Barclays U.S. Credit Index finished the first quarter five basis points (bps) tighter at 112. The expected pro-growth agenda from Washington, along with supportive Q4 (4^th quarter) earnings more than offset heavy corporate issuance, temporary oil volatility, and anxiety around European elections.

While it’s likely that the combination of a stronger macroeconomic backdrop, a pro-business administration, and improving corporate earnings will drive credit valuations modestly higher, we don’t believe now is the time to be aggressively adding risk. At current levels, which are approaching the post-financial crisis tights, the potential upside for IGC is likely capped not far from here. That is not to say that we expect a meaningful selloff in credit. A favorable supply/demand imbalance, in conjunction with an improving global growth outlook and patient (albeit hiking) Fed, should help keep valuations range bound.

We expect IGC spreads to finish 2017 modestly tighter but anticipate occasional bouts of volatility as the markets’ perception of the most significant risk drivers of 2017 evolve. In addition to our bottom up credit analysis, the macro events we’ll be watching most closely include the Fed’s ability to communicate their intentions clearly and raise rates without disrupting the market, Washington D.C.’s ability to implement their proposed policies, European growth and the ECB’s reaction, and OPEC’s willingness/ability to maintain stable oil prices.

Equity Market Outlook (As of March 31, 2017)

Equities finished the first quarter up 6% as post-election expectations of stronger growth, lower corporate tax rates, foreign cash repatriation, and less regulation drove the S&P 500 to its all-time high of 2396 on March 1st before finishing the quarter slightly lower at 2363.

Markets were largely well-behaved despite another rate hike by the U.S. Federal Reserve in March. Volatility remained relatively muted (VIX trading largely between 11 and 13) and the 10-Year Treasury yield traded around 2.40 for the majority of the quarter. Sector-wise, information technology (+13%) and consumer discretionary (+8%) were leaders, while energy (-7%) and telecommunication services (-4%) lagged. Quantitatively, growth significantly outperformed in the quarter, in contrast to the 4Q16 post-election rally which was more ‘risk-off’ (valuation and quality outperformed then). Investors also cheered stocks with low bankruptcy prospects.

The legislative failure of the American Health Care Act in March accelerated the unwind of the Trump Trade as post-election outperformers such as small caps, banks, and high effective tax payers have underperformed in 2017 despite the broader market rally. Small cap names, which had outperformed the S&P 500 by 9% between the election and year-end on the prospect of lower taxes and stronger growth, underperformed by 4% in the quarter. Banks, which returned +33% between the election and March 1st on the potential for higher rates and stronger growth, declined 7% since then. High effective tax payers (the spread between high and low tax companies) has steadily underperformed since its 12/1/16 peak and is now below pre-election levels. Simply put, the equity market is currently very reliant on accommodative fiscal policy materializing.

We believe equities can return ~12% in 2017, representing an additional 6% return over the remainder of the year. Our base case assumes ~7% earnings per share (EPS), ~3% multiple expansion, and ~2% dividend yield but remain wary of policy-induced volatility.

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

CRN: 2017-0503-5949R

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. 

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.

The forecasts, opinions and estimates expressed in this report constitute HIMCO’s judgment as of March 31, 2017 and are subject to change without notice based on market, economic and other conditions. No reliance should be placed on any such forecasts or opinions when making an investment decision. 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.

The information provided does not constitute investment advice and is not an offering of or a solicitation to buy or sell any security, product, service, fund, or UIT. Sectors referenced should not be construed as a solicitation or recommendation or be used as the basis for any investment decision. All data referenced is from sources deemed to be reliable but cannot be guaranteed as to accuracy or completeness.

Past performance is no guarantee of future results. An investor cannot invest directly in an index.

Investment Risks: All investments involve risk, including the possible loss of principal. Equity markets can be volatile. Stock prices rise and fall based on changes in an individual company’s financial condition and overall market conditions. Stock prices can decline significantly in response to adverse market conditions, company-specific events and other domestic and international political and economic developments. Investments in foreign securities involve risks beyond those inherent in domestic investments. These risks are magnified in emerging markets. Investments in small- and mid-capitalization companies may involve a higher degree of risk and volatility than investments in larger, more established companies. An issuer of a security may be unwilling or unable to pay income on a security. Common stocks do not assure dividend payments.