3rd Quarter 2017

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Markets began the year pricing in the benefits alluded to by the surprise victory of President Trump, as risk-asset prices and U.S. Treasury yields moved up notably. As the year has progressed, markets have continued to discount the possibility of meaningful fiscal stimulus and, therefore, a resulting reflation trade. Tenyear U.S. Treasury yields have declined meaningfully since their peak, and the two-year versus 10-year yield curve has flattened, suggesting that the market is suspicious with respect to potential future inflationary policy. Throughout 2017 and the third quarter, administrative gridlock caused market participants to doubt the administration's ability to meaningfully implement its agenda. However, towards the tail end of third quarter, a combination of U.S. Federal Reserve (Fed) member comments and a flicker of hope around tax reform caused treasury rates to rise 0.15%-0.20% across the curve.

Meanwhile, risk assets continued to perform well during the quarter, although not in a straight line, due to North Korea tensions, missteps following the Charlottesville, Virginia, protests, and multiple devastating hurricanes. The bottom line, however, is that stocks are up, high-yield bond prices are up, and investment-grade spreads are tighter. Earlier in the year, the U.S. economy appeared to slow, but it has since picked up steam within the context of a continued subdued recovery. The European recovery also gained strength throughout the year, albeit from low levels. China provided few major scares as solid growth continued, although concerns around overall debt levels eventually toppling the economy remain in the back of investors' minds.

The U.S. economy continues to grow, and unemployment continues to fall while, somewhat mysteriously, inflation has barely budged. The Fed continues along the path of reiterating its belief that transitory factors are at play and will ultimately subside. However, certain members have publicly begun to question our broad understanding of inflation, suggesting traditional models, such as the Phillips Curve—an economic theory that inflation and unemployment have a stable and inverse relationship—may no longer apply. In some ways, this may be true. Today the Phillips Curve might need to be looked at on a global basis as today's workforce is more mobile than any time in history due to technological factors, such as the outsourcing of services. Given generally lax inflation, one might imagine the Fed, as well as other central banks, having plenty of cover to keep rates lower for longer. However, the Fed continues to raise short-term rates, perhaps with an eye toward taming ever-increasing risk-asset prices.

The Fed also recently announced the when, how, and why of its balance sheet reduction. The passive, maturity rolloff approach has been well received by markets so far. An October start date to the roll-off begs several questions: Will everything remain calm as is currently expected by market participants? Can global financial markets handle a Fed balance sheet unwinding, and a potential European Central Bank (ECB) quantitative easing (QE) reduction simultaneously? If QE initiation in some way helped economies and markets, then isn't it reasonable to expect the withdrawal of QE to have marginally negative implications, even if implemented at a measured pace? We recently experienced an example of how intertwined global markets are when German 10-year bund yields increased from 0.25% to 0.60% and 10-year U.S. Treasury yields increased from 2.14% to 2.38%, due to comments made by ECB President Mario Draghi in late June. Still, markets remain sanguine around the balance sheet reductions. Yet, as the great QE experiment comes to an end, perhaps it is wise to be skeptical that the unwinding will go off without a hitch.

What this Means for the Portfolios

Investment-grade spreads generally tightened over the quarter with corporations reporting decent revenue and earnings growth and flat-to-slightly-better credit metrics. However, all was not smooth sailing for credit. Heavy new issue corporate supply in July and early August seemed to cause a bit of market indigestion, despite continued solid inflows into investment-grade funds and strong demand from other investors. Spreads took another leg wider with the North Korea missile launch and reaction to the Trump administration's response to the Charlottesville incident, which led to rumors of tax-reform champion Gary Cohn's imminent resignation. That did not happen, and spreads ultimately widened about 0.10% before starting the reverse march back to about 1.0% at quarter end.

Given how tight spreads are generally, the 0.10% move wider didn't present a truly attractive buying opportunity. As a result, we continue to hold high levels of cash, which we are ready to deploy as meaningful opportunities present themselves without over-reaching for yield.

The consumer remains healthy as employment continues to increase, though debt levels continue to rise in areas, such as student loans, auto loans, and unsecured debt. Asset-backed securities spreads have continued to tighten as well. However, we still favorably view the senior tranches of these assets as they are generally quite short-dated and well-structured to protect the top tranches from losses. Even here though, our activity has slowed, given spread tightening and overall compensation.

Over the quarter we have seen some opportunities in agency mortgages. Spreads have not tightened as much relative to other asset classes, and have even moved wider in some cases. Ultimately, this may be the result of market worry over the Fed's plan to allow its balance sheet to run down, including agency mortgage-backed securities (MBS). While the impact is certainly unknown, we believe it will be manageable in the context of our overall portfolios. Our starting exposure to mortgages, and we believe current spreads in the marketplace, are adequate compensation for the low level of convexity risk we are assuming given the types of agency MBS we are purchasing.

We continue to follow our central tenet of investing—seeking the best relative value in terms of risk and reward—and for now that continues to point to higher-quality instruments for the portfolio and a general posture of caution.

Thank you for investing with us in Thornburg Limited Term Income, Limited Term U.S. Government, and Low Duration Income bond funds.

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