Paying attention to the cracks

lewthwaite-brett

Brett Lewthwaite

  • Executive Director, Global Co-Head of Fixed Income
    Global Chief Investment Officer of Fixed Income
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Introduction

The Macquarie Fixed Income (MFI) team’s Strategic Forum is always a key date in our calendars. Three times a year we step away to assess the economic backdrop and conduct deep dive research into the key fixed income asset classes to determine our medium term outlook.

Our second Forum for the year, held in mid-May, occurred against a backdrop where consensus had become even more attached to the view that economic growth was strengthening and therefore, inflation must follow, evidencing the 3% in bond yields as firm proof that the bond bull market is (finally) over. In MFI we are increasingly aware that even as this narrative emboldens, the underlying evidence supporting the view appears to be increasingly in retreat.

Synchronised and stronger? Alas, no longer

Looking at the underlying evidence our analysis of economic growth concluded that while it remains broadly satisfactory and should extend beyond 2018, it is now exhibiting a profile of diverging regional prospects led by the US with all other regions decoupling and showing a notable softening in momentum.

Turning to inflation, despite the consensus hype, real evidence of inflation excluding the influence of surging oil prices remains minimal. MFI’s own inflation models suggest both US cyclical and structural inflation indicators are rising modestly but we expect the structural influences relating to demographics, digitalization, and indebtedness will continue to place downward pressure on a significant outbreak. The risk we identified was that if some wage pressure does emerge, consensus holds a much stronger conviction that inflation is imminent which means markets may run with the narrative which would increase volatility.

Focusing on central banks, while the Fed is expected to continue on its path of further gradual interest rate hikes, it no longer appears certain that Europe or Japan would follow suit. This prompted us to question the idea of sustained policy divergence, concluding there were limits to how much further central banks could diverge given global interdependencies. Further our discussion focused on whether the expected rate hikes and further balance sheet reduction, also known as Quantitative Tightening (QT), was perhaps already erring on the side of too much too soon for the Fed.

The narrative continues… missing two key realities

Despite our analysis showing a softening of growth momentum particularly in Europe and China, consensus has carried forth and even strengthened its conviction in the narrative of broadening growth, imminent inflation, and bond yields higher.

Despite this narrative, we again reiterated our findings from previous Forums that it contains two significant oversights that we believe are integral to understanding the outlook for financial markets, namely debt and the impact of Quantitative Easing (QE).

We have spoken at length about the structural challenges that ever increasing indebtedness poses to economies yet we continue to be perplexed at how little attention it receives in many market outlooks. As we like to say, if market commentary or research doesn’t refer to it, save your time and don’t bother reading it.

The second missing reality is an emerging factor that refers to the shift by central banks away from their extraordinary monetary policy efforts toward QT. Indeed, the $US20 trillion of QE intervention and abnormal (negative) settling of interest rates, exhibited best by the trillions of dollars of negative yielding global bonds, caused the most incredible insatiable global chase for yield. Market participants have enjoyed these highly supportive forces, yet the possible reversal of this central bank intervention, that was so instrumental in elevating risk asset prices, seemingly is not a relevant consideration for the outlook.

Determining whether central banks slow, stop, or change direction is a key factor in considering the outlook. So, the more important question in our mind is not whether growth will be strong enough to lift inflation (our view is that it probably is not), but more is it strong enough to surmount the impact of the removal of the single biggest multi-year support to this incredibly complacent, low-volatility environment we have been in? The more volatile markets since our January Strategic Forum suggests that scenario is unlikely.

Cracks… the changing nature of the chase for yield

Entering 2018, our broad view was the ‘chase for yield’ that was driven primarily by extraordinary global central bank support would likely remain a predominant driver of fixed income markets. However, since our January meeting this previously strong technical support has reduced markedly with the confluence of a number of factors limiting demand particularly for US dollar fixed income. These factors include funding technical, US tax implications, LIBOR / OIS, Flat yield curves.

Many market participants consider these influences to be temporary and expect the strong technical bid for yield to return. Whereas we are more attuned to the view that these anomalies are early signs of ‘cracks’ in the system with central bank withdrawal at their heart. Summarised quite simply, Quantitative Easing lifted all boats and with Quantitative Tightening effectively being QE in reverse, vulnerabilities are likely to be revealed as the tide recedes. We view these changes with a greater level of permanence and believe they may only be the opening act should the Fed continue on its tightening path.

Central banks closer to pausing, or risk ending the cycle

In considering these influences, and the other structural factors affecting the global economy, we believe central banks will need to be highly cautious, and very patient with shifts toward varying degrees of less easing through to policy tightening. Otherwise market disruptions, volatility and financial conditions will increase and quickly dampen economic growth. In other words – cracks are already present, and appear likely to only grow larger should central banks press on with QT and reduce their extraordinary involvement and support in financial markets.

While all this is true, we do not believe central banks want to upset the current economic cycle. While the Fed has been hiking it isn’t seeking to cool off an overheating economy, more it is reducing its levels of extraordinary support and accommodation. The European Central Bank (ECB) and the Bank of Japan (BoJ) may not even be afforded the opportunity to commence withdrawal. And so in many ways it really is just a US story, and not one of particularly strong growth, nor with a threat of inflation. In other words, it is unlikely that central banks will be forced to move quicker and earlier than what consensus already has priced. If they do, they risk bringing this now elongated cycle to a quick conclusion.

Investment implications

In concluding our analysis, the team noted that a rational investor would acknowledge that:

  • If unthinkable central bank support and QE was wonderful for financial markets, then its withdrawal must be something to consider, and it is rational to think it would be at least abrasive.
  • High debt and high interest rates do not go hand in hand. As we like to say, these two are not natural dance partners. They cannot and will not co-exist.
  • This cycle is elongated and while it is supported by solid and improving corporate fundamentals, our sense is that it may be approaching the beginning of its end.

Overlaying these conclusions with the expensive valuations on offer, it seems there is little upside left in many markets. Considering this backdrop, we concluded a further shift towards a more defensive portfolio setting was appropriate. Part of that more defensive approach involves accumulating duration if yields make another break higher and a strategic risk reduction and diversification in credit, where we look to continue participating but at a reduced level. This approach should allow us to position our portfolios well to defend further or take advantage of future opportunities.