Fixed Income Strategic Forum: Divergent global performance is like ”musical chairs”
October 16, 2018
At its triannual Strategic Forum in September 2018, the Macquarie fixed income team discussed the global economic backdrop and a medium-term outlook across asset classes. A brief form of the team’s analysis is found in the notes from the Strategic Forum.
Download the notes from the Strategic Forum
As the Macquarie Fixed Income team gathered in September for its final Strategic Forum of 2018, the backdrop was one of challenges and vulnerabilities emerging from the shift from quantitative easing (QE) to quantitative tightening (QT), led foremost by the US Federal Reserve.
Our analysis of key macro themes concluded that the outlook for global growth remains relatively robust, albeit with regional divergence and with momentum beginning to soften. We also concluded that the much-anticipated inflation pressures were most likely to remain contained, although the risks of tariff-related stagnation had increased.
The team concluded that a key factor in determining the medium-term outlook for the global economy hinges on the extent to which the Fed continues to hike policy rates. Overall, we favor a gradual and cautious approach by the Fed as cracks emerging in financial markets become more acute. We believe the Fed is closer to pausing its current tightening cycle than consensus forecasts would predict, which may lead to an environment of converging growth, potentially positive for financial markets.
We recognized there is a risk that the US economy would continue to outperform, causing the Fed to tighten further than anticipated. This would cause further unintended US dollar liquidity stress and further strain in already challenged financial markets.
We also reflected on current events related to trade wars, softening Chinese growth, and the upcoming US midterm elections, all of which need to be carefully considered as they could be pivotal in how financial markets perform for the remainder of 2018.
In this late-cycle, increasingly volatile environment — further challenged by significant structural headwinds — the team recommended maintaining our defensive positioning as we head toward year-end.
Current state of play
Our September Strategic Forum followed a period characterized by the ongoing theme of diverging economic performance.
Divergent growth, largely a result of US outperformance, has resulted in divergent central bank policy, led by the Fed’s tightening policy of reducing QE toward QT while also gradually increasing policy interest rates. The currency markets have expressed this divergence via a stronger US dollar throughout 2018. Combined, we began to witness signs of considerable abrasion and underperformance in several notable asset classes, in particular emerging markets.
In May, we noted that the 2018 theme had undercurrents that could be summarized quite simply as: If QE lifted all boats, then QT and its associated interest rate increases will, in effect, be QE in reverse, and vulnerabilities are likely to be revealed as the once-great central bank tide recedes.
In September, we began to witness these vulnerabilities. We observe that asset class performance has in large part been driven by proximity to the US. Those closer to the region have enjoyed the benefits of stronger economic growth induced by fiscal stimulus. Those farther away may feel the effects of the chase for yield ending, best exhibited by reduced US dollar liquidity and the acute effects on those most reliant on US dollar funding.
Against this backdrop, the team debated whether the ingredients for further US economic outperformance remained or this divergence is nearing its extreme, and we noted that convergence was a possible scenario heading into year-end. As one team member described so astutely, the current theme of divergence is like a game of “musical chairs,” whereby Fed tightening and the associated reduction of US dollar liquidity could result in more widespread abrasion and an environment in which the next most vulnerable asset classes could miss out on one of the highly coveted remaining chairs.
We began the year with consensus, anticipating synchronized global economic growth that was on its strongest footing since the global financial crisis. By May, this landscape had evolved with global growth positive but softening, and exhibiting a diverging profile led by the US. At the September forum, we acknowledged this trend had continued, with global growth robust, albeit with slowing momentum driven in part by trade and tariff uncertainty.
An area that we believe requires close attention is China, where current indicators of activity suggest a more challenged growth picture. Commodity prices have been softening and China’s Total Social Financing measure has shifted lower into contractionary territory. The message from these indicators appears to be that domestic demand is under pressure. On a positive note, other economic data such as China’s Purchasing Managers’ Index (PMI) remains solid. So far, the People’s Bank of China (PBoC) is delivering a measured response to this pressure, seemingly managing the situation rather than responding with a more overt stimulative stance. Nonetheless, the US is pushing hard on China in relation to trade and tariffs, arguably at a time when China is already under domestic pressure. This increases the possibility that the PBoC may be required to be more aggressive on fiscal policy, monetary policy, and/or allowing the currency to weaken. Most market participants expect that China will do whatever it takes to manage the situation and not allow harm to the economy. We remain alert to the possibility of a further slowing of Chinese growth and are watching for indications as to how China may respond to the prevailing environment.
In summary, while we believe that economic growth is regionally divergent and is beginning to show signs of slowing from solid levels, we have concluded that the now prolonged growth cycle should extend beyond 2018, supported by US fiscal easing. However, we are mindful of the possibility that the flattening and potential inversion of the US yield curve may indicate that an end to this cycle is approaching. We concluded that the probability of a recession in early 2019 remains low, although risks are rising, particularly if the Fed continues with its tightening plans through this year and into next.
Despite the consensus fixation on inflation, real evidence remains minimal, excluding the influence of higher oil prices. That said, the optical tightness shown by some labor market indicators are likely to keep markets alert to the threat of demand-led inflation.
In May, our inflation models showed that US cyclical and structural inflation indicators had both been rising modestly and warranted close watching. Since then, cyclical pressures have eased, and slower-moving structural inflation factors have been somewhat surprising in that they have also fallen back. We acknowledge that some upside risk to inflation remains, although we believe any pressure is likely to be rather modest. Indeed, our analysis suggests that we may currently be witnessing the peak in US inflation.
While we remain unconvinced that inflation will meaningfully pick up, even if some wage pressure does emerge, we acknowledge that the consensus holds a much stronger conviction of imminent inflation. We therefore remain alert to the possibility of inflation as a market narrative or theme, even if the reality seems more likely that inflation remains elusive. Longer term, we continue to expect the structural influences related to demographics, digitalization, and indebtedness to continue to place downward pressure on inflation.
Focusing on central banks, our research and analysis from May continued to hold true. Our view remains that while the Fed is expected to continue on its path of gradual interest rate hikes, it no longer appears likely that Europe or Japan will follow anytime soon.
Our September discussion of the Fed concluded that the market is highly confident of the Fed delivering further hikes in September and December. (Note: The Fed indeed raised the federal funds rate, for the third time in 2018, at its Sept. 26, 2018, meeting.) Balancing this is the caution that the yield curve is very flat, and inversion is one of the key risks to the economy that we believe the Fed is keen to avoid. The team also noted that Fed Chairman Jerome Powell could be taking a pragmatic approach, recognizing and taking action if the cracks of Fed policy grow larger and more widespread. The Fed has been operating on the basis of transparency, and so we are paying close attention to any change in its rhetoric.
More globally, we acknowledged there has not been much change in the stance of the other central banks. Expectations around the European Central Bank (ECB) is for QE to end this year, but growth and inflation dynamics suggest that rate hikes are still some way off. The PBoC is also expected to remain accommodative with selective easing as required.
Structural backdrop: Is the chase for yield over?
Despite its omission from many market commentaries, structural forces are ultimately the long-term driver of markets in our view. Debt, demographics, digitalization, and the newest addition of QE-to-QT must always be considered when taking a longer-term view of the outlook for markets.
We began by acknowledging that the $US20 trillion central bank intervention and unnatural setting of interest rates created the great global chase for yield and has played a dominant role in fixed income markets since the global financial crisis. It has caused bond yields to remain low, credit spreads to tighten, and risk asset prices to trend higher.
As we entered 2018, our broad view was that the chase for yield would likely remain a predominant driver of fixed income. However, since January, previously strong technical support has reduced markedly as we had the first real attempt by a major central bank, the Fed, to embark on shifting from QE to QT. The results, as expected, have been abrasive and are set to accelerate as the ECB ends its QE program in December and the Bank of Japan continues its stealth taper by widening the band on its yield curve control program.
This situation is best typified by the now attractive yield of approximately 2.5% in the shortest-dated US Treasury securities. If this short-term and high-quality yield is available, then it is natural that investors will seek commensurately higher yield for all other higher-risk, longer-dated, and lower-quality yielding securities. This attraction combined with the additional borrowing requirements of the US Treasury are resulting in a reduction of US dollar liquidity.
These abrasive effects are now very visible in areas such as emerging markets. In May, local currency emerging market debt had returned around +1% year to date, and by September returns were -10% — an 11-percentage-point swing in just a few months. (Source: Bloomberg Barclays Emerging Markets Local Currency Government Index.) That makes for quite a large crack.
In our view, many market participants consider the impact to be temporary and expect the strong technical bid for yield to return. The catalyst for this is unclear, and as such, we are more attuned to the view that these anomalies are the expected signs of cracks in the system with central bank withdrawal at the heart. It has not surprised us that the central bank tide has not really started going out, and that already there are signs of considerable financial stress in the further reaches of the markets.
The path forward: A game of “musical chairs”
Although the overall structural force is the shift from QE to QT, currently it is primarily the Fed that has advanced reduction of its balance sheet and hiking of rates, with an outcome of divergence. While it is not clear how much further this divergence theme can go, the team views possible scenarios like a game of musical chairs.
Further divergence — more chairs removed
With strong economic growth, the Fed appears set to continue its gradual hiking cycle, with the market expecting another rate hike this year and more increases through 2019. This path is putting pressure on US dollar liquidity in the system, and we are seeing dislocations as a result. In effect, with each tightening step, the Fed is taking away chairs, and as it does, an additional asset class falls out of market favor. There is a risk that if the Fed keeps going, more asset classes could be left standing without support. In this scenario, the risk of broader contagion rises, as is often the case in classic US dollar liquidity-induced market events. We would favor avoiding the next most likely asset classes to underperform: European periphery, European financials, and commodity-related industries.
The global economy converges — music keeps playing
As the limits of divergence reach extreme levels, there is the potential that divergence turns into convergence over the next couple of quarters.
Ultimately, we do not believe central banks want to upset the current economic cycle. Further, we think central banks are highly cognizant of the need to be cautious, and that they are showing patience with varying degrees of reduced easing through policy tightening. Outside the US, cracks are already occurring and appear likely to grow larger should the Fed continue to raise rates. As a result, we may see the Fed slow or pause, which in effect would most likely mean a continuation of the music and an extension of the business cycle.
There are a number of potential catalysts for a shift to convergence:
QE to QT cracks become larger and more widespread and begin to impact markets such as US equities. In this environment, we would expect the Fed to slow or pause in response to financial market volatility.
The US dollar weakens. As a general principle, countries with strengthening currencies, such as the US, tend to eventually encounter headwinds or restraint of economic growth, and countries that experience currency weakness, such as Europe, can benefit by being more competitive on a relative basis. As such, it is quite plausible that US growth may begin to slow while we see growth pick up in the rest of the world. This would likely result in dollar weakness and a reduction of some of the current market tension that’s been induced by the US dollar.
China recommences considerable stimulus. China could also be a trigger toward convergence through a shift toward more overt stimulative policy, which could boost growth in the region and more globally.
US midterm elections. Should the Democrats win the House (and, more dramatically, the Senate), a lower US dollar and less certain outlook could give the Fed a moment to pause, Trump would be more restricted in policy implementation, or we could see a compromise on the China trade issue.
In summary, many events could tilt the trajectory back towards convergence, although we need to be conscious that the overall environment could still be one where the central bank QE tide is still drifting out. Financial market performance may therefore be challenged regardless.
Deglobalization — the game changes
Finally, we remain attuned to the possibility that the environment is evolving and that markets should pay close attention to the reduced global cooperation occurring. Tariffs and trade wars, which we refer to as deglobalization, is likely to pressure global growth to the downside. Given the other structural headwinds, we remain cognizant that the global economy could be entering a more challenging period rather than getting closer to the pre-global financial crisis “normal.”
Overall, we favor more abrasive divergence in the near term as the Fed continues to raise rates and reduce its balance sheet, although we believe the Fed is closer to pausing than consensus forecasts would indicate, which would then likely lead to an environment of convergence.
At the beginning of the year, we agreed that a more defensive stance was warranted given the outlook that we were likely to experience increased volatility in 2018. This was reaffirmed at our May Strategic Forum when the first signs of cracks were beginning to appear. This stance and broad avoidance of underperforming markets has served us well.
In our September meeting, we reiterated that this cycle is elongated and, while supported by solid corporate fundamentals, the sense is in the air that it may be approaching the beginning of the end. Overlaying this with the structural headwinds of the abrasive shift to QT and elevated debt levels, we agreed the most sensible approach is to maintain our defensive positioning by accumulating interest rate duration and gradually exiting fully valued credit market segments.
Rates. We recommend maintaining strategic overweight duration positioning with a view to adding to this should US yields rise between the 3.00% and 3.25% target area. The extent to which rates can rise is limited, and if further cracks should appear, yields are likely to fall.
The team is also watching for idiosyncratic opportunities to trade duration. For example, firmer data in Europe could lead to more optimistic policy forecasts. As a result, we expect small upward pressure in European yields, although the relative steepness of the curve should cap any significant selloff in the long run.
Credit. The credit market continues to be characterized by the polarizing factors of strong fundamentals and expensive valuations, leading to a rangebound environment for the asset class. Against this backdrop, the recommendation is to continue to reduce risk strategically, with a bias to maintaining liquidity and acknowledging that we are late in the cycle. The focus remains on extracting value through diverse sources such as industry selection, geographic tilts, and curve positioning, combined with our fundamental bottom-up research of individual names.
Currency. The divergence theme has played out acutely in the currency markets with the US dollar strengthening throughout 2018. The team respects this narrative and believes the dollar could rise further into year-end as the Fed continues to tighten. Augmenting this view is the negative feedback loop whereby dollar strength causes stress in emerging markets, resulting in further dollar appreciation as capital flows from the region.
The team cautioned that longer-term headwinds and event risk remain a threat for the US dollar. Specifically, we are focusing on the unfolding trade negotiations, the upcoming US midterm elections, and any sign of a change in Fed rhetoric.
On the other major currencies, our views can be summarized as follows: Emerging markets FX is likely to remain under pressure, the euro should be range traded versus the US dollar with recovery in the region expected to be gradual, the Japanese yen may continue to benefit from its safe-haven status, and we recommend selling the Australian dollar on rallies due to the region’s strong reliance on China.
Emerging markets. We remain cautious on the outlook for emerging markets, recognizing recent underperformance and that the trend for fundamentals is challenged. There may be a point of convergence for the asset class if the Fed changes course, though we would need to see a sustained reversal of the negative momentum, in particular in the currency market as an indicator of an opportunity to take advantage of much improved relative value in the asset class.
The views expressed represent the Manager's assessment of the market environment as of October 2018, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
IMPORTANT RISK CONSIDERATIONS
Investing involves risk, including the possible loss of principal.
Past performance does not guarantee future results.
Diversification may not protect against market risk.
Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt.
International investments entail risks not ordinarily associated with US investments including fluctuation in currency values, differences in accounting principles, or economic or political instability in other nations. Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility and lower trading volume.
Currency risk is the risk that fluctuations in exchange rates between the US dollar and foreign currencies and between various foreign currencies may cause the value of an investment to decline.
The Bloomberg Barclays Emerging Markets Local Currency Government Index is a flagship index that measures the performance of local currency emerging markets (EM) debt. Classification as an EM is rules-based and reviewed annually using World Bank income group, International Monetary Fund country classification, and additional considerations such as market size and investability.
The Purchasing Managers' Index (PMI) is an indicator of the economic health of the manufacturing sector of a country or an economy.