Just When It Looked Safe to Go Back in the Water
August 19, 2019
Financial markets continued their good run in July, with the S&P 500 Index hitting a new all-time high on July 26 and the U.S. Federal Reserve (Fed) cutting rates on July 31 for the first time in 11 years. After May’s volatility on the back of bad news about U.S./China trade negotiations, things seemed to be getting better. And with central bank meetings out of the way by the end of the month, markets were set for a quiet August. Looked good on the surface: What happened?
Fixed Income Outlook
Unfortunately, by the end of July, the news flow shifted and what looked like a benign August became a lot more interesting. What gives? Two things changed. The first, which is easily reversible, is that the Fed’s cautious 25 basis point rate cut on July 31 disappointed markets, which wanted more–not necessarily more basis points but more commitment to additional cuts in the future.
The second change is not as easily reversed. The sudden escalation of the U.S./China trade war in early August is a potentially trend-altering dynamic. Further tariffs on Chinese imports, and China’s retaliation by buying fewer U.S. agricultural goods along with the sudden depreciation of the Chinese currency, increase global economic risks significantly.
For the first time since 2015, the chance of a more meaningful economic slowdown must be taken seriously. While we do not believe a true recession will occur, trade developments will exacerbate an already fragile economic situation, especially for manufacturing and global trade. Global business confidence has been weak for more than a year. These developments will not improve matters and will most likely hinder any rebound in economic activity anticipated for the second half of the year. What about Goldilocks? Can’t central banks help?
Central banks will try, even as their monetary ammunition runs low (especially outside the U.S.), to keep the global economy chugging along, no matter what politicians try to do. So, buckle your seat belts, prepare for more volatility but do not panic. We believe lower rates can and will cushion the blow coming from trade, but unfortunately, there are legitimate questions as to how much monetary easing can help. On the negative side, lower interest rates cannot overcome the uncertainty about future economic relationships.
The problem is that trade issues keep escalating, and without knowing the end game how can investors be confident that they have seen the worst? We think the yield curve is the best barometer of market confidence. We think a measure of success, e.g., reflation, would be a steepening of yield curves. If monetary stimulus is working its magic, curves should steepen. Unfortunately, so far, this is not happening. Long maturity bonds are rallying and short maturity bonds, particularly in the U.S., are well below official rates. Not a vote of confidence. Conditions are not much better or are even worse outside the U.S. Until yield curve steepening begins to happen, it is unlikely economies are on sound footings and it is unlikely risky assets will perform well.
This provides an environment where we should expect to see more monetary stimulus priced into markets, yields fall, yield curves steepen and riskier assets struggle. The ability of credit and emerging markets to absorb bad news is hurt by valuations. These markets have generated outsized returns this year and are not in a position to weather too much bad news. Whether or not there is a legitimate case for further underperformance, we do not think there is a strong case to add to positions in high-yield and emerging markets. Unfortunately, we also do not believe we have enough information to wholesale scale back exposures.
In the interim, we believe a focus on fundamentals–corporate, sovereign and structure (in the case of securitized assets)–will serve us best, and in that regard countries that have strong and/or improving fundamentals with reasonable valuations are best placed to weather this storm. On the developed sovereign side we continue to like Australia, Spain and the U.S.; in the emerging markets sovereign space we like Brazil and Peru on the local side and selected smaller countries, somewhat insulated from global trade issues, on the external side. The USD should remain generally firm except in specific instances, e.g., we like the Egyptian pound, which has a relatively unique set of fundamentals supporting it.
Our recent mantra of nimbleness as a requirement for success remains in place. Markets and policymakers are on the move. With markets anticipating (rightly or wrongly) big policy moves, investors are going to have to make key decisions about what tradeoffs central banks will make with regard to forestalling recession pressures by preemptive moves, responding to trade risks and acting too cautiously, letting recessionary forces become too strong to stop.
Developed Market (DM) Rate/Foreign Currency (FX)
Monthly Review: In July, developed market sovereign bonds were mixed following the precipitous drop in yields over the preceding months. The yield on the 10-year U.S. Treasury bond rose one basis point over the month, while 10-year gilt yields fell by 22 basis points, and most Eurozone government bonds followed suit and declined as well. Throughout the month, the markets anxiously awaited the Federal Open Market Committee (FOMC) meeting on July 31st. During the weeks leading up to the meeting, markets priced in a 25 basis point rate cut with certainty, but also the probability of a larger 50 basis point cut. While the Fed’s decision to cut by only 25 basis points did not come as a significant surprise to the market, investors were disappointed that the Fed did not commit to a more significant easing bias going forward. In the Eurozone, the ECB confirmed it is likely to ease policy at its meeting in September, with a combination of rate cuts, renewed quantitative easing (QE) and other easing measures likely. This largely confirmed the shift in position President Mario Draghi communicated in his speech at Sintra in early June. In the U.K., Boris Johnson was elected leader of the Conservative Party on July 23. Key roles have been given to committed supporters of Brexit whilst more than half of Theresa May's old cabinet has departed.
Outlook: U.S. growth is likely to be lower for the remainder of 2019, although stabilized via easier monetary policy. Central banks have become more accommodative, particularly in the U.S. and Eurozone, and we expect that to continue as uncertainty in the geopolitical and economic landscape remains prevalent. We currently see three major risks to the outlook, which are Brexit, U.S./China trade disputes and the U.S. presidential election.
Emerging Market (EM) Rate/FX
Monthly Review: EM fixed income assets continued to perform well in July as the market continued to add risk, especially within dollar-denominated debt. JP Morgan estimated that portfolio flows into EM fixed income totaled $9.2 billion, primarily to hard currency strategies. The markets, however, were disappointed by the U.S. Federal Reserve’s FOMC decision at the end of the month to only cut 25 basis points, and were also perplexed by its convoluted statements at the accompanying press conference. The immediate impact was most evident in weaker EM currencies, especially euro-linked currencies in Eastern Europe, which capped off a month in which the dollar strengthened and the euro weakened. Local bond performance was positive and outweighed the negative currency impact on an aggregate level. Within hard currency assets, the high-yield segment outperformed the investment-grade segment, and sovereigns outperformed corporates. Commodity prices were broadly weaker in the period, led by agricultural commodities, followed by crude oil prices, which responded to a weaker global growth outlook and the invoicing impact of a stronger USD. Performance within metals was mixed as precious metals generally performed well while base metal prices were broadly weaker.
Outlook: The outlook for risky assets in the next weeks, and EM debt in particular, is mixed. Regarding U.S.-China trade disputes, hopes of an extended truce after the Shanghai summit were dashed a few days later by President Trump’s announcement on a 10% tariff to be imposed on the remaining $300 billion of imports from China, to take effect on Sept. 1. Moreover, expected China retaliation should add to heightened volatility, likely challenging the performance of risky assets. On the other hand, the monetary stance being adopted across the developed and emerging worlds remains largely supportive, but there could be potential setbacks, as highlighted by the negative market reaction to the “hawkish” Fed cut last month.
Monthly Review: July saw corporate spreads tighter overall, continuing the trend in June post the move to synchronized central bank easing expectations. The key drivers in July were (1) expectations of easier monetary policy from Central Banks, (2) corporate earnings exceeding weak expectations giving confidence that a downturn isn’t imminent and (3) strong demand for credit. The Bloomberg Barclays U.S. Corporate Index closed 6 basis points tighter in July to end the month at 107 basis points over government bonds.1 Financials and non-financials credits performed in line. Within financials, longer dated names outperformed. Euro investment grade tightened 12 basis points in July to 99 basis points, as measured by the Bloomberg Barclays Euro-Aggregate Corporate Index.2
Outlook: While valuations have tightened in the strong performance of 2019 to date, we would note the market recently ignored a number of signals that macro risk is rising. This includes increased risk of a hard Brexit, no resolution from continued trade negotiations between the U.S. and China, and weak global manufacturing data. Uncertainty makes the short-term outlook for corporate earnings less clear. Our base case does not call for a recession; rather we expect continued low global growth and low inflation, supported by low real rates and easy financial conditions. Our strategy has been to take profits on long-held positions as spreads moved below the long-run average and that triggered profit taking in the month, but we remain net long of risk looking to be tactical over the coming quarter.
Monthly Review: The Bloomberg Barclays U.S. Mortgage-Backed Securities (MBS) Index was up 0.40% in July, outperforming the Bloomberg Barclays U.S. Treasury Index, which was down 0.12%, as interest rates remained range bound and MBS durations were relatively unchanged.3 Current coupon agency MBS nominal spreads tightened 2 basis points in July to 85 basis points above interpolated U.S. Treasuries.4 The duration of the Bloomberg Barclays U.S. MBS Index shortened 0.08 years to 3.07 years during July, a continuing trend, as mortgage prepayment speeds have accelerated in recent months as the lower mortgage rates have begun to impact refinancing activity.5 The Fed’s MBS portfolio shrank by $21 billion during July to $1.512 trillion and is now $125 billion lower year-to-date.6
Outlook: Overall our outlook remains largely the same from last month. We have a positive fundamental credit outlook for residential and consumer credit conditions in both the U.S. and Europe. We continue to have a slightly negative view on agency MBS due to the supply-demand dynamics from the Fed continuing to reduce its MBS holdings and increasing market float by approximately $20 billion each month, but we have become less negative on agency MBS in 2019 as it has underperformed credit mortgage assets this year. We continue to have a mixed outlook on commercial real estate conditions due the more idiosyncratic nature of specific real estate sectors and properties.
1 Source: Bloomberg Barclays, data as of July 31, 2019
2 Source: Bloomberg Barclays, data as of July 31, 2019
3 Source: Bloomberg, data as of July 31, 2019
4 Source: JP Morgan, as of July 31, 2019
5 Source: Bloomberg, as of July 31, 2019
6 Source: Federal Reserve Bank of New York, as of July 31, 2019
Fixed income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In the current rising interest rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. Longer-term securities may be more sensitive to interest rate changes. In a declining interest rate environment, the portfolio may generate less income. Certain U.S. government securities purchased by the strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. High-yield securities (junk bonds) are lower-rated securities that may have a higher degree of credit and liquidity risk. Sovereign debt securities are subject to default risk. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default, and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. The currency market is highly volatile. Prices in these markets are influenced by, among other things, changing supply and demand for a particular currency; trade; fiscal, money and domestic or foreign exchange control programs and policies; and changes in domestic and foreign interest rates. Investments in foreign markets entail special risks such as currency, political, economic and market risks. The risks of investing in emerging market countries are greater than the risks generally associated with foreign investments. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). Due to the possibility that prepayments will alter the cash flows on collateralized mortgage obligations (CMOs), it is not possible to determine in advance their final maturity date or average life. In addition, if the collateral securing the CMOs or any third-party guarantees are insufficient to make payments, the portfolio could sustain a loss.