Last quarter, we laid out our “soft landing” thesis, forecasting that economic growth would slow without triggering a recession. This core thesis is intact and strengthening based on underlying growth dynamics and transitions in central bank policy. Specifically, the cycle’s extension and durability derives from the strength of the U.S. economy—especially the consumer economy—and the prospect of trade policy stabilization, which can also help steady other developed and emerging economies. Policy clarity is improving not just at the Fed, but also at central banks in Europe, Japan and China. At the same time, growth dynamics in China and emerging markets also point to continued low but moderate and stable growth.
From an investment perspective, this state of affairs supports a preference for credit markets and an appetite for moderate risk. Continued confidence in the global economic cycle gives us conviction to be opportunistic when the market temporarily veers off course and to recognize changes in valuations due primarily to technical factors. Following opportunistic purchases during the December market volatility, a robust subsequent rally made it possible to rebalance holdings and reduce exposures in certain sectors (global investment grade, emerging markets and municipal bonds) where some returns seemed front-loaded.
As we look ahead, we perceive that elevated and, by now, well-known concerns around bank loans and BBB-rated debt may be overstated over the short to intermediate term, making these assets an interesting place to prospect for risk and yield. We further suspect that the benign environment for central bank policy-making won’t last throughout 2019, and we will continue to see pockets of volatility in the markets.
U.S. Economy Fuels Extension of the Global Cycle
Over the past couple of years, it has been a common assumption that the U.S. economy is in the late-stage business cycle, with many investors focused on the timing of the next recession. Investors were rightly concerned; the current expansionary business cycle, which began in June 2009 and is in its 117th month, will no doubt surpass the longest such cycle on record of 120 months (March 1991 to March 2001). In what could be good news for fixed income risk assets, a more dovish Fed and, perhaps surprisingly, the U.S. – China trade war mean that the expansionary phase of the U.S. business cycle could last longer than previously anticipated.
According to the National Bureau of Economic Research, the U.S. has gone through 11 business cycles since 1945, and the duration of the average business cycle from trough to peak is about 58 months. Given the current cycle has now lasted double the average, investors appear concerned that this expansion could end soon.
Still, despite the deceleration of growth in the second half of 2018, the U.S. economy continues to expand at or close to trends. We expect the economy to maintain growth around 2% based on:
- Continued strength in the U.S. labor market
- Signs of bottoming in the U.S. housing market
- A more patient Fed
Continued Strength in the U.S. Labor Market
A tightening jobs market is supporting wages, which in turn should continue to support consumer spending and help avert a deeper economic slowdown this year. So far in 2019, the pace of U.S. wage increases has held up well. After adjusting for inflation, hourly earnings increased 1.9% year-over-year in February, their strongest gains since 2015. Wage gains are most apparent in the service sectors, connoting resilience in the cyclical economy.
A softer-than-expected February jobs report, however, paired with poor retail sales and soft inflation, have raised concerns about the durability of jobs and wage growth. U.S. non-farm payrolls rose a seasonally adjusted 20,000 in February, well below expectations and the slowest pace for job growth since September 2017. Taking a step back from month-to-month noise, on a three-month basis non-farm payrolls have been notably smooth and jobless claims have not been rising. If you look at the mix of jobs being created, strength in small business hiring may also reflect economic momentum.
With the jobless rate dipping at 3.8%, we believe job growth can continue due to labor market slack, as more individuals are drawn into the workforce.
Signs of Bottoming in the U.S. Housing Market
While housing starts have missed expectations for over a year, we are seeing some reasons for optimism into the spring:
- Affordability: Following multiple years of mid- to high-single-digit price increases, housing still remains affordable by historical measures, with affordability essentially in line with the period of 2001 – 2003. Tailwinds include recent moderation in housing price increases and a drop in the primary mortgage rate by about 60 basis points from the peak.
- Supply: The supply of for-sale homes is currently at 3.9 months of sales volume, below the levels from the relatively benign period of 1999 – 2004.
- Demand: Over the intermediate term, we believe there is strong pent-up demand for housing as roughly 32% of all 18- to 34-yearolds are still living with their parents. If the number of people per household returns to its 2000 – 2003 average, it will require the formation of almost three million households.
- Builder behavior: Following the housing downturn, regulatory changes increased the upfront fixed costs to build new homes and inspired builders to construct larger, more expensive homes in order to protect profitability. This created a mismatch between the supply of new homes and the demand for smaller, cheaper homes from younger first-time homebuyers. Since the beginning of 2018, a decline in the average median price of a new home may reflect better positioning by builders to meet market demand.
Investment Upshot: Improvement to the U.S. housing market supports opportunities in securitized mortgage securities and private mortgage lending.
Automobile Sector Decoupling from Global Economic Growth
While global macroeconomic activity is expected to remain positive, global passenger vehicle volume has reached a period of stagnation. The duration and extent of this plateau will vary by region, but the overall effect will be slower growth in vehicle sales than economic metrics would typically imply. This is the first time the auto industry has faced a synchronized global downturn in its three largest markets: U.S., E.U. and China.
After years of very low interest rates globally and high levels of stimulus and incentives to purchase vehicles, demand for autos appears to have peaked. Moody’s is estimating global auto sales growth of 1.2% in 2019, a slight acceleration from only 0.2% growth in 2018, but a steep drop-off from the average of 3.4% growth in the two preceding years. The industry has several challenges to overcome if it hopes to resume growth:
- China turnaround: Moody’s global estimates embed reasonably sanguine projections of Chinese auto sales (up 2.0%) in 2019 after a decline (-2.0%) in 2018. The predicted acceleration in Chinese auto sales, which we have not yet seen this year, is expected to come from a reduction in the country’s auto purchase tax. In 2017, this tax was increased from 5% to 10%. Automaker incentives have proven insufficient to offset the impact of the tax and stimulate demand. While a reduction in the tax back down to 5% will help, it will be challenging to reverse the double-digit declines since September 2018.
- Tariffs and regulatory headwinds: Additional potential headwinds for the sector include auto tariffs and increasing regulatory burdens. While we consider the threat of tariffs to be transitory and not likely to be impactful to the industry for an extended period, the pressure on increased regulations at a time of limited sales growth poses a more durable challenge to the sector. Meeting carbon emissions targets for 2020 in Europe will require significant capital expenditures and could also result in some meaningful fines in the short term, if new standards are not met.
- Industry transformation: Finally, the industry is in the early stages of meaningful secular changes. Alternative fuels and autonomous vehicles will require significant capital expenditures to maintain industry leadership. Furthermore, ride sharing and ride hailing could result in diminished aggregate demand for automobiles, reduced ability to differentiate between products (commoditization), and the potential for entire new business models such as subscription-based revenues. These challenges represent varying degrees of urgency, but all will require automakers to maintain strong balance sheets and financial flexibility to navigate the coming years.
During this period of reduced sales globally, increased regulatory burden and increased business risk, credit selection is critical in the auto industry. Global growth alone can no longer support these credit profiles as it once did.
Investment Upshot: The strongest credits in the auto sector will be globally respected brands with sufficient balance sheet capacity to support investment during a period of secular change.
A Patient U.S. Federal Reserve on Policy Hikes and the Balance Sheet
The Fed has taken two steps that should provide support for the U.S. (and global) economy:
- Reiterating the decision to pause rate hikes for the time being
- Announcing an earlier balance sheet normalization at higher-than-expected levels
In January, the Fed effectively announced that monetary policy will be ‘on hold’ for six months, and followed that dovish message in March with a further signal that they do not expect to hike rates at all in 2019.
In addition, the Fed announced the end of balance sheet reductions by September 2019. The Fed is initiating the end of balance sheet reduction, or quantitative tightening (QT), for the following reasons:
- Dampening effect of QT: Over the last year and a half, the Fed has reduced its balance sheet by $500 billion, causing some adverse reactions in the market, especially during the fourth quarter of 2018. By our estimates, $200 billion of QT over a period of four months ($50 billion per month) has had a similar counter-stimulus impact as a 25-basis-point rate hike. This form of stealth tightening is no longer needed as the global economy continued to decelerate during the second half of 2018.
- Regulatory demand for reserves: Regulatory changes since 2008 have increased banks’ demand for reserves. In that context, we estimate a balance of $1.2 – 1.5 trillion is currently desirable, compared to the $0.5 – 1.0 trillion originally envisioned by the Federal Open Market Committee (FOMC). So far, the FOMC has been able to control short-term rates despite the size of its balance sheet, but this demand for reserves argues for a permanently larger balance sheet than in the past.
- Crowding out risks: In the current business cycle, U.S. government federal deficits have grown, whereas in prior cycles deficits tended to shrink as the economy grew and the cycle matured. The combination of fiscal stimulus and tax reform by the Trump administration and Congress has almost doubled the federal deficit. As this government debt comes to market, it risks crowding out other asset sales, resulting in tighter financial conditions.
In the longer run, the Fed’s balance sheet is likely to be primarily composed of shorter-maturity Treasuries, which dominated allocation pre-crisis, with less emphasis on mortgage-backed securities (MBS). The exact target duration of the assets will be shaped by market forces and the path of economic data. Once the balance sheet is normalized, the timing of the return to balance sheet growth is an open question. If future balance sheet growth aligns with the growth of currency in circulation, as was the case prior to 2008, then the balance sheet would surpass its 2015 peak within three to four years.
With government bond yields falling in the first quarter, we see a disconnect between the level of real and nominal Treasury yields and our expected economic outlook. We suspect the coming quarters will bring more volatility to interest rates than seen in the first quarter, and more asymmetry toward higher yield outcomes.
Europe Faces Political and Policy Uncertainty
The second half of 2018 saw a significant deterioration in Eurozone corporate confidence. This pessimism was fueled by the automobile sector, under pressure from new regulation to reduce auto pollution and fears of the global tariff war, which has already impacted exports to China. This general lack of confidence translated into a significant decline in industrial production.
The European Central Bank (ECB) decided early in March to act to support economic activity by extending its forward guidance. Also, we have seen some stabilization in European data in 2019, with better data on capital expenditures and steady consumer consumption.
As highlighted in the following chart, the labor market in Europe, similar to the United States, remains strong and supports a global soft landing thesis.
New Stimulus and New Leadership at the European Central Bank (ECB)
In the past, the ECB typically put policy on hold when facing new uncertainties and took its time to understand the magnitude of the coming challenges, such as Brexit and tariff wars. Still, with confidence low and economic forecasts falling, the central bank decided to act in advance to stem market pessimism. On March 7, it announced a new targeted longer-term refinancing operation (TLTRO) that will run from September 2019 through March 2021, thereby providing full funding through 2023. The ECB also left rates unchanged through the end of 2019 and committed to reinvest the principal payments from maturing securities.
TLTRO programs aim to foster better credit and spending by lending at low rates to banks. This third-generation TLTRO proposes quarterly two-year lending operations through 2021 at variable rates indexed at the key ECB rate, which is 0% today, but is subject to change at each ECB council. The new TLTRO has another key objective: to offer a source of long-term funding for banks that under Basel III have to reach a net stable funding ratio (NSFR) of at least one year of funding.
What’s next for the ECB will depend in large part on the nomination of its new president after May European elections. The next leader is unlikely to be as dovish as outgoing ECB President Mario Draghi.
In terms of country exposure, we have started to increase our exposure to Italy: we anticipate the end of the government based on a populist coalition since the Five Stars party has lost ground in the regional elections.
As we expect a growth stabilization and the absence of a no-deal Brexit, we forecast higher bond yields for long maturities less supported by the ECB dovish policy. As a result, we maintain an underweight exposure to the long-maturity bonds. The strong recent rally of core government bonds appears to be overdone.
One investment area we find particularly compelling right now is European bank securities, especially for subordinated bonds, for the following reasons:
- Banks are relatively low risk. They have just increased their capital and are now supervised by the ECB instead of national central banks.
- Non-performing loans (NPLs) have been reduced to a very low level, except in Greece, although risks do remain at a few banks in Germany (Deutsche Bank), Italy (small banks) and Greece (high NPLs).
- Primary flows are limited by the new TLTRO, excess cash at safe banks and the ECB announcement that some banks need less subordinated debt.
Investment Upshot: Positive outlook for European bank credit spreads, especially subordinated bonds.
Emerging Markets Stabilization and Recovery
We believe economic growth rates in emerging markets may have bottomed and may start improving, helped by policy reactions in these countries and changes in developed markets. Early leading indicators reveal potential “green shoots.” With data near lows, a strong global consumer economy suggests the slowdown will be shallow.
A few factors support our view of stability to potential improvement in emerging market growth:
- Economic pressures: Growth in emerging markets does face some downward pressures. However, we view the scope of the slowdown as marginal in the context of signs of stabilization. Cyclical indicators such as fiscal and current account balances remain well behaved, with lower inflationary pressures providing room for monetary easing in most emerging economies.
- Credit quality: For corporate credits, leverage metrics continue to improve while default rates are likely to remain below historical averages in 2019.
- Trade wars: Risk of U.S. – China trade-tariff escalation eases as negotiations continue with no specific deadline, increasing odds for an agreement. But the U.S. administration’s protectionist stance remains, with the looming threat of U.S. tariffs on autos, steel and aluminum against the EU and Japan on national security grounds.
- Central bank policy repercussions: With the Fed signaling a lengthy pause in its tightening cycle and the ECB extending its targeted lending program, financial conditions in developed markets have eased, which should alleviate economic headwinds in emerging markets. Furthermore, a less hawkish Fed and lower global trade-related tensions significantly diminish U.S. dollar appreciation biases while diminishing drivers of depreciation of Chinese currency.
- China deceleration: China growth has slowed but should remain above the critical 6.0% level, according to the most recent government predictions. Moreover, China has responded to slowing growth with policy-easing of its own, including RRR cuts, rate reductions, more credit to small and medium businesses, and corporate VAT cuts. These easing measures have helped to support credits within China and have moderated the expected default rate.
Investment Upshot: While yields and spreads in emerging market sovereigns and credits have recovered from multi-year highs, they continue to provide attractive excess risk premia relative to developed market credits.