Experienced investors are careful to distinguish changes in facts from changes in market prices. Facts are consequential and grounded in data while market prices can swing on theories and sentiment. Of course, facts do change: the macroeconomic environment can improve or decelerate, perhaps unexpectedly; geopolitical power can shift; and monetary policy frameworks can evolve. In these cases, it’s rational—even required—that investors adjust their portfolios to suit the new reality.
But in many cases, dramatic movements in market prices—whether rising or falling stock markets or bond yields—turn out to be not much more than temporary market overreactions to changing theories. At these times, the real investing opportunity is to recognize and exploit short-term dislocations between the facts and over- or undervalued market prices.
We enter the third quarter with this debate front and center. Fixed income market prices have adjusted across two key dimensions: first, the U.S. bond market has moved from pricing a Fed tightening cycle to a significant Fed easing cycle, and interest rates on government bonds in Europe have moved into more extreme negative yield territory; second, credit markets have repriced to wider spreads with underperformance of cyclical sectors, suggesting investors are positioning for an increasingly negative macroeconomic environment.
Are these market changes reflective of changing facts that investors should embrace? Or are these price changes reflecting overblown fears of a global slowdown or recession? In our minds, it’s a bit of both. We do think the Federal Reserve and the European Central Bank (ECB) have shifted toward easing biases, but it’s more due to how they want to respond to low inflation than significant fears about the growth outlook. As it relates to credit, the global economy does face uncertainty, but it remains on firmer ground, especially in terms of consumption, than market pricing would suggest.
After the de-risking of credit instruments in the first quarter and early second quarter, we think the outlook and opportunities are sufficiently compelling for investors to begin re-deploying capital into select fixed income markets while remaining cautious on the scope of central bank easing currently priced into markets.
Navigating the soft landing
Since the summer of 2018, we’ve been advancing our soft landing thesis that global economic growth would slow without triggering a recession. This soft landing is now upon us.
To navigate the markets over the next two quarters, investors should keep in mind:
- Volatility comes with the territory: The second quarter represents what a soft landing looks like for financial instruments. A slow growth environment produces volatile markets rife with fears of hard landings, recessions and market crashes. Even if economic outcomes are ultimately consistent with a soft landing, financial markets will still be prone to pricing extreme outcomes given where we are in the growth cycle, as well as impending adjustments to fiscal and monetary policy.
- A soft landing is still the most likely scenario: We have a high degree of confidence that a global soft landing is more likely than more negative scenarios. Across the U.S., Europe and Asia, consumption rates in the major global economies are stable, despite weakness in production and trade sectors. Ultimately, structural shifts in many major economies toward services-oriented consumption make them less prone to recession and hard landings over the next 12 months. We believe that investors should continue to invest for a continued soft-landing outcome, but as discussed below, recognize that tail risks are rising and centered on trade policy.
- The main Western central banks want to prolong the cycle: The key message from the Federal Reserve and ECB meetings in June is that the primary policy objective is to support growth near term. Tightening to get policy to “neutral” or combat inflation pressures is out, and supporting growth while inflation remains low is in. The global economy is naturally poised for a soft landing, and central bank policy is going to support that outcome.
Economic risks in trade policy
As noted above, developments that could tip the global environment toward a more negative outcome center on tariff policy toward China and other major trading countries, particularly in the automobile sector. In the second quarter, the decline in bond yields and risk assets began with the imposition of 25% tariffs on a wider range of Chinese goods. These tariffs are orders of magnitude larger than previous applied tariffs, impact a greater range of consumer and globally interconnected goods and supply chains, and can have meaningful impacts on growth rates. While our base case remains that deals will be struck over the course of 2019, trade policy represents the singular risk that in our view can move a soft landing into something more pernicious.
According to the Tax Foundation,1 the current tariffs of 25% on $250 billion of Chinese goods would reduce long-run U.S. GDP by approximately 0.20%. But importantly, the threatened tariffs on additional Chinese goods and the automobile sector have substantially more negative impacts on U.S. GDP, wages and employment.
In addition, tariffs negatively impact China. We estimate that if fully enacted, the threatened Chinese tariffs could reduce Chinese GDP by 1%, with spillover impacts across the world as an important source of economic demand is reduced. Auto tariffs are potentially even more disruptive to the global economy given the complexity and integration of global supply chains.
Monetary policy expectations
As we highlighted in the introduction, an important development in the second quarter was the global re-rating of monetary policy expectations. As indicated in the chart below, the market is now seemingly pricing in that the Federal Reserve will ease by 100 basis points over the next 18 months and the European Central Bank will remain on hold through 2020.
As our Multi-Asset Class team has noted, quantitative analysis of market correlations strongly suggests that markets are responding to, and pricing, a significantly deteriorating growth environment. The market is not pricing Fed easing because of credit issues or liquidity concerns, or even financial stability issues; it’s pricing Fed easing because of expectations of a meaningful downtick in growth rates that would engender a Fed response. Related to this idea, credit spreads, while wider, are certainly not at distressed or structurally cheap valuations. We believe this partly reflects market anticipation of a Fed response that stabilizes the economic outlook. Growth is driving monetary expectations, which are impacting credit spreads, rather than a reverse causation where credit spreads (or financial conditions generally) could drive an expected Fed response.
A playbook for easing
Starting with the Federal Reserve, they have now signaled a reasonably strong easing bias. In periods of growth transition, the Fed has historically walked a thin line, balancing the desire for proof of actual deterioration with the need for pre-emptive action. Our view, however, is that this will be a short but significant easing cycle. Given underlying growth dynamics, the required amount of Fed easing is relatively low and we believe they will adjust policy relatively quickly to get there. The easing cycle of 1998—three eases totaling 75 bps—may be the best analogy.
If and when the Fed begins easing, it will represent a milestone for bond markets. The Fed has not cut rates in over 10 years and we suspect many investors will have forgotten how powerful a Fed tailwind can be for markets. There will be the usual changes: structural moves to a steeper yield curve and a weaker dollar, but more subtle changes as well, particularly relating to the efficient management of short duration fixed income and foreign exchange hedging when forward rates persistently drop below spot rates. The playbook the market’s been using for 10 years relating to a Fed on hold or a Fed tightening will need to be discarded, and the Fed easing playbook dusted off and put to work.
Shifting gears to the euro zone, pressure on the ECB to deliver more accommodative monetary policy is growing in the face of slowing momentum, and historically low inflation expectations. At its meeting in June, the ECB signaled that new stimulus is coming. Should economic and geopolitical pressures persist, we expect in the summer or fall that the ECB will amend its forward guidance to alleviate the burden on banks subjected to the negative interest rate on deposits. We also expect the ECB to introduce a “tiering” system that will enable it to move rates further into negative territory, if needed. Lastly, as some policymakers have already argued, the ECB can pave the way for additional QE by relaxing conditions, for example by raising the issuer limit above 33%. If the Federal Reserve cuts rates, easing by the ECB becomes even more likely.
Unlike other developed market central banks, the Bank of Japan (BOJ) has shown little appetite for normalizing monetary policy over the last few years. While the ECB at least put an end to QE in December 2018, the BOJ not only continues its asset purchases, but its policy rate remains at -10bps and it continues to exert “yield curve control” with 10-year yields anchored at 0%. With the size of the BOJ’s balance sheet at about 100% of GDP, investors have questioned how much ammunition the bank has left to stimulate the economy. Policymakers insist that they have ample tools at their disposal, and while we do not expect the BOJ to be the first bank to ease, we cannot rule out additional easing measures should the Fed or ECB opt for more accommodative monetary policy. Given the already large size of the balance sheet, we expect further easing to most likely come in the form of interest rate cuts. Needless to say, in an environment where trading arrangements are under intense scrutiny, monetary policy decisions run the risk of being perceived as an additional weapon in the burgeoning trade war.
Finally, the People’s Bank of China (PBOC) remains firmly on a policy-easing path. After four reserve requirement cuts in 2018, the PBOC has delivered further cuts this year. The PBOC faces a difficult challenge in navigating fiscal easing while assuring currency stability and monetary easing; but, like the other major global central banks, the bias has been and remains toward a more accommodative policy.