The first half of 2019 was kind to financial markets. Will the good times keep on rolling? In our view, that will depend on whether loosening monetary policy is still an effective way to boost growth.
When the year began, markets were bracing for tighter policy from the Federal Reserve, which had already raised interest rates nine times since 2015. The European Central Bank (ECB) had just ended quantitative easing, which many saw as a prelude to an eventual rate hike.
As trade hostilities between the US and China took a toll on the global growth outlook, government bond yields plunged along with inflation expectations. Parts of the yield curves in the US and Japan inverted—typically a harbinger of recession—and the German yield curve flattened to a historical low. Central banks grew more dovish in response, with both the Fed and ECB signalling plans to cut rates (and, in the ECB’s case, restart asset purchases).
Risk assets, on the other hand, are suggesting that the global economy has hit a temporary speed bump, not the severe slowdown that government bond yields seem to be signalling. Credit spreads in the US and Europe have tightened, emerging-market debt has rallied, and the S&P 500 Index hit a record high.
In the second half of 2019, investors will have to decide which signal to follow.
Central Banks to the Rescue?
For risk assets’ signal to be right, we’ll need evidence that easier monetary policy in the world’s major economies can still revive global growth—or at least forestall a recession. This is especially the case in the US, where the credit cycle is in its later stages.
We’re cautiously optimistic. We still think the global economy is slowing to trend and will avoid a contraction. The way we see it, 75–100 basis points of Fed rate cuts over the next six to nine months should be enough to stabilize US growth and help steepen the yield curve a bit. We think monetary (and fiscal) policy stimulus will do the same for China’s economy. This should be good news for risk assets and would likely push government bond yields a bit higher.
It’s a bit different in Europe, where open economies and limited policy flexibility make countries more vulnerable to a downswing in the global trade cycle. Rate cuts and asset purchases should help fend off recession and prevent bond yields from rising, though we doubt they will materially lift inflation. But if new ECB president Christine Lagarde can persuade governments to embrace fiscal stimulus, our outlook might brighten.
With monetary policy, though, the risk is one of diminishing returns. In the past, a healthy economy at or near full employment was justification for raising rates to fend off inflation. Once growth had slowed, rate cuts would spark new credit creation, helping to revive business activity and restart growth.
Today, the link between unemployment and inflation has broken down—the US economy is a prime example of this—and the massive global credit creation over the past decade of low rates raises questions about how stimulatory another round of cuts would be.
Other Risks to Watch
Beyond central bank policy, many of the risks we’re monitoring fit into the geopolitical category. The US-China trade conflict and its impact on businesses and trade-sensitive economies around the world are high on the list. The truce in this trade war is uneasy at best and could be the beginning of a broader, multiyear conflict between the two countries. It’s also possible that trade hostilities could break out elsewhere, including between the US and the European Union (EU).
If the truce persists, it should help support asset prices and global growth. But if hostilities heat up again, they could hurt China’s economy as well as that of Germany and the broader eurozone, which has been hit particularly hard by trade disruption. Such an outcome would ramp up the pressure on the Fed to cut rates more aggressively for fear that slower growth abroad would hurt the US economy.
Brexit should be on investors’ radar, too, particularly with new UK prime minister Boris Johnson on record as saying he’d be willing to take the country out of the EU on October 31 without trade or political agreements in place. Our economists fear a “no-deal Brexit” could do considerable harm to the UK economy and cause disruption in financial markets.
Another risk is illiquidity. When global interest rates are as low as they are today, investors sometimes reach farther than they should for yield. That can lead them into assets that can be difficult to sell quickly without taking a big loss. A good rule of thumb: be wary of strategies that promise daily liquidity—the ability to buy or sell assets at the end of each trading day—but that invest in relatively illiquid assets.
Navigating Today’s Market
Given the uncertainty in markets, it’s a good bet conditions will get choppier in the second half of the year. That doesn’t mean bond investors should head for the harbour. With interest rates as low as they are, exposure to growth-sensitive assets with decent return potential is essential. But the downside risks to global growth make it equally important to avoid reaching too far for yield without regard to credit and liquidity risk.
For European investors, it could be best to stay close to home, rather than reach for seemingly higher yields overseas. In particular, the cost of hedging US investments back into euros remains high. So any yield advantage from holding US bonds may prove illusory, after adjusting for the cost of protecting against currency risk.
The good news is that European bonds are in something of a sweet spot. On one hand, the imminent return of quantitative easing in the euro area is a clear positive for risk assets. We see opportunities in European bank debt, including subordinated bonds, which offer attractive yields and solid fundamentals. And we’d expect risk assets in general to get an added boost if eurozone fiscal policy turns expansionary before the year is out.
On the other hand, sluggish euro-area growth and downside global growth risks are likely to prevent government bond yields from moving too much in either direction. As a result, these assets should continue to provide a nice offset to risk assets should global markets hit a rough patch. At the same time, sovereign assets are even likely to benefit from QE. For instance, there’s plenty of room for Italian sovereign yields to fall and prices to rise.
Make no mistake: bond yields are astonishingly low. Some 27% of global government bonds and 51% of European government bonds now trade with negative yields. But low yields don’t have to mean low returns. Most yield curves across Europe remain steep, providing an opportunity to benefit from “roll.” When investors buy bonds at a steep point along the curve, the bonds experience a price increase as time passes and yields decline, or “roll” down the yield curve, assuming the curve remains the same.
In these conditions, we think investors might want to consider a dynamically managed, benchmark-agnostic portfolio that can allocate to both credit and government debt. We’ve found that such an approach can offer not only higher yield potential than a traditional euro aggregate approach but also lower risk and comparable volatility.
Beyond the eurozone, US residential mortgage-backed bonds that provide exposure to the still strong US consumer sector (and are less vulnerable to trade tensions) look attractive, as does exposure to select commercial mortgage-backed debt.
Stay Active and Be Selective
There’s no way to sugarcoat it: there’s a lot of uncertainty on the horizon, and that means a lot of risk—economic, political and otherwise—that investors must manage. But staying active and maintaining selective exposure to income-generating assets are, in our view, the most sensible ways to play the hand that the markets and the global economy have dealt us.