Fixed Income Strategic Forum: Take your cues from the tide, invest with the flow
February 19, 2019
At its triannual Strategic Forum in January 2019, the Macquarie global 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
Volatility returned in late 2018 as the almost decade-long quantitative easing (QE) induced, global chase for yield finally came to an end. Financial markets began adjusting from an environment once awash with QE to one characterized by the ongoing reduction in central bank liquidity. It’s a quantitative tightening (QT) world and the liquidity tide is receding.
The Macquarie Fixed Income team’s first Strategic Forum of 2019 delved into this topic, concluding that as QT appears set to continue in 2019, they believe bonds should continue to perform well in this more volatile environment. Credit markets require a more cautious approach, with opportunities likely to present themselves as the tide ebbs and flows.
This paper provides highlights from the Strategic Forum, including an outlook on the macro environment, the impact of the receding liquidity tide, and the investment implications. In summary, we concluded that a sensible approach is to take our cues from the tide and invest with the flow.
Macro outlook: The current state of play
As we gathered in early 2019 for our Strategic Forum, consensus outlook and market sentiment had changed markedly since the last forum in September. While 2018 had begun with consensus expectations and hope of “synchronized global growth,” it turned to one of divergent global growth and a further fracturing of global relations, ending with an acute bout of market volatility.
Our conclusions from the September 2018 Strategic Forum have more or less played out. Our expectations were for more abrasive economic divergence near term, with broadening of the QT cracks as the US Federal Reserve continued to raise rates and reduce its balance sheet, which would likely result in the Fed pausing far sooner than consensus forecasts.
The late-year volatility had many causes, in our view — the ongoing US-China trade tensions, a prolonged US government shutdown, and anxiety over increasingly tumultuous Brexit negotiations, coupled with a determined, albeit gradual, shift in global central bank policy from extreme accommodation and QE to an environment of QT, all culminating in fears of a material slowing of global economic conditions.
Against this backdrop, the team’s starting point for the Strategic Forum was to undertake a thorough assessment of the facts provided by the available macroeconomic data. We noted that global growth was slowing through the second half of 2018, led by China and Europe in particular, and with US growth more resilient but still slowing. The analysis revealed that Chinese growth continued to slow despite repeated efforts by the authorities to stimulate, which led to a conclusion that the slowdown was being managed. In contrast, European authorities seemed to be ignorant of the substantive slowdown manifesting across countries as the European Central Bank (ECB) ended QE in December. We concluded that this policy approach would likely be unsustainable.
Inflation continues to form a deep part of our analytical framework and as we concluded in September, the inflation pulse globally was weak despite the enormous efforts by central banks to stimulate. With QE turning to QT, we suspect that inflation will gradually fade from discussion during 2019. This conclusion supports our view that rate hikes and QT are close to their end point already.
In summary, we expect global growth to slow further in 2019, though recession risk still remains low. Inflation is moving toward a peak keeping central banks on tightening alert. While we see the macro outlook benign for policy it may take a further bout of asset market volatility to get the attention of policy makers, and that combination could fuel expectations of easing later in 2019.
Our broad overarching view is that financial markets are adjusting from a world awash in abundant liquidity and the insatiable chase for yield, to a world with a significant reduction in available liquidity. Below we explore this transition in detail.
The liquidity tide is receding
“A rational investor would believe that if unthinkable central bank support and QE was wonderful for financial markets, then its withdrawal must be something to consider, and it’s rational to think it would be at least abrasive.” – Macquarie Fixed Income presentation at Morningstar conference, May 2018
It is a widely held view that QE was good for asset prices, that central banks’ purchases inundated markets with abundant liquidity, and that for years, financial markets exhibited an insatiable chase for yield. But in 2018, things changed. This chase ended as QE programs wound down and faced the prospect of QT. While that all logically makes sense, it is less clear to many how the QT influence affects markets. In other words, how does the QT mechanism operate?
First, US yields began to rise and the curve flattened, as the Fed hiked rates from the lower 0.25% bounds. Then the United States implemented a sizeable fiscal stimulus that is debt-funded requiring considerably more US government borrowing, while other government initiatives encouraged repatriation of offshore cash and profits from US multinationals. These influences resulted in US dollar strength as flows were and still are increasingly attracted to the yields available in the US.
As the US short-end yields rise, US cash, for the first time in nearly a decade, gradually becomes an attractive investment. This attractive “risk-free” yield then ripples through to all other markets.
The situation is best symbolized by the now attractive yield of ~2.6% available in the shortest-dated risk-free US Treasury security. If this short term and high-quality yield is available, then it is natural that investors will seek commensurately higher yields for all other higher-risk, longer-dated, and lower-quality yielding securities.
This attraction, combined with the crowding out effect due to the additional borrowing requirements of the US Treasury, results in a reduction of US dollar liquidity as dollars leave other asset classes and come home to be borrowed by the US government. This, in combination with the reduction of the Fed’s balance sheet, is in effect how the QE tide began receding.
The dominant theme of 2018 can be summarized quite simply as: “If QE lifted all boats then QT, and associated interest rate increases, in effect will be QE in reverse, and vulnerabilities are likely to be revealed as the once great central bank tide recedes” (from the May 2018 Strategic Forum).
In 2018, the almost decade-long chase for yield came to an end as the world changed from one of plentiful liquidity to one where liquidity, and in particular US dollar liquidity, was now in retreat. That is a significant adjustment to the investment environment.
Like a game of musical chairs, then they all fall down
“This [rate hike and QT] 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 — and there is a risk that if the Fed keeps going, more and more asset classes will 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. Here we favor avoiding the next most likely asset classes to underperform.” – Strategic Forum, September 2018
At our last forum, we highlighted that we were beginning to witness the spreading of QT’s vulnerabilities. While those closer to the US had enjoyed the benefits of fiscal stimulus-induced stronger economic growth, those further away were feeling the effects of the end of the insatiable chase for yield and the shift to a world of reducing liquidity, and worst of all reduced US dollar liquidity. And those most reliant on US dollar funding were acutely impacted.
The change in tide commenced in February 2018 with leveraged volatility vehicles (volatility sellers) the first to be affected, and then shifted to the most US dollar-reliant emerging markets (namely Argentina and Turkey), then the European periphery due to the Italian elections and budgetary concerns — these two in turn weighed heavily on European banks. From there, the effects of reduced liquidity began to ripple broadly and amplify. Highly indebted investment-grade corporates (for example, General Electric) soon found themselves out of favor, and not long after, equities with highly elevated price/earnings ratios (such as the market darling tech stocks of Facebook, Apple, Amazon, Netflix, and Alphabet’s Google, known as the FAANGs). As 2018 came to an end, global QE as a collective was no longer positive and the environment, for the first time since the financial crisis had become one of global QT. The QE tide was, as it is now, in retreat and the cracks that emerged throughout 2018, first seeming as isolated events, had multiplied and worsened, culminating in an acute bout of broad and global equity market weakness as the year ended.
As one team member described so astutely in September, the dominant theme of QT had become like “a game of musical chairs” whereby the Fed and its associated reduction of US dollar liquidity would likely result in more widespread abrasion where the next most vulnerable asset classes could miss out on one of those highly coveted remaining chairs. By year end the game had accelerated — the only chairs left standing were cash and, with a late run, government bonds.
For those who enjoy history and statistics, the 2018 low for the S&P 500® Index was in December, which has only happened six times in the past. Five of those times ended with recessions. And 2018 was the worst December for the S&P 500 since 1931.
It is a QT world — for now at least
As we begin 2019, the QT influences and cracks are all still with us. In fact, they are now more challenging than they were in 2018 when QE was declining although there were still some residual European and Japanese QE offsetting the US QT, whereas in 2019 we are now in a global net QT world.
Indeed, as we entered 2019, financial markets are now, for the first time since 2008, in a global “liquidity-drain” environment. Leading right up until early January, it seemed central banks were steadfast in their resolve to continue in the direction of QT and belief that (further) interest rate increases were warranted.
Elsewhere, market volatility was further being affected by the ongoing US-China trade tensions, the prolonged US government shutdown, anxiety regarding the increasingly tumultuous Brexit negotiations, and to top it off, signs of material slowing in many global growth economic indicators.
We understand why the market can be easily distracted by these influences, and while we acknowledge that these are weighing on the outlook, our primary focus and concern is the reality that we are operating in a QT environment, at least for now.
In many ways, even if the Fed announces that it is on hold (as we expect) with respect to further tightening, the reality is that central banks globally are still moving away from QE and toward QT. The big liquidity bathtub markets have all bathed in for the last 10 years is still losing water. While the liquidity drains, the risk that the cracks re-emerge and get worse is very real in our view.
Words are not enough, and a pause won’t halt the tide
What we have seen since the December rate increase has been a seismic shift from the Fed and Chairman Jerome Powell. Faced with a significant stock market decline, the late December selloff proved too much for the Fed, and since then it has reversed much of its hawkish guidance. No longer are we a “long way from neutral.” Even though the Fed’s “dot plots” are supposed to act as guidance to future rate policy, and current forecasts indicate expectations of a much higher federal funds rate, Powell has appeared to forego this as a realistic expectation.
The Fed has also done an about-face on comments that the balance sheet reduction was on autopilot, and stressed after the January 2019 Fed meeting that it is now flexible and can be adjusted. The “tightening tantrum” induced turnaround has been enough for equity markets and risk assets to post sizeable recoveries in January. However, the key question that remains for 2019 is, “Are words enough”?
In our minds, a pause by the Fed does not stop the withdrawal of US dollar liquidity. A pause is a pause, not an ease. As such, the QE tide appears set to remain in retreat, and with it, the abundant liquidity that financial markets have enjoyed. While words hinting at a pause are encouraging and do offer some respite, much like a brief rain shower to an increasingly parched landscape, words alone won’t stop the liquidity drain. The causes of QT liquidity reduction remain and without actions to slow or end the drain, it seems likely that the cracks will re-emerge.
Do we need to see another risk selloff before the Fed stops the current QT and potentially even reverses policy? Our thoughts as a group are that while the Fed now appears to be in support mode, ultimately QE was a volatility suppressant and therefore its removal should increase volatility. Higher volatility is not good for equities or credit, which pay a higher return for selling that volatility or owning that asset class.
While we believe this liquidity drain will play a dominant role in market movements in the coming months, we are also realistic in that we don’t expect markets to move all in one direction. As markets become increasingly parched, from time to time we will get brief liquidity showers via more words from central banks or policy adjustments, which the market will embrace in the hope that the tide will soon stop its retreat. January is a good example of this, where a few words of reprieve were embraced as if a liquidity tropical storm had occurred, when in fact it was just words. But we believe time will prove that words are unlikely to be enough and will need to be followed by action.
Outlook: Watching and waiting
We are watching for genuine policy movements that will stabilize the tide or, even better, bring it back in. Alternatively, if that doesn’t happen, we believe financial markets will adjust and offer better value to reflect the appropriate reward for the risks that come with now being in a QT world. This mix implies that further spikes in volatility are likely, and for the time being, we can be patient in remaining defensive as we assess the likelihood of the former while being well-placed to capture opportunities in the event that the latter plays out.
In our minds the actions that we believe may address the underlying tidal influences include:
A prolonged pause by the Fed in rate hikes and actions to alter the balance sheet reduction program
ECB acknowledgement of the weakening growth profile in Europe and responds with concrete policy actions including a possible return to QE
A significant policy response from China designed to meaningfully elevate domestic economic growth with benefits to global growth
Other forms of stimulus, such as fiscal initiatives, although we acknowledge this is unlikely.
We highlight with caution that when we experienced similar liquidity drain conditions in late 2015, a coordinated response was forthcoming from the so-called Shanghai accord in February 2016. In concert, the actions of the Fed backing away from policy tightening, the ECB introducing negative interest rates and corporate bond QE, the Bank of Japan’s joining the ECB in the introduction of negative interest rates, and a considerable stimulus response from China, were an enormous response to the softening environment. Compare this situation to what we have now in early 2019, where none of those actions appear close to being considered — indeed policymakers are heading in the opposite direction — and the possibility of a collective response seems as remote as it has been in decades in what is now a far more fractured geopolitical environment.
On this note, we remain attuned to the possibility that the environment is evolving and that markets should pay close attention to the reduction in global cooperation occurring. Tariffs and trade wars, which we refer to as de-globalization, are 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-financial crisis ”normal.”
Recognizing the abrasive environment that resulted from the beginning of QT, and that we are already in an elongated expansionary cycle, we were positioned relatively defensively during 2018 on the expectation that we were likely to experience increased volatility. This defensive positioning and broad avoidance of the “fallen chairs” served us well.
This defensive bias for our portfolios was reaffirmed as the QT environment is expected to continue for now. In summary, we agreed the most sensible approach is to maintain our strategic overweight duration positioning while continuing to strategically hold lower credit risk exposure, particularly in relation to the higher beta components of the credit markets. The following provides further details on the key recommendations for our portfolios from the investment teams.
Rates | We believe the Fed is on hold for the near term and in all likelihood will be forced to amend its QT program. Further abrasion in risk markets would likely be required first and as such bonds could trade lower in yield on the associated flight to safety. Our base case is the Fed will pause and 10-year US Treasury yields will likely be rangebound at 2.60%-2.80% over the medium term. For now, the recommendation is to maintain overweight duration levels in our portfolios, while reducing exposure to Europe, and keeping a close eye on any policy response from central banks to alter the outlook.
Credit | The credit market continues to be underpinned by strong fundamentals and with the recent selloff, offers more attractive valuations. However, QT remains a significant technical headwind and until we get an identifiable sustained pause, the recommendation is to continue to reduce risk on any spread tightening, particularly in high yield. Investment grade is more balanced with valuations closer to the 2016 wides and at levels that generally produce attractive returns in the following 12-month period. With the rise in idiosyncratic events, our focus on extracting value through diverse sources such as industry selection, geographic tilts, and curve positioning, combined with deep fundamental bottom up research of each individual name, becomes ever more important.
Emerging markets | The view for emerging markets (EM) debt can be summarized as uninspiring fundamentals, resistible valuations, and strong technical factors warranting a defensive tilt. Economic growth in EM continued to slow towards the end of 2018 across all regions, although led by China. Valuations are not offering significant reward currently although there is technical support from the asset class being under-owned. The recommendation is to add EM to our portfolios only on the basis of a supportive global view indicated by a stable or declining US dollar and stable to tighter global spreads. Within the asset class, an allocation, in our view, should be tilted toward countries offering the balance of a stable credit quality, manageable external financing needs, and a credible policy framework with relatively inexpensive valuations.
Currency | As the US economy slows, the market consensus is for a weaker US dollar. In our view this narrative misses the bigger picture of overall synchronized slower global growth, reduced liquidity, and a shift from QE to QT. The recommendation is to remain long in the US dollar and Japanese yen in the short term as these will likely offer the best protection in a flight-to-quality scenario. Commodity-linked currencies such as the Australian dollar and New Zealand dollar will likely remain under pressure along with the euro as the economic outlook deteriorates.
IMPORTANT RISK CONSIDERATIONS
Investing involves risk, including the possible loss of principal.
Past performance does not guarantee future results.
The views expressed represent the investment team's assessment of the market environment as of February 2019, 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.
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.
Fixed income securities may also be subject to prepayment risk, or the risk that the security’s principal value may be prepaid prior to maturity at the time when interest rates are lower than what the bond was paying. A portfolio may then have to reinvest at a lower interest rate.
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.
Market risk is the risk that all or a majority of the securities in a certain market — like the stock market or bond market — will decline in value because of factors such as adverse political or economic conditions, future expectations, investor confidence, or heavy institutional selling.
The S&P 500 Index measures the performance of 500 mostly large-cap stocks
weighted by market value, and is often used to represent performance of the US stock
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