21 October 2019
At its triannual Strategic Forum in September 2019, the Macquarie 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
As fixed income investors, we tend to believe that the bond market rarely gets it wrong. Historically, a sustained inversion of the US yield curve (2-year and 10-year Treasury bonds) has generally been followed by a recession. Since our last Strategic Forum in May, the pronounced move lower in bond yields around the world and the US curve inversion has therefore captured our attention. While the rally in and of itself is worthy of debate and discussion – “Are we headed toward recession?” – it is also the sheer amount of global bonds that trade with a negative yield that has us wondering what the bond market may be foretelling.
To say that the backdrop to our latest Strategic Forum in September calls for sitting up and paying attention is an understatement. When 10-year German bund yields are -0.70% and 30-year yields are at -0.22%, it begs the question: “Is everything out there okay?’” There are other even longer dated bonds like Austrian 70-year bonds with yields as low as +0.50% – for 70 years! The reality is there is now $US17 trillion of negative yielding bonds outstanding. (Source: Bloomberg.)
If that does not have your attention, what about this next highly unusual anomaly. At the time of the Strategic Forum, the highest yield in the developed sovereign world was, wait for it, the US federal funds rate. When has the highest yield on offer ever been the lowest risk asset in the world? There is something wrong with this picture.
With that backdrop of “paying attention,” we commenced our third Strategic Forum for 2019 with the key question on our minds: “Should we fear a recession?” Some say we should; some say that this time is different. Plunging bond yields and inverting yield curves cry out “recession,” yet many still continue to see reasons for risk assets to perform as central banks and policymakers once again do more to contain the environment and maintain what is now a long and mature cycle.
In order to determine our medium-term view and identify the key impacts on markets, Macquarie Fixed Income (MFI) brought together our global team of 115 investment professionals across 5 locations to debate and discuss the prevailing themes and likely risks. The team completed a detailed analysis of the economic outlook, geopolitical developments, and the underlying forces that cause recession. We concluded that the risk of a recession in the United States had risen since the May Forum, although it would likely be short and shallow if it did occur. However, the recession risk in other countries has been greater, with significant idiosyncratic risks at play.
The investment implications from these discussions were to maintain a sensible approach to high-quality credit investments while remaining cautious and selective in the higher beta risk sectors. After reducing duration levels based on the recent move lower in yields, we are looking for opportunities to accumulate should yields rise further.
Economic backdrop reveals a contrasting, fatigued, and fragile global cycle
This long expansion phase has underwhelmed and while expansions “do not die of old age,” this one is looking fatigued and fragile. The modest monetary tightening cycle from 2015 to 2018 certainly contributed to this, but the reduction in global trade amid a world of deteriorating cooperation is a more likely driver of this current global slowdown. Global trade volumes have fallen, global industrial production has collapsed, and while the services and consumer sectors appear resilient, many economies offer a contrasting picture where the industrial sector is heading into recession.
While the slowing of growth is global it is noticeable that the US is again proving resilient. The prior de-leveraging by the US consumer and a corporate sector buoyed by tax cuts and fewer regulations have helped the US economy. Outside the US, the global economy is weaker with numerous downside risks. China played a key role in 2009 and again in 2015-2016 by injecting policy stimulus that lifted domestic and global growth. The current cycle is different because Chinese policy easing is both more modest and targeted domestically. We also note that the slowing of Chinese growth is structural, reflecting an economy transitioning from investment-led to consumption-led. When this picture is overlaid with a protracted trade dispute the global growth outlook is fragile. Further, a common theme across geographies is that inflation is biased to the downside, a picture confirmed by a scan across base metal prices.
Globally, central banks are on the move (again) to ease and hope their action provides a positive multiplier, but bond markets and consumers are sceptical. Demographics, too much debt, and a workforce seeing increased digitalisation, mean that consumers are saving and are more likely to save more when faced with even lower rates. The appetite for increased borrowing is low.
With low bond yields and inverted yield curves warning of recession, attention is turning toward what else can be done to prolong the expansion. More monetary policy? Can weak and unstable governments unleash fiscal easing? Even more unconventional actions? The current expansion has been the longest, albeit the shallowest, and has required the most extraordinary amount of ongoing (predominantly) monetary stimulus to maintain. Now as we head toward the end of 2019, the evidence of a global slowdown is building and with it the heightened risk of recession in an environment that is very vulnerable to any exogenous shock.
It’s never different this time
We at MFI believe that the bond market rarely gets it wrong. When the bond yield curve inverts, as the saying goes, “It’s never different this time,” and almost always a sustained inversion of the yield curve foreshadows that troubles lie ahead. With the backdrop of weaker global growth, we also noted that the US corporate sector leverage is rising and profits are falling. This collection of evidence warrants caution and close attention and we prefer to work from the basis that signals such as these are not to be ignored, and understanding their drivers is paramount to portfolio positioning for the way forward.
If the bond market and yield curve are alerting us to a recession, it is the credit market that will give us clues to if and when the timing of recession will occur. History suggests somewhere between six and 18 months forward. It is at this point we dig deep into our research seeking to confirm the picture that has been painted by the bond market and seek equally alternate reasons that might explain the pronounced movements in global bond markets.
The trade war and the slowing global economy
During our September Forum, we reviewed the economic data in detail,analysed the usual causes of recessions, and concluded that the evidence does not appear to be in place to suggest the US is headed for one in the short term. Bank interest margins are rising when historically they fall as the curve flattens, and thus lending standards are not being tightened. The US economy appears to be in a relatively good place underpinned by a robust labour market, solid consumer, corporate tax relief, and modest wage strength. While there are signs the economy is tiring and slowing and the risk of a recession is rising, we perceive that only a few macro warning signals are flashing.
The rest of the world is different. This slowdown appears to be very much a global one, and China is at the epicentre. The same analysis of economic data and normal causes of recessions applied to China reveals growing risks of recession, and possible crisis. It has been a long time since China experienced a material slowdown (excluding the global financial crisis when all economies were impacted) and China wasn’t such a large contributor to global gross domestic product (GDP) the last time it did.
At our January and May Forums, we highlighted the importance of the outlook for the Chinese economy and the need for stimulus from China. So far, the response has been underwhelming with a noticeably greater inward focus that is unlikely to have flow-on benefits to global growth. The ongoing US-China trade dispute is clearly weighing on global trade and expectations of a resolution have faded. Optimism on a trade resolution has consistently disappointed and there is no evidence in our opinion that they will reach a resolution any time soon. China appears increasingly unlikely to bend and they may indeed be more focussed on the long haul and incentivised to prioritise looking after its “own.”
In examining the way forward, we questioned whether China is now motivated to do a deal at all. It will, of course, be wary of the risks of the Hong Kong troubles, and the risk that this could spread into other provinces. However, China could take a stance of withstanding the near-term economic pressure rather than pursuing any form of soft deal that may aid President Trump’s 2020 election chances. The incentives to resolve the trade dispute may be shifting. China and President Xi will not want to be seen as weak. Likewise for the US, the trade war is now a national cause for China – a rallying call to the nation. If indeed the preferred path is to drag negotiations out with a view to dealing with the next US administration, this would be to the detriment of the global economy. If this is now the plausible scenario, what will the Trump Administration do in response? Increase the pressure further, become increasingly erratic, or get something, even soft, agreed? With so much uncertainty, the likelihood of a meaningful resolution to the trade disputes seems unlikely in the short-term.
Acknowledging the global slowdown, central banks are on the move (again) to ease. In Europe, inflationary expectations have fallen dramatically and it is therefore no surprise that the European Central Bank has been required to act with a resumption of quantitative easing (QE) after ending it only nine months ago and lowering deposit rates further into negative territory. The anticipation of a broad based QE resumption in Europe has resulted in a steep escalation of the quantity of negative yielding global sovereign bonds, and it is this relentless force that has reignited the global (and insatiable) chase for yield as Europe effectively drags everyone else lower and lower.
It’s never different this time – or is it?
While we are long believers that bond markets rarely get it wrong, we are wise enough to know that rarely does not mean never. For confirmation that “it’s never different this time” when yield curves invert our attention is focused on the credit market narrative. Will the global slowdown ultimately become a recession and impact markets in the way a recession normally would? Or does the global insatiable chase for yield keep the credit market open and functioning freely despite the deteriorating fundamental outlook and in doing so further lengthen the already elongated economic cycle?
This question, more simply, centres on whether the desperate need for yield can gazump the global slowdown. Stimulus is required and ideally of the fiscal variety; however, it is unlikely that governments will be able to agree anything sizable in a timely manner. Stimulus will more likely come in monetary form, and given this, an assessment needs to be made of whether policymakers can keep the environment contained once again.
Policymakers have pivoted in their policy stance and ended their tightening action and hawkish rhetoric; however, this time they do not appear coordinated and the global economy most likely requires a more substantive stimulus approach from China. Global growth will likely remain modest at best without it, and even with the most “ideal” of stimulus from Europe and the US, our enthusiasm is tempered as we question the effectiveness of further monetary stimulus.
Since 2008, all of the once unthinkable stimulus has accumulated, yet in 2019 here we are asking: just do more! Why are we still here? The problems are structural, and they appear to be getting worse. The central bank contained environment relies on cyclical policies to try to address structural issues. This is good for asset prices but not for the real economy, resulting in rising inequality which in turn leads to more populist political outcomes that are nationalistic in nature. As a result, trade disputes have manifested, fueling the most recent structural headwind of deglobalisation. It is increasingly clear that monetary policy is nearing exhaustion and, in fact, could arguably be making problems worse.
Nevertheless, markets have become increasingly accustomed to the pattern of the last 10 years of embracing any, and all, policy comforts afforded. Will they do so again? We expect they will, but the diminishing returns from monetary policy and the consequences of trillions of negative yielding bonds suggests that the risks that the contained environment breaks or tips over are rising. We worry that the container is increasingly unstable and is vulnerable to a shock.
When determining the investment implications of our Strategic Forum, we assess the outlook and medium-term views of the team with our current portfolio positioning.
In our September forum, the investment implications were to continue to participate in high-quality credit investments, while remaining cautious and selective in our approach to the higher beta risk sectors. After reducing duration levels based on the recent move lower in yields, we look for opportunities to accumulate should yields rise further. The following provides further detail on our views across the underlying investment streams:
Credit | Credit market fundamentals have weakened in some sectors. Idiosyncratic events and escalating trade wars have reinforced the need for diligent industry and security selection. Valuations have improved since May, but there are reasons to be wary. Overall, our approach is to continue to reduce exposure to credit at the margin and wait for opportunities to add, in particular higher beta sectors, on meaningful repricing. When participating, our focus will continue to be 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. With duration at low yield levels, we will continue to look for alternative hedging options.
Emerging markets | The emerging markets (EM) debt view can be summarised succinctly as mixed fundamentals and valuations, and supportive technical factors warranting a defensive tilt with a focus on carry. Economic growth in EM has stabilised in 2019, mirroring the credit expansion in China. The challenges of Argentina and Turkey have largely been contained with overall spreads remaining rangebound. Valuations are not offering significant reward although there is technical support from the asset class being under-owned. Our investment approach is to maintain a defensive tilt preferring US dollar-denominated EM debt over local currency debt. Corporates are also preferred over sovereigns due to higher carry and a wider opportunity set. The team remains cautious on EM foreign exchange (FX) but alert to opportunities to add on if there is any shift to a more positive global growth outlook.
Rates | With the swift shift in central bank policy away from tightening, bond yields moved considerably lower and outperformed. We expect the US Federal Reserve and other central banks globally to continue to be supportive. Absent a significant risk event, we expect US Treasurys to be rangebound with further volatility in risk markets opening up the potential for lower yields. While we tactically reduced our duration exposure on the significant move lower in yield, we remain of the view that any back up in yield is an opportunity to add duration as a counterbalance for the risk in portfolios.
Currency | We expect moderate US dollar strength with the US acting as a safe haven should global growth falter. The team is cautious of the impact of Chinese stimulus on global growth and looking to underweight currencies with high exposure to China. Similarly, cyclical currencies such as the Australian, New Zealand, and Canadian dollars are less favoured due to both domestic and global factors pointing to currency weakness.
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