February 28, 2020
At its triannual Strategic Forum in January 2020, 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
In order to determine our medium-term view and identify the key drivers and risks across fixed income markets, Macquarie Fixed Income (MFI) once again brought together our global team of 115 investment professionals from five locations to debate and discuss the prevailing themes at our January Strategic Forum.
Our first point of interest and review related to the question of whether there was indeed merit in the consensus outlook of 2020 as a better year for global growth and, therefore, financial markets. We subscribe to the view that there are some signs of stability toward an uptick in global growth. However, the backdrop is a fragile and fatigued global economy and, as such, we believe the market response may have been over-zealous. Further aiding this view is the reaction of the bond market that, in stark contrast to equities, does not appear to be as accepting of the outlook.
Our discussions next focused on how markets are currently witnessing the central bank “response” phase. In effect, global growth endured a quantitative tightening (QT) induced slowdown in 2019 that required central banks to pivot, reverse, and provide yet another round of “just do more!” stimulus. In assessing the key drivers of markets, the question in our minds, quite simply, centred on whether the need for yield could outmanoeuvre the China-led global slowdown. We acknowledged at the time of the Forum that the chase for yield had the upper hand for the time being and that close attention was warranted on Chinese growth indicators and credit markets for early indications of any changes to this.
In assessing the investment implications, we reiterated that we had already moved to being more defensive during 2019, cautiously participating in risk markets and accumulating duration on yield backups. While we recognise growth has stabilised, trade tensions have decreased, and central banks remain supportive, much of this has been priced in, possibly even more than justified. As such, we will continue to reduce risk as appropriate and await a repricing and better opportunities.
Sidebar: Since the Forum, markets have had to contend with the outbreak of the coronavirus. We have assessed this new market influence in the context of the “contained environment,” which to date central banks have been able support. But could the central bank firewall be susceptible to a virus?
In assessing the prevailing economic environment, we acknowledged that consensus is encouraged by a recovery in growth in 2020, following a disappointing and weak 2019. A number of broad-based factors supported the consensus view – recovering commodity prices, particularly copper; encouraging early Chinese data releases; and the signing of the Phase 1 trade deal between the US and China that many expect will reduce one of the biggest drags on business confidence.
We must keep in mind, however, that 2019 proved much weaker than expected, with a significant pivot by central banks required to avoid a recession. Last year was characterised by the divergence between resilient service and consumer sectors, and the effective recessionary environment surrounding global manufacturing. Thus, with the low starting base, the effects of recent monetary stimulus flowing through, and the trade deal reducing uncertainty, we think it is reasonable to expect improved economic growth.
In our view, China continues to play a crucial role in this outlook. We explored the risks surrounding its financial system given the series of recent defaults. The authorities control the lenders and appear to have eased back on the deleveraging focus of recent years. While nonperforming loans are rising, the profile of low foreign ownership of Chinese debt, low central government debt, and strong household balance sheets led us to conclude that a material downturn is not on the forecast horizon. In terms of China’s policy response, we highlighted that stimulus has been far less than previous versions and had a noticeably greater inward focus that is unlikely to have much in the way of flow-on benefits to global growth. Nevertheless, it is encouraging that stimulus does appear to be stronger this year than what we witnessed in 2019.
In summary, our view following our deep dive review of economic data confirmed that there were some signs of stability toward an uptick in global growth; however, the backdrop is a fragile and fatigued global economy that continues along a path of underwhelming expansion and is vulnerable to any modest shock. Given our assessment, we concluded that financial markets were correct in their interpretation that the outlook for 2020 was likely to be better than the backdrop of 2019; however, the response appeared overly enthusiastic and, in our mind, at risk of a reality check at some point should the growth pulse not eventuate or be as strong as the market has anticipated.
Containment – central banks respond (again)
In our September 2019 Strategic Forum, we referred to the prevailing environment as being in the central bank “response” phase. In this current elongated cycle, there have been several mid-cycle slowdowns that have been met each and every time with policy “responses” from central banks in an effort to support growth and thereby encourage more buoyant financial market conditions. We have long referred to this as “the contained environment,” in which central banks have been repeatedly required to act to contain risks and prevent any faltering in the economic growth outlook.
During 2019, we witnessed yet another central bank containment exercise. In effect, global growth was enduring a QT-induced slowdown that threatened a recession, which prompted central banks to pivot, reverse, and provide yet another round of “just do more!” stimulus.
As we reflected on the outlook within the framework of the contained environment and assessing the effectiveness on growth, the key question in our minds was: Would the China-led global slowdown ultimately become a recession and impact markets in the way a recession normally would? Or would the central bank response and consequent re-emergence of the insatiable global chase for yield keep credit markets open and functioning freely despite the deteriorating fundamental outlook? This question more simply centred on whether the desperate need for yield could outmanoeuvre the global slowdown. In early 2020, it appeared the global chase for yield was gaining the upper hand. This was further affirmed by a deluge of new issuance in the credit market and a continuation of tighter and tighter credit spreads, giving credence to the view that the pivot and response from central banks had been effective in ensuring the credit markets remain fully functioning and open to almost all borrowers. With recession risks elevated, it is imperative in our view that credit markets remain open, in our view.
While risk markets have been enjoying the fresh application of policy stimulus, in our minds it is still uncertain as to whether the “response” transmission through to economic growth would be meaningful enough, particularly as this time the predominant driver of the prevailing slowdown has been slower China growth. This is why we have been wary of the extent of the financial market response and believe it may be vulnerable to a correction.
The bond market does not appear as convinced
In stark contrast has been the reaction from the bond market. While US Treasury yields had increased somewhat and the yield curve had steepened so it was no longer inverted, the bond market response could broadly be characterised as unimpressed with the fundamental outlook. If anything, the reaction illustrates a pattern suggestive that the “response” phase may end in yields falling again and the curve flattening and inverting as is generally the case when the risk of recession is higher. As we highlighted in our September Strategic Forum, the bond market rarely gets it wrong. As such, the bond market continues to warrant close attention in 2020 as we are alert to the view that any cautionary signals from this market should not be ignored.
We have long pondered on how markets have become increasingly accustomed to the pattern of the last 10 years of embracing any and all policy comforts afforded and, in doing so, have demonstrated just how dependent they are on this support.
Even if the initial response from risk markets has been to dismiss such troubling dependency concerns and embrace the prospect of more stimulus – markets have become more and more familiar, and we would argue too complacent, with a “buying the dip” mentality. Markets have slipped comfortably back in to enjoying the warm embrace of the “more stimulus please!” contained environment.
The very real diminishing returns to economic growth from monetary policy and the consequences of trillions of dollars of negative-yielding bonds suggest that an alternative approach will be needed in time. Fiscal policy is the obvious choice; however, it appears unlikely that most governments will be able to implement anything sizeable any time soon. Therefore, the recurring pattern of “more stimulus please” – coming in monetary form – appears set to continue in our view, for as long as the contained environment and associated financial market support can remain intact.
Central bank firewall – susceptible to a virus?
We have often been asked – what then could end the contained environment? In response, we have referred to the possibility that something would eventually crack or tip the container over. In our minds, this outcome would most likely come in one of two forms.
The first would be a situation where a pick up in inflation appeared, preventing central banks from continuing to offer stimulus and liquidity support. Given our long-held views on the deflationary structural challenges facing the global economy (the 5 Ds of debt, demographics, dependencies, digitalisation, and deglobalisation), we believe there is a low probability of this occurring, unless an unexpected shock appeared and raised the price of an imperative need.
The second would be a situation where central banks act but growth slumps regardless. In other words, a situation where growth no longer responds to the stimulus (containment) and markets are forced to price weak recessionary fundamentals. We have always believed that this is a more heightened risk. Looking at how this might occur, we have often cited that some form of unexpected shock could cause demand to slump regardless. This could take the form of a geopolitical event, a natural disaster, or indeed, a pandemic. This leads us to the risks posed by the coronavirus which emerged shortly following the Forum.
The immediate concern for markets centres around how the reduction in mobility might impact growth, particularly in China but also more broadly. This is an unwelcome development in an already fragile growth environment, particularly given the importance of China to the global supply chain and therefore the global economy. Factoring this turn of events into the growth outlook, one can only downgrade it in the short term.
Adding this to our already more-cautious-than-consensus outlook for growth, and considering that markets have already priced a much better growth outlook, we are left concerned that the early 2020 optimism will be very difficult to be delivered upon.
A more serious question worth pondering is whether the coronavirus will test the central bank contained environment. Indeed, it seems likely that more easing will be required; however, its effectiveness is questionable as the virus would primarily impact Main Street, not Wall Street. Given the low-altitude growth environment, and to use the technical terminology: Could the central bank firewall be susceptible to a virus infection? While not our base case, this is a risk that should not be dismissed.
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.
Overall, our positioning coming into the Forum reflected our more cautious tone relative to market optimism. While we recognise growth has stabilised, trade tensions have decreased and central banks remain supportive, much of this has been priced in, possibly even more so than justified. As such, we have continued to participate; however, we have derisked into year-end and again early this year as we pause and await a repricing and better opportunities.
The following provides further detail on our views across the underlying investment streams:
Rates | At the time of the Forum, bond yields had retracted somewhat from the significant rally and lows earlier in the year. Our base case is for a pause in rate cuts from the major central banks; however, balance sheets should continue to rise. Bond curves are expected to modestly steepen and, regionally, we prefer US Treasurys over German bunds. Our investment approach is to continue to maintain longer exposure to duration and add more on yield backups.
Credit | Credit market fundamentals weakened over 2019, driven by a softening in earnings; however, balance sheets remain solid with stable free cash flows. While there was a reprieve in the trade dispute into year end, initial impacts had been felt in a number of sectors, including transportation, industrials, and chemicals, and a general slowdown in capital expenditures was noted, in particular in the manufacturing sector. Technical factors supported the asset class (again) through the “response” phase and should continue to do so; however, it appears much of this has already been reflected in prices. Valuations are expensive in both investment grade and high yield and with expectations for a limited uplift in 2020, we continue to participate though have reduced risk and will continue to do so as the environment warrants. Across credit accounts, this prudent reduction in risk is being offset with allocations to agency mortgage-backed securities (MBS) or, if not permitted, US Treasurys. Essentially, we have put placeholders down until the market reprices and offers better opportunities.
Structured | Fundamentals in structured products are currently supportive as the asset class has lagged investment grade corporates, creating relative value opportunities. In particular, value is returning to agency MBS with stable and supportive US fundamentals, a housing market in mid-cycle, and balanced technicals. For strategies permitting the asset class, our inclination is to increase the allocation to structured products as we believe it offers attractive relative value versus investment grade corporates at this point in the cycle.
Emerging markets | The emerging markets debt (EMD) view is one of cautious optimism with growth expected to remain subdued while inflation is contained and technicals remain supportive especially in the “lower for longer” world. Our EMD strategies are conservatively positioned recognising this environment, with the team reducing risk as we ended 2019. Our investment strategy is to participate in US-dollar-denominated EMD, tilt toward EM corporates for additional carry, and allocate to frontier sovereigns that have better fundamentals. For diversification, EM local currency is an attractive option. The team is cautious on adding further risk at this stage and prefers to pause for now until there is more clarity on the coronavirus and its impact on China and global growth.
Currency | The developed currency outlook is balanced with some pressure to the downside for the US dollar and neutral for the euro with the European Central Bank likely on hold, and the Australian dollar remains a sell on rallies. At the Forum, the team acknowledged the environment was one of low volatility, with the team awaiting a catalyst for a change in outlook and positioning. Since then, the outbreak of coronavirus has led to outperformance of the US dollar due to its safe haven status.