June 19, 2019
At its triannual Strategic Forum in May 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
After a tumultuous end to 2018, the major global central banks pivoted in their policy stance and ended their tightening action and hawkish rhetoric. This about-face was embraced, and with asset prices anticipating further central bank life support, the market tone was more optimistic for the Macquarie Fixed Income team’s second Strategic Forum of 2019 in May. Despite this supportive market backdrop, we believe that global growth is expected to slow further in 2019, but that recession risk remains low for now.
Our Strategic Forum’s purpose is to determine the medium-term view and identify the key themes and risks likely to impact markets. In May, we observed that the most recent central bank tightening cycle was both limited and short lived, and by consequence this indicates that policy continues to move further away from “normal.” This dependency is troubling to us, especially as global coordination diminishes, evidenced by increasing trade tensions.
In 2011, our year-end presentation used as its title a line from Charles Dickens’s Oliver Twist: “Please sir, can I have some more?” – implying that in 2011 the global economy would need more and more stimulus. At the time, this view was non-consensus, with a quiet unease and disbelief emanating from the audience at our presentation. While upon reflection, the view was accurate several times over, we never thought we would be dusting off the theme and using it again in 2019. Nonetheless, it does appear that the global economy and financial markets may require yet more stimulus, in our view.
This paper provides highlights from the recent Strategic Forum, including an outlook on the macro environment, the impact of the dependency on central bank (life) support, and the investment implications. In summary, we concluded that a sensible approach is to maintain strategic overweight duration positions while participating in higher quality credit with a view to reduce, should growth falter.
The current environment
As we gathered in May for our second Strategic Forum of 2019, the market backdrop had markedly improved since our first Forum in January, driven primarily by the pivot in sentiment from global central banks. The about-face from the US Federal Reserve, the European Central Bank (ECB), and a stimulus boost from China were embraced by risk assets, evidenced by the S&P 500® Index posting gains of 17.51% year to date as of April 30, 2019.
In January, we had discussed that central bank policy since the global financial crisis had been one of the key determinants of financial market performance, in what we term the central bank “contained environment” (a lengthy period of time whereby central banks have repeatedly acted to contain risk). This looked set to continue with our Forum theme of “Take your cues from the [liquidity] tide; invest with the [stimulus] flow.”
Until early 2018, central banks were still easing through extreme accommodation policy settings and quantitative easing (QE) that “you know, I know, we all know” resulted in the boosting of asset prices globally. This dynamic began to shift in 2018 with global central banks embarking on a journey toward quantitative tightening (QT). For the first time in over a decade, QE liquidity would end and begin to be withdrawn. The weak performance of markets in the fourth quarter of 2018 demonstrated just how dependent asset prices had become on the support and rolling stimulus programs from global policymakers.
At our May 2019 Forum, we acknowledged that central banks reversed course quicker than anticipated and markets had responded with relief – for now, at least. This naturally has led to the question: What next? To answer this, we undertook, as always, a thorough assessment of the global economic environment.
The economic outlook
Global growth since the financial crisis continues its long, underwhelming expansion with the structural challenges of indebtedness, demographics, and deglobalisation all hampering policymakers’ ongoing attempts to stimulate the global economy. In 2019, we observed that global manufacturing and trade have deteriorated, and this picture contrasts with the optimism portrayed by asset markets in recent months. Our analysis suggests that the US economy is fatigued but remains resilient with strong employment and modest wage growth underpinning the prolonged expansion. However, ongoing trade tensions are causing small business confidence to falter, which will require close watching.
Turning to China, we concluded that a wait-and-see approach is warranted, compared with the more optimistic consensus opinion, regarding the impact of recent stimulus where the government appears to be doing just enough to stabilize the economy, and the flow-through effect (benefits) to global growth may not be as strong as consensus anticipates.
In Europe, the consensus outlook is more optimistic albeit from weak levels, with the peripherals, in particular printing, showing an uptick in data. Germany, through its reliance on exports to China, remains a concern with a difficult trade environment weighing on growth.
Despite this somewhat subdued and vulnerable global growth profile, we concluded that recession risk remains low although it is ticking up. We are also alert to the signal coming from the recently inverted US yield curve. Inflation continues to form a deep part of our analytical framework, yet its emergence remains elusive with the biggest long-term risk remaining to the downside.
In summary, global growth is expected to slow further in 2019, though recession risk remains low at this time, in our view. Inflation has not reignited and remains within subdued ranges. With central banks having pivoted toward easing, it appears likely they will continue their approach of being responsive to downside market risk, meaning any possibility of a much longed for return to normal remains a long way off.
The purpose of our Strategic Forum is to set medium-term views and identify the key themes and risks we believe will impact markets. In May, we discussed just how brief the recent tightening cycle was and how this confirms our view of the extent of market dependence on central banks and other forms of stimulus support. We acknowledged that while there are similarities between the beginning of 2019 and 2016 in terms of support, this time is indeed different with global trade tensions weighing on a prospect of coordinated support. We discuss these in more detail in the following sections.
Tightening cycle – over already?
Was that it? In “normal” market cycles, the role of central banks is to ease policy to stimulate growth and tighten when economies are overheating. This policy reaction went “unconventional” with extraordinary efforts since the global financial crisis, as central banks reduced interest rates to zero (and even negative!) and embarked on QE for almost a decade. This support was embraced by financial markets at each and every phase, regardless of the imbalances, exuberance, and unintended consequences that emerged. Interestingly, throughout much of the last 10 years, many market participants heralded imminent policy tightening and the return to normal, while in previous Strategic Forums we frequently pointed out that central banks were still easing and in fact were getting further away from normal. Indeed, it is only now in 2019 that global net QE has turned from positive (easing) to negative (tightening).
In 2018, with global growth on a solid and synchronised footing, central banks were able to use this backdrop to begin reversing some of their extraordinary support – at last a tightening cycle had begun. The Fed was able to increase interest rates while continuing to reduce its balance sheet, the ECB worked toward ending its QE program, and the Bank of Japan relaxed its approach to longer-term yield setting. This shift in approach to global tightening was similarly heralded by many as the beginning of “the return to normal” and with a strong global growth footing, optimism was high.
As expressed in previous Strategic Forums,, we again were more cautious, and even sceptical, of this view. We questioned whether global growth, primarily US-led, was indeed strong enough to carry the reversal of the largest distorter and contributor to financial market performance over the past decade – the absence of, and then withdrawal of, QE.
As we progressed through 2018, this view largely played out, in what we referred to as the game of musical chairs. As the shift toward a QT cycle drew closer, the once insatiable chase for yield ended, and as US dollars were drawn homeward, one by one, asset classes that enjoyed the benefits of the global chase for yield started to lose their chairs. It began with emerging markets, moved to European banks, and then peripheral European sovereigns. Cracks in technology stocks emerged mid-year, and we ended 2018 with a sell-off in all credit markets and finally in US equities in December. Game over. By early January, it was clear that the first real tightening cycle since the global financial crisis was coming to an early and abrupt end.
Upon review, it is conclusive that this tightening cycle was both very limited and short lived. Only the Fed was really able to affect something resembling a tightening cycle, no doubt in large part aided and supported by a significant US fiscal stimulus package, whereas almost all other major economies were unable to commence much in the way of any meaningful tightening. The ECB was able to end QE, but unable to raise interest rates, which are still negative(!), and others like Australia could not tighten at all. Further, by the start of the second quarter of 2019, almost all developed market central banks have now pivoted back to indicating some level of easing bias.
A troubling dependency
The year 2018 highlighted just how reliant and dependent financial market pricing has become on ongoing central bank support and other forms of stimulus. This is a troubling, if not unsurprising, finding.
The markets’ recovery from their acute episode of angina in the first quarter of 2019 validated this, as the Fed pivoted quickly to communicate its tightening phase had ended, and that it would examine and end its balance sheet reduction program (end QT). In effect, the musical chairs had returned and the game played on – cue, buy the dip! This was further aided as China restarted a targeted stimulus program and financial market commentators drew parallels with the coordinated response seen in early 2016, now often referred to as the Shanghai Accord.
As noted, 2018’s price action demonstrated with concern just how significant and dependent financial markets are on ongoing central bank support, and we use the word “ongoing” deliberately. Even if the initial response from financial markets has been to dismiss such troubling dependency concerns and embrace the prospect of more stimulus, markets have become very familiar with, and we would argue, too complacent with, a “buy the dip” mentality. In doing so, they appear to have quickly and unconsciously abandoned any hope of the return to normal with all its purported positive connotations, and have slipped comfortably back into enjoying the warm embrace of the “more stimulus, please(!)” contained environment.
While markets, for the time being at least, appear unconcerned by the increasingly apparent reliance on ongoing stimulus, it does beg the question – where to next? QE for the people or a growing acceptance of concepts such as modern monetary theory?
More stimulus, like 2016? Not so fast
Markets have been quick to draw parallels between the distress in December 2018 and the slowing of global growth in late 2015. Back then, central banks coordinated a response, all contributing to inject more stimulus into the global economy following the G20 meeting in February 2016 in China. Global QE moved markedly higher and financial markets experienced strong gains for the remainder of 2016. In 2019, we have seen markets respond similarly, potentially anticipating a similar coordinated effort from policymakers, with the Fed pivot and targeted Chinese stimulus being interpreted as signs that if further stimulus is needed, as many of us expect, then policymakers will deliver.
While this might be the case, we would caution that the geopolitical environment of 2019 is very different from that of early 2016, and that drawing parallels to 2016 appears misplaced. China is evidence of this. While at the headline level, their latest stimulus efforts may be viewed as a positive for the global economy, when we compared this round of stimulus with that undertaken in 2016, there are meaningful differences in both the cause and focus.
China’s 2016 stimulus focused on lifting the domestic economy with a loosening of lending standards and a revamp of real estate taxes to boost the property market. While the broad focus of the stimulus did take some time to make a direct impact, global growth ultimately benefited.
This time around in 2019, the cause for stimulus is to offset some of the impact of China’s credit tightening policies, and infrastructure is a key beneficiary. With the added pressure of ongoing trade tensions with the United States, we anticipate the global flow-on effects are likely to be much more muted.
As such, the rapid rebound from equity markets since early January appears overzealous and at risk of faltering, particularly when compared to bond yields that have not responded to the better sentiment and continue to shift lower in yield, reflecting concerns about the outlook for global growth and lack of inflation. Further, the US yield curve has now inverted, and if sustained for more than one month suggests recession risk has become more elevated, all of which indicates a faltering of confidence in the outlook. This environment has been further compounded by the recent deterioration in the US-China trade dispute.
Trade tensions – global growth and trade downside risks
Financial markets and many commentators/analysts were expecting the US and China to move toward some form of trade agreement. Thus, the sudden escalation in trade tensions in the first two weeks of May caught markets by surprise. The news flow implies that negotiations have moved further apart with recent speculation that the dispute could escalate.
While markets may be taking comfort from the prospect that central banks may ease policy, and/or presume that the White House will “blink” if equities fall, and this may be the most likely outcome, we are mindful that there are two sides to any negotiation and this is not being factored in. China could end up being the surprise player and we realise that Trump is not the one holding all the cards. Regardless, the key takeaway is that the trade dispute appears to have escalated from being about “fair trade” and a “better deal,” to one more centred on significant and genuine geopolitical differences. As such, the prospects for global growth and global trade are facing considerable additional downside risks.
When determining the investment implications of the Forum, we assess the outlook and medium-term views of the team with our current portfolio positioning.
At our January Forum, we recognised that central banks would likely take some action to counter the volatility of the 2018 year-end selloff and recommended a strategic overweight duration positioning. The team also recommended continuing to participate in higher quality credit investments while avoiding the higher beta sectors. This positioning served us well as bond yields continued to rally solidly while improving credit market sentiment also aided portfolio returns.
In May, our view of further conservative participation reflected the asymmetry of risks that are skewed to the downside. Slowing global growth, and the rise of several deglobalisation challenges exemplified by the recent sharp spike in trade tensions are all weighing on sentiment. Our positioning is further validated by the relatively expensive valuations exhibited especially in the riskier asset classes that benefited from the potentially premature or overextended relief rally year to date.
Our overall investment approach is to continue to participate in high-quality credit investments, avoid the higher beta risk sectors, continue to hold longer duration for protection, and await opportunities to increase risk when valuations reflect the more challenging global outlook.
The following provides further detail on our views across the underlying investment streams:
Credit | Credit market fundamentals appear stable to improving; however, idiosyncratic events and emerging new trends like escalating trade wars have reinforced the need for diligent industry and security selection. With the compression in spreads earlier this year, valuations are less attractive but still off the tights of 2018. Technical factors of strong demand for investment grade with reduced supply continue to support. Overall, our approach is to continue to reduce exposure to credit at the margins and wait for opportunities to add, in particular higher beta sectors, on a 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.
Rates | With the swift shift in central bank policy away from tightening, bond yields moved considerably lower and outperformed. We expect the Fed to maintain its pause on policy with the next move most likely to be lower. Absent a significant risk event, we expect Treasurys to be rangebound with further volatility opening up the potential for lower yields. The investment approach is to maintain strategic overweight duration levels and add more duration should yields rise.
Emerging markets | The emerging markets debt (EMD) 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. The investment approach is to maintain a defensive tilt with US dollar-denominated EMD offering carry over similar rated corporates. Corporates are also preferred over sovereigns due to higher carry and a wider opportunity set. The team remains cautious on EM foreign exchanges (FX) but alert to opportunities to add on any shift to a more positive global growth outlook.
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, with Europe in particular heavily linked to the region.