Q2 2019: Lower rates, slower growth
With trade tensions being the largest threat to the macro outlook, investors are looking to central banks to provide support. So far, central banks have indicated their willingness to provide easier monetary conditions. As such, we expect the US Federal Reserve (Fed) to cut rates, China to continue to support the economy through policy moves and the European Central Bank (ECB) to evaluate which of its potential policy options is most appropriate to manage downside risks.
Our fixed income forecasting views for the second quarter (Q2) of 2019 centre around the following themes:
Central bank “put”
Global government bond yields were broadly lower in Q2, as central banks in the US and Europe indicated that interest rates could be lowered. Markets are behaving as if there is a belief that central banks will move to limit downside risks to economic growth and that a broad global slowdown will be avoided. The main macro risk is the threat of a further escalation in the trade conflicts between the US and other trading partners. This follows threats of new tariffs from some inflammatory tweets sent by President Donald Trump, although these fears were allayed in late June following what appeared to have been a cordial meeting with Chinese President Xi Jinping at the G20 summit. Safe-haven assets are in demand because of the uncertainty.
US growth slowing
Markets have priced in 100 basis points of rate cuts from the Fed by the end of 20201. This would be consistent with a slowdown but not a recession, such as we saw in 1995-96. Risk assets continued to perform during that time. Today we are a little cautious on credit, but no big credit underperformance is expected, and total returns are expected to be positive.
Negative yields on more assets
The 10-year US Treasury yield fell from 2.41% to 2.01% over Q22. Within Europe, there were falls for 10-year bond yields across the German, French and Spanish markets3. In emerging markets, Argentine government bonds came under severe pressure early in the quarter, with a 100-year bond issued in 2017 trading at 66 cents on the dollar4.
Further compounding the fall in European bond yields in Q2 were remarks made by Mario Draghi, President of the ECB. He indicated that policymakers had the necessary tools, including further rate cuts and possibly restarting of quantitative easing, to support the economy in the event of a downturn.
As more of the global bond universe trades with negative yields, investors could favour positive-yielding assets as long as there is no global recession. This means flatter yield curves in Europe, narrower sovereign spreads in both the semi-core and periphery and stable-to-lower credit spreads, with a buy-on-widening mentality likely to prevail.
Potential risk of much lower rates and the realisation of downside growth risks
The ECB is preparing the market for more easing – perhaps re-starting asset purchases – while the Fed is under pressure to meet rate cut expectations. This is, in part, a reflection of the fear of a more pronounced slowdown if the US raises tariffs on more imports.
Long duration and creditThe lack of severe financial imbalances, contained leverage growth and the absence of inflation risks may explain why recession risks are still quite slow, apart from the cyclical threat from protectionism. A reduction of global economic tensions and the resolution to some political issues in Europe could help sustain credit markets. However, holding duration as a hedge in our portfolios remains a key theme.
1 Cox, Jeff, ‘A Fed letdown on rate cuts could be the stock market’s biggest threat now’, CNBC, 26 June 2019
2 Franck, Thomas, ’10-year Treasury yield drops as low as 1.97%, first time below 2% since November 2016’, CNBC, 20 June 2019
3 Ainger, John, ‘German Yields Fall Below ECB Deposit Rate as Governments Cash In’, Bloomberg, 4 July 2019
4 Smith, Colby, ‘Argentina’s century bond caught in dash for exit’, Financial Times, 26 April 2019
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