The topic of this quarter’s Fixed Income Quarterly Outlook was ‘Will the global economy recover? Where are the vulnerabilities and the opportunities’. Rates are signaling a deflationary trap with continued safe-haven bid. Risk assets are signaling slower growth with more accommodation under way, but a softer landing.
Our thesis is that the US and the global economy are moving from mid-to-late cycle correction, to cyclical pick-up.
There are some concerning underlying trends in the world economy. Global PMIs are declining, inflation expectations are still low and there is a rise in volatility and geopolitical risks. We also face the potential unraveling of globalization and the possibility of a more sustained global trade and tech conflict.
There is nevertheless good reason to expect an improvement in market sentiment toward the global economy. China is stimulating its economy strongly and central banks, including the Fed, stand ready to ease policy and proactively reflate. This is in sharp contrast to the pre-GFC period.
The US economy is slowing, but the private sector there does not have any large imbalances and is saving the fiscal stimulus provided by the large government fiscal deficit. Lower rates globally have already eased financial conditions and will have a positive impact on investment spending. US inflation is muted and real income growth is above 3%, supporting consumption.
Potential shocks like an Italian debt crisis or systemic corporate debt problems seem contained by easy money and yield grabs. We expect a cyclical growth pickup globally.
Low inflation gives central banks plenty of room to repress savings. Eventually this will cause either political problems or inflation – or both.
Despite concerns about growth conditions, it will be hard to be positioned overly bearish, since fighting the Fed or ECB has been a losing game over the past decade. We have a small overall underweight position in our portfolio centered on the US, which we believe has the smallest output gap and is most at risk of higher rates and steeper curves.
Should our scenario of a mid-cycle correction begin to develop, as we expect, we will implement a further and gradual reduction in duration exposure at the portfolio level. In Europe and Japan, which we believe have larger output gaps, we are positioned for further curve flattening and have broadly neutral duration exposures.
We have been approved to invest in China’s domestic bond market and find China’s relatively higher yields appealing. Given that we expect further stimulus from China, we find its domestic bonds the most attractive amongst the major blocks. They remain a small part of our benchmark but will grow over time and, we believe, are priced attractively for international investors from a yield and policy perspective, with the currency hedged.
Italian bonds moved to the bottom of our 240-310 target range towards the end of the quarter and broke this range in early July. We increased our duration in Italy at attractive levels near the top of our range only a month ago, and took profit near the bottom of the range. We have also increased our exposure to France and expect curves in periphery markets to continue to flatten in the current yield-grab environment.
We expect to keep a modest overweight exposure to credit risk overall, with a higher quality allocation. We don’t expect credit markets to tighten much, but instead to deliver carry-like returns, which isn’t exciting, but is attractive given the current yield environment. We have been buying short-dated emerging market hard-currency bonds on an outright basis, of issuers we deem to have sufficient reserves to add spread yield to the portfolio.
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