In line with the views in the recently published Credit Quarterly Outlook, we still believe we are late cycle in credit and we see downside economic risks. While rates markets are off some of the over-extended levels of late August, they have moved significantly, joining earlier sharp moves in gold.
In this report, we summarize our thoughts on the business cycle and review the outlook for five of the major fixed income sectors in our global multi-sector universe. We also consider asset class positioning in the cycle and wrap up with investment conclusions for our portfolios.
Global macro data has been underwhelming, with little sign of a turnaround yet, particularly in manufacturing. Economic momentum in China, which has led the global business cycle since the Global Financial Crisis, has stayed weak.
We like to view the business cycle outlook in terms of scenarios.
On the optimistic side, while leading industry indicators in most developed markets are still pointing south, those for China have started to bottom out (Figure 1).
Longer term, however, we doubt whether any recovery would be as strong as currently priced in by risk markets, for two reasons. First, even with an interim deal, uncertainty about the future course of the trade war will remain high. Together with other risk events, including a no-deal Brexit scenario, this could continue to weigh on global capex intentions. Indeed, the news-based global economic policy uncertainty index of Baker, Bloom and Davis hit a fresh record in August (Figure 2).
Secondly, Chinese authorities seem to have a higher tolerance for slower growth given the focus on deleveraging and de-risking their financial system, after the record credit growth of the last decade. This means further policy easing is likely to be reactive and slow in delivery.
Consequently, while global policymakers may succeed in extending the business cycle, the risk of a recession at some point over the next 12-24 months remains significant. Against this backdrop, talk of the need for fiscal loosening in developed markets will likely intensify. But we fear that action, certainly in Europe, will be reactive rather than proactive.
Given the worsened growth outlook and trade uncertainty, fundamental support for duration positions has increased. While our central scenario is for the low growth, low inflation backdrop to persist and for recession to – just about – be averted, the risks around our base case are skewed to a recessionary outcome. This has ramifications for developed market bond yields, where we see further downside potential for US Treasury yields than for Bund yields.
Markets have scaled back some of their expectations for further Fed and ECB monetary easing, to now price in 75 basis points and 15 basis points of further rate cuts respectively: 10-year yields have come off their late-August/early-September lows. Further, the prospect of renewed sovereign bond purchases in the Eurozone in the wake of continued strong regulatory demand for safe assets, should, if anything, keep term premia more depressed.
Ordinarily, the weak Eurozone growth outlook would point to caution on peripheral spreads. Encouragingly, the sharp drop in bond yields, and hence new borrowing costs, helps fiscal sustainability.
Technical factors overall offer strong support to peripheral spreads. Above all is the ECB’s recently announced net QE program, which is expected to continue until shortly before the ECB starts raising rates – which in turn has been made state-dependent on a rise in core inflation. The first rate hike is unlikely to occur before 2022 – in the market’s opinion. Moreover, low net supply should be a supporting factor to peripheral EGBs in Q4.
We are positive on some specific emerging market (EM) hard-currency sovereigns, whilst being neutral EM rates overall excluding China, and are cautious on EM FX. The growth outlook remains challenging, particularly for manufacturing, (commodity) export-driven issuers. However, the inflationary environment in general is benign to improving, providing some cushion for many of the EM central banks to cut rates and be more accommodative.
In the past quarter, central banks have become increasingly proactive with a more synchronized easing cycle offset by a resilient dollar as well as concerns about dollar liquidity. EM FX has been in a bear market the past five years and macro concerns will continue to support havens such as the dollar.
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