Markets continue to be weak and volatile, while growth expectations are depressed globally. However, conditions for a better year in 2019 are gradually falling into place. Fred Belak, head of Robeco’s Global Fixed Income Macro team, expects the Fed to announce a pause in its tightening cycle. In addition, lagged effects of Chinese stimulus should become visible and we expect a more constructive tone in US-China trade talks. Risk sentiment is still negative, but markets can expect one last squeeze of reflation this year before the Fed is finally forced to call a halt in 2020.
“We have recently shifted our Fed view to a last hike in December and an extended pause with no rate hikes in 2019. Global liquidity has tightened enough to impair the US economic outlook as financial conditions have shifted,” says Belak. “The inversion at the short end of the US curve signals to a cautious Fed that a pause now makes sense. Although we believe there will be a growth slowdown in 2019, we remain optimistic that a Fed pause will lead to only a shallow dip in 2019. We are late cycle in the US, but not at the end of the cycle yet.”
China remains the key driver of global growth and Belak notes “China’s growth slowdown is the result of tight monetary policy as authorities there try to rein in a largely debt fueled growth model. China has been expanding fiscally by stimulating in the face of a severe manufacturing slowdown and a hit from Trump’s tariff policies”.
“Although there is little sign of it yet, we expect China to stabilize, positively impacting global growth. The trade war between the US and China appears to be on hold with both sides benefitting from a halt to escalating trade tensions for now, allowing a gradual reflation of markets”.
On a more cautious note, liquidity conditions remain tight. Belak: “QT (quantitative tightening) of 500 Billion USD expected for this year would be the equivalent of a 50 bps rate hike. Should markets remain weak after the Fed signals a pause in rate hikes, addressing the pace of QT would be a further tool to reflate global markets in 2019”. He adds there remain no convincing growth drivers in Europe. “With little monetary policy ammunition, the region remains largely dependent on global trade for growth.”
Quantitative tightening hit markets with a bang last quarter, and valuations have cheapened almost across the board. Belak comments “US 10-year yields at around 3% seem reasonably attractive with the Fed expected to pause at around 2.5%. We do not envisage a sharp rise in 10-year Bund yields. Currently 25bps of hikes are priced in for the next two years, in line with our projections. In peripheral Europe, the sharp rise in bond spreads since the second quarter of 2018 means that valuations have become more attractive. In contrast, we see least value in Japanese government bonds. The BoJ has been ‘stealth-tapering’ its purchases, which will likely continue.”
In emerging markets, selectivity is the key. “Valuations for local debt have improved over the past quarter, although it is difficult to speak about EM as a homogeneous asset class. Emerging currencies spot rates versus the USD are back at levels last seen in the beginning of 2016. An environment of somewhat slowing growth in the US and a Fed that is on hold should be beneficial to emerging market currencies.”
Credit spreads have widened considerably this quarter. “At current levels, EU IG cash bonds are almost fully priced for a 2015/2016 type of slowdown environment” Belak concludes.
Over the next quarter, technical factors are likely to put downward pressure on bond prices. “Probably the most important of these factors is the planned reduction in QE by the BOJ and ECB, and higher net new issuance of US Treasuries”, Belak highlights. “In credit markets, fund outflows and concerns about the end of QE are driving forced sellers at a time when market liquidity is very challenging”.
The one exception to this negative technical picture is in emerging markets. “We view emerging local bond technicals as slightly positive, because investor surveys and factsheets show investors are now neutral against their benchmarks in both duration and FX positioning for the first time this year”.
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