Global growth has slowed for two years, at some point trends will bottom out. Markets, as we know, anticipate. While it might be too early, with or without recession, a recovery will eventually ensue. On the other hand, a US recession could still be averted in 2020 given central bank easing, more modest current account imbalances than in prior cycles, and a US election which logic suggests should focus White House minds on a more moderate approach to trade.
Fixed income might not seem an obvious choice for a recovery phase. But within our USD 55 trillion global aggregate opportunity set, there are a surprisingly large and varied number of sectors that can outperform. We highlight three.
A key challenge for investors is that while many safe haven assets have begun to price for recession, many risky assets have not. Government bond prices and gold have appreciated, but their risky counterparts in the main haven’t sold off – despite the softer economic backdrop.
Be it years of easy monetary policy, the push of negative rates, a Pavlovian response from investors who have been conditioned for over a decade to buy every dip, downside risks are just not priced in, away from specific pockets such as CCCs and Argentine fixed income. Amid buoyant equity markets, aggregate HY spreads are close to their richest quartile versus history. EM spreads too. But we find three value exceptions.
First, inflation. The path of inflation implied by the difference between nominal bonds and real yields (the breakeven), has fallen to levels seen in prior soft patches, such as the Eurozone crisis and 2015-16 commodity downturn (see below figure). There are both cyclical inflation trends (lower producer prices, softer survey data and a weaker oil price, for example) and secular trends (globalization trends as mentioned earlier, including falling goods prices amid technological advances in production and distribution).
Should the secular dominate, then mean reversion to prior inflation norms may prove over-optimistic. Nevertheless, in a world where central banks have made valuations challenging almost across the board, break-evens have moved where other cyclical fixed income assets have not.
Second, several cyclical currencies have cheapened up materially (see the figure below), amid the weak commodity and strong dollar environment of recent years. Again, watch for the secular trends: take Australia where household debt and real estate prices suggest further downside first. But by using macro research to screen for macroprudential risks, a cleaner subset of opportunities can be created, should the recovery scenario come into fashion in 2020.
Third, in the sovereign space, recovery should help Italian and other periphery bond markets push further versus the core Eurozone. Domestic political news flow will periodically hit the tape, but in general, there is a correlation between Eurozone growth and periphery spreads. While safe havens (German, Dutch and other AAA/AA sovereigns) are likely to underperform in a recovery, the flipside is that single-A and lower sovereigns should outperform.
Finally in credit, relief on global growth and trade concerns could see spreads retrace tighter. At the time of writing, the gains to be had are small. Yet that doesn’t mean investors should ignore credit opportunities in 2020. The potential ranges in spreads can be broad. For example, at the start of Q4 2018, US high yield spreads were just 332, well into their richest quartile versus history.
Yet on 1 January 2019, just three months later, they stood at 537 bps, more than 200 bps wider and pricing in a default rate of nearly 9%. That proved an attractive tactical entry point, not just in US HY but across DM credit. Given the uncertainties increasingly referenced by central bankers, investors should remain nimble and ready to execute if credit opportunities re-emerge, one of the key facets of a total return product.
Of course there isn’t just one kind of recovery. Should the US economy avoid recession but growth remain sluggish, selected BBB and BB EM local government bonds should fare well. But in a more pronounced recovery scenario, we see three opportunities: global inflation-linked bonds, selected cyclical currencies and Eurozone periphery bonds.
We think euro-denominated spread products enjoy additional protection given the ECB has only just recommenced its second ever quantitative easing program, with an open-ended nature this time round. In credit, as the last 12 months have shown, opportunities can appear and disappear rapidly. It’s important to have a flexible approach, because the pendulum of market melodrama has a habit of swinging too far.