Themes in Focus
Jim Cielinski, Global Head of Fixed Income, provides his perspective on some of the key macroeconomic factors that are driving fixed income markets.
Could we be entering a second Goldilocks period?
It is unlikely. Risk markets are certainly eager to price in a Goldilocks period where there is little inflation, growth is slow and steady, and volatility remains tame, but we are dancing on a knife edge now. The Goldilocks period has worked in the past because central banks — the Bank of Japan, the US Federal Reserve (Fed) and the European Central Bank (ECB) — were ready and willing to stimulate economies with trillions of dollars of stimulus. This time, however, we are missing that tool in the tool kit. The ECB really cannot do much, the Bank of Japan has already done most of what it is going to do and the Fed has only ceased tightening. They are not going to backtrack into big-time easing or monetary stimulus. Without that toolkit, the ability to navigate the narrow course where growth and inflation are just right will be illusory.
Has the US ‘had its porridge’ with the Trump tax cuts or can growth stabilise again?
Last year, there was almost too much growth and too many inflationary fears in the US. We could argue that the porridge, in reference to the Goldilocks analogy, was too hot. Now we are finally seeing growth moderate. It is important, however, that this growth does not slow down too much. So far it has behaved, and the odds are the markets are now pricing in too much short-term deterioration. Make no mistake – this slowdown is global — but the US is coming from a stronger starting point, and I think it will be able to stabilise in the second half at these lower levels.
Could a bear be coming down the path?
It is hard to see a material bear market without some kind of recession and I still believe the odds of a global recession are low. It is interesting that we have flipped back and forth from fearing too high an inflation rate to fearing recession and while a number of leading indicators of recession suggest that we should be wary, some of the coincident and lagging indicators suggest that we still have some time on our side. Absent a policy mistake by the Fed, which was one of the biggest fears in terms of potential recession drivers, I think we avoid it for 2019.
Let us not get complacent though, as the odds of recession are larger today and there are pressures emanating from several sources. Debt continues to grow, monetary stimulus is no longer acting as a tailwind and margin improvement is dissipating. So while profits are robust, margin weakness and growing debt expose the markets to potential shock. As we move into 2020, it is important to keep a keen eye on credit growth and margin deterioration and also on what happens in growth engines such as China.
Is China the swing factor for global growth?
When I look at what the important swing factors are for this year, China is right up there. In addition to trade protectionism, they are also combatting slowing growth. While they have employed an array of easing measures, the magnitude of what they are doing is relatively small; recent measures only equate to about 20% of what they have done in past easing cycles. Beijing’s hands are tied in an effort to stimulate the economy, and I do not think their efforts will reverse the slowdown we are currently seeing. Although China will likely continue to grow stronger than many regions of the world, the slowdown is going to have an impact on global trade. What happens in China will dictate what risk assets do, as they have spurred roughly two thirds of global credit growth in recent years, which is what greases the gears of global growth.
What are the implications of all this for interest rates?
The obvious answer is lower, but most of this move has already happened. The market has priced in the view that nearly all central banks are likely to either stand put or ease. Equally, the downward movement in inflation pressures has been reflected through a much lower term premium. So I think we have already seen the bulk of the rates decline.
Central banks will not be the big story for the rest of 2019. In my view, it is likely that the Fed and most other banks will not tighten or ease much in the next twelve months. In some cases, the threshold for a policy shift is too high and in other cases, central banks’ hands are tied. The story will shift; it will now be more about the pace of the global slowdown in the context of central bank inaction. That means that volatility may persist, but it will be driven by different factors. For me, there would need to be another leg to the global slowdown for rates to go materially lower from here. At this stage, I think one could look at the global slowdown and say it is probable that the Fed’s next move is an ease, and that this tightening cycle could very well be over.
When looking outside the US, there has been a similar decline in rates. Yields in Germany and Japan are less than zero and I think that means two things. One, the potential for big return upside is probably limited and two, it does make the US look relatively attractive.
Rates are low and are going to stay low, but I think the key for fixed income investors is to recognise that even at low yields, there is a diversification benefit. Particularly as you get late in a cycle, owning fixed income and owning high quality fixed income – whether it is short, medium or long duration – can provide important diversification benefits to a broad portfolio.
What should investors consider when investing in corporate credit?
The current backdrop for corporate credit makes it difficult to pinpoint which sector or region will be particularly good or bad. One thing we can see, however, is a divergence in behaviour. Many issuers are restrained; they recognise the risk present and are beginning to look toward opportunities either to delever or generally be more cautious. Meanwhile, some companies continue to lever up, under the belief that rates are low and there is still a lot of growth ahead.
For me, it’s less about which sector or region should garner attention. It is more about finding those credits and risk assets that are behaving prudently and in a way that is more ‘bondholder friendly’. I see a lot of those across the globe. But equally, in almost every region, I see potential trouble spots that could come back to haunt you in a recession. So security selection, while always key, is probably more critical today than it is normally.