Jim Cielinski, Global Head of Fixed Income, provides his perspective on some of the key macroeconomic factors that are driving fixed income markets.
- Moving beyond ‘peak liquidity’ will define markets in 2019
- Politics elevates the probability of ‘bi-modal’ outcomes
- Late-cycle corrections are creating value in selected areas
- The yield curve signals a slowdown but not necessarily a recession
What do you expect to be the defining characteristic of 2019?
The liquidity cycle has turned. In addition, 2018 was as good it gets for the global economy. The interplay of a decelerating macro backdrop and a weakening liquidity cycle is the biggest issue facing markets in 2019. We have been spoiled by steady growth, quantitative easing (QE) and low interest rates, which have propelled almost every asset class upward. The unwind will be unpredictable. This is a liquidity driven market as much as a standard economic-driven marketplace – and that is a big difference.
Has the risk of a policy error by central bankers receded?
I think the risk of the US Federal Reserve (Fed) overshooting is falling, but it is still out there. The Fed does not know “how far is too far”, but their recent comments about tighter financial conditions and the global nature of the slowdown paint a picture of gradualism. They have already removed the emergency accommodation provided in the post-crisis period, arguing that a go-slow approach is warranted. Receding inflationary pressures are also removing the need for the European Central Bank to raise rates. I don’t think policymakers have overdone it yet, but emerging political issues, should they play out negatively, could mean that policymakers have already erred.
Will politics play a role of outsized importance in 2019?
Politics is probably more important today than at any time I can think of in my career. We have trade tension, Brexit, Italy, and a number of things on the political front in the US. Unlike most political events that are ripples in a pond, we are talking about political factors that could have far-reaching ramifications. To my mind, that makes it hard to say there is a central case. Many of these factors are either going to end up as good or bad – an ‘in-between’ central case is not the likely outcome. Markets are not very good at understanding this type of ‘bi-modal’ world.
Where are we in the credit cycle?
Both credit spreads and defaults likely bottomed in 2018. Does it mean a 2008-type of event awaits us? No, but it does mean more stress and market volatility, and challenging returns in many parts of the market. With that said, we have moved to levels that reflect a lot of this new reality, so it does not mean a pure avoidance strategy is the best path forward, but I think the best days in the cycle are clearly behind us.
I look at many markets and European credit is one where the market correction is fairly far advanced. Underperformance has been marked against the US in 2018, yet Europe is earlier in the credit cycle. Provided that growth can remain at least moderate and Italy does not cause a crisis to erupt, I see opportunity in doing cross-market trades, perhaps favouring Europe over the US in 2019. Economic cycle differences and political risks create lots of different drivers globally so credit cycles do not all progress in unison. Emerging market debt also looks interesting.
Is the flattening/inversion of the US yield curve a concern?
If you do not find an inverted curve to be somewhat concerning, you are making a statement that you are smarter than the market. It pays to be more humble. An inverted curve does not, of itself, cause a recession, despite dominating recent news headlines. But it does reflect a market expectation that growth and inflation will slow down in the future. The bond market overall is a good predictor and I think that a slowdown is likely to unfold. We should not, however, get too carried away and say a recession is just around the corner just because of a very modest inversion in parts of the US Treasury market.
Is volatility creating more value?
Volatility is both the friend and the enemy of active managers. It creates value and it creates risk. I do not think of volatility as inherently good or bad. It should be advantageous if you have an active management skillset that allows you to look around the globe and pick those areas where volatility has overly depressed valuations, or identify where assets are overvalued. Volatility is here to stay – it is a key component of the end of the liquidity cycle. I am excited by it, but you always have to recognise it as both a risk and an opportunity, particularly when markets are illiquid. A lower price does not automatically imply that an asset is cheap.
Credit spread - the difference in yield between a corporate bond and the equivalent government bond of similar maturity.
Quantitative easing (QE) - a monetary policy occasionally used by central banks to increase the money supply by buying government securities or other securities from the market.
Inverted yield curve - an unusual environment where the yield on longer-term debt instruments is lower than for shorter-term debt instruments of the same credit quality. In normal environments investors would typically demand a higher yield for lending for longer periods.