10 October 2018
Brett Lewthwaite: Global Chief Investment Officer, Fixed Income | Global Co-Head, Fixed Income
The Macquarie Fixed Income team’s Strategic Forum is always a key date in our calendars. Three times a year we step away to assess the economic backdrop and conduct deep dive research into key asset classes, to determine our medium-term outlook.
Back in May, we highlighted that 2018’s theme had undercurrents summarised quite simply as: If Quantitative Easing (QE) lifted all boats then Quantitative Tightening (QT), and associated interest rate increases, in effect will be QE in reverse, and vulnerabilities are likely to be revealed as the once great central bank tide recedes.
In September, we began to witness these vulnerabilities, and observe that asset class performance has in large part been driven by proximity to the US. Those closer to the region have enjoyed the benefits of fiscal stimulus-induced stronger economic growth. Those further away are feeling the effects of the end to the insatiable chase for yield, best exhibited by the reduction in USD liquidity, and those most reliant on USD funding being impacted acutely.
Divergent growth is in large part a result of US outperformance, resulting in diverging central bank policy, led foremost by the US Federal Reserve (the Fed) tightening policy through reduced QE through to QT, while also gradually increasing policy interest rates.
The currency markets have expressed this divergence via a stronger USD throughout 2018. Combined, we began to witness signs of considerable abrasion and underperformance in several notable asset classes, in particular emerging markets (EM).
Against this backdrop the team debated whether the ingredients for further US economic outperformance remained or whether this divergence is nearing its extreme, and that convergence is a possible scenario as we head toward year end.
As one team member described so astutely, the current theme of divergence is like ‘a game of musical chairs’ whereby the Fed and its associated reduction of USD liquidity could result in more widespread abrasion, where the next most vulnerable asset classes could miss out on one of those highly coveted remaining chairs. The team outlined the ways this game could play out as follow.
Further divergence – More chairs are removed
With strong economic growth, the Fed appears set to continue on its gradual hiking cycle, with the market expecting another hike this year and further increases through 2019. This path is putting pressure on USD liquidity in the system and we are seeing dislocations as a result.
In effect, with each tightening step, the Fed is taking away chairs and as it does an additional asset class falls out of market favour. There is a risk that if the Fed keeps going, more and more asset classes will be left standing without support.
In this scenario, the risk of broader contagion rises as is often the case in classic USD liquidity-induced market events. Here we would favour avoiding the next most likely asset classes to underperform – European periphery, European financials, and commodity related industries.
The global economy converges – Music keeps playing
As the limits of divergence reach extreme levels, there is the potential that divergence turns into convergence over the next couple of quarters.
Ultimately, we do not believe central banks want to upset the current economic cycle and rather are highly cognisant of the need to be cautious, and very patient with shifts toward varying degrees of less easing through to policy tightening. With cracks outside the US already present and appearing likely to grow larger should the Fed continue to hike, we may see the Fed slow or pause – this would most likely result in a continuation of the music and an extension of the business cycle.
There are many potential catalysts for a shift to convergence:
QE to QT cracks become larger and more widespread and begin to impact markets such as US equities: In this environment we would expect the Fed to slow or pause in response to financial market volatility.
USD weakens: As a general principle, countries with strengthening currencies, such as the US, tend to eventually encounter headwinds or restraint of economic growth, and countries who experience currency weakness, such as Europe, can benefit by being more competitive on a relative basis. As such it is quite plausible that US growth may begin to slow while we see a growth pick up in the rest-of-the-world. This would likely result in USD weakness and a reduction of some of the current USD induced tension in financial markets.
China recommences considerable stimulus: China could also be a trigger toward convergence through a shift toward more overt stimulative policy, which could boost growth in the region and more globally.
US mid-term elections: The upcoming US mid-term elections is another event worth examining closely. Should the Democrats win the House (and more dramatically the Senate), a lower USD and less certain outlook could give the Fed a moment to pause. Trump would be more restricted in policy implementation, or we could see a compromise reached on the China trade issue.
In summary, many events could tilt the trajectory back towards convergence, albeit we need to be conscious that the overall environment could still be one where the central bank QE tide is still drifting out. Financial market performance may therefore be challenged regardless.
De-globalisation – The game changes
Finally, we remain attuned to the possibility that the environment is evolving and that markets should be paying close attention to the reduction in global co-operation occurring.
Tariffs and trade wars which we refer to as de-globalisation is likely to pressure global growth to the downside, and given other structural headwinds, we remain cognisant that the global economy could be entering a more challenging period rather than getting closer to the pre-GFC ‘normal’.
Overall, we favour more abrasive divergence near term as the Fed continues to raise rates and reduce its balance sheet. Although we also believe the Fed are closer to pausing than consensus forecasts, which would then likely lead to an environment of convergence.
At the beginning of the year, we agreed that a more defensive investment stance was warranted given the outlook that we were likely to experience increased volatility in 2018. This was re-affirmed at our May Strategic Forum where the first signs of cracks were beginning to appear. This stance and broad avoidance of underperforming markets has served us well.
Wrapping up our September meeting we again reiterated that this cycle is elongated and while supported by solid corporate fundamentals, the sense that it may be approaching the beginning of its end is in the air. Overlaying this with the structural headwinds of the abrasive shift to QT and elevated debt levels, we agreed the most sensible approach moving forward is to maintain our defensive positioning by accumulating interest rate duration, and gradually exiting fully valued credit market segments.