Brett Lewthwaite, Global CIO, Fixed Income / Global Co-Head of Fixed Income
Our second Strategic Forum for 2018, held in May, occurred against a backdrop of bond yields having reached 3% and an optimistic consensus view for continued global growth and inflation. We are more cautious on this outlook acknowledging that the evidence supporting synchronised global growth is waning and inflation remains elusive. We further re-iterated that the consensus narrative often omits the significant impacts of debt and the reversal of Quantitative Easing (QE) in their forecast. With cracks already emerging and valuations stretched in many fixed income markets, we concluded that a further shift towards a more defensive portfolio setting was appropriate.
The Macquarie Fixed Income (MFI) 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 the key fixed income asset classes to determine our medium term outlook. This disciplined and global approach to managing portfolios ensures we are unaffected or distracted by the noise and position our portfolios based on the themes that really matter.
Before we delve into the details of our May 2018 Forum, a quick reminder of the outcomes from January 2018. The backdrop was positive coming into the new-year with consensus narrating that global growth was strong and synchronised, supported by the view that a pro-business US administration was at last making progress. We were more cautious of this outlook, and remained grounded by the extent to which structural forces would challenge this. Overall we acknowledged that valuations were stretched and as such concluded a movement toward a more defensive stance, accumulating duration, and reducing credit risk at the margins was appropriate.
Our second Forum for the year, held in mid-May, occurred against a backdrop where the US 10-year bond yield had reached the psychologically important 3% level. Consensus had become even more attached to the view that economic growth was strengthening and therefore, inflation must follow, evidencing the 3% in bond yields as firm proof that the bond bull market is (finally) over. In MFI we are increasingly aware that even as this narrative emboldens, the underlying evidence supporting the view appears to be increasingly in retreat. Furthermore, when we reviewed the nuances of fixed income markets, we acknowledged that cracks were already emerging on what has been only a moderate shift higher in yields, and are only too aware of the increased likelihood of further abrasion should yields continue to shift upward. This contrast of market opinions made a great backdrop for debate and discussion.
Synchronised and stronger? Alas, no longer
Our analysis of economic growth concluded that while it remains broadly satisfactory, it is now exhibiting a profile of diverging regional prospects led by the US with all other regions decoupling and showing a notable softening in momentum. And even the US appears to be following the pattern of past years, with softer momentum into the northern hemisphere summer, although at a rate modestly higher than past years—a likely result of the recent US fiscal easing. Nonetheless, while we believe that economic growth is no longer synchronised or as strong, we concluded that the now-prolonged growth cycle should extend beyond 2018. The risks to this outlook are rising, particularly if the US Federal Reserve (Fed) continues with its tightening plans and causes the yield curve to invert.
Turning to inflation, despite the consensus hype, real evidence of inflation excluding the influence of surging oil prices remains minimal. That said, the optical tightness shown by some — but not all — labour market indicators is likely to keep markets alert to the threat of demand-led inflation. MFI’s own inflation models suggest both US cyclical and structural inflation indicators are rising modestly, and bear watching. That said, we expect the structural influences relating to demographics, digitalization, and indebtedness will continue to place downward pressure on inflation. While we remain unconvinced that inflation will meaningfully pick up, even if some wage pressure does emerge we acknowledge consensus holds a much stronger conviction that inflation is imminent. We therefore remain alert to the possibility of inflation becoming an embraced market narrative or theme -- even if the reality seems more likely to be one where it remains elusive.
Focusing on central banks, while the Fed is expected to continue on its path of further gradual interest rate hikes, it no longer appears certain that Europe or Japan would follow suit anytime soon. This prompted us to question the idea of sustained policy divergence, concluding there were limits to how much further central banks could diverge given global interdependencies. Further our discussion focused on whether just two more rates hikes in 2018 (consensus believes three more) in conjunction with further balance sheet reduction, also known as Quantitative Tightening (QT), was perhaps already erring on the side of too much too soon.
The narrative continues… missing two key realities
Despite our analysis showing a softening of growth momentum particularly in Europe and China, consensus has carried forth and even strengthened its conviction in the narrative of broadening growth, imminent inflation, and bond yields higher.
Despite this narrative, we again reiterated our findings from previous Forums that it contains two significant oversights that we believe are integral to understanding the outlook for financial markets, namely debt and the impact of Quantitative Easing (QE).
We have spoken at length about the structural challenges that ever increasing indebtedness poses to economies yet we continue to be perplexed at how little attention it receives in many market outlooks. As we like to say, if market commentary or research doesn’t refer to it, save your time and don’t bother reading it.
The second missing reality is an emerging factor that refers to the shift by central banks away from their extraordinary monetary policy efforts toward Quantitative Tightening (QT). Indeed, the $US20 trillion of QE intervention and abnormal (negative) settling of interest rates, exhibited best by the trillions of dollars of negative yielding global bonds, caused the most incredible insatiable global chase for yield. Market participants have enjoyed these highly supportive forces, yet the possible reversal of this central bank intervention, that was so instrumental in elevating risk asset prices, seemingly is not a relevant consideration for the outlook.
Determining whether central banks slow, stop, or change direction is a key factor in considering the outlook. So, the more important question in our mind is not whether growth will be strong enough to lift inflation (our view is that it probably is not), but more is it strong enough to surmount the impact of the removal of the single biggest multi-year support to this incredibly complacent, low-volatility environment we have been in? The more volatile markets since our January Strategic Forum suggests that scenario is unlikely.
Cracks… the changing nature of the chase for yield
Entering 2018, our broad view was the ‘chase for yield’ that was driven primarily by extraordinary global central bank support would likely remain a predominant driver of fixed income markets. However, since our January meeting this previously strong technical support has reduced markedly with the confluence of a number of factors limiting demand particularly for US dollar fixed income. These factors include:
- Funding technicals | The combination of the US Treasury needing to borrow more, primarily in the short end, while the Fed is buying less, as it allows its balance sheet to decrease (QT), is causing a technical imbalance over supply in front end funding markets.
- US tax implications | The positive impacts from tax reform on corporates is well known, however unintended consequences are beginning to emerge especially in regards to repatriation of offshore funds. Specifically, US corporates which historically held their offshore holdings in US Treasury bills and investment grade bonds are now liquidating these holdings in order to use the cash for other purposes such as M&A and shareholder returns. This further reduces demand for shorter dated securities.
- LIBOR / OIS | The rising of the LIBOR/OIS spread that led up to and through the March quarter end as a result of the above technical factors has caused currency-hedging costs for offshore investors to increase, thereby decreasing the attractiveness of the US yields and further reducing demand.
- Flat curves | A flatter USD yield curve also changes the nature of demand for US bonds, with investors reassessing their investment preferences and questioning the relative value of longer dated non-Treasury securities in particular, which no longer appear as attractive now there are other competing options.
Many market participants consider these influences to be temporary and expect the strong technical bid for yield to return. Whereas we are more attuned to the view that these anomalies are early signs of ‘cracks’ in the system with central bank withdrawal at their heart. Summarised quite simply, Quantitative Easing lifted all boats and with Quantitative Tightening effectively being QE in reverse, vulnerabilities are likely to be revealed as the tide recedes. We view these changes with a greater level of permanence and believe they may only be the opening act should the Fed continue on its tightening path.
Central banks closer to pausing, or risk ending the cycle
In considering these influences, and the other structural factors affecting the global economy, we believe central banks will need to be highly cautious, and very patient with shifts toward varying degrees of less easing through to policy tightening. Otherwise market disruptions, volatility and financial conditions will increase and quickly dampen economic growth. In other words — cracks are already present, and appear likely to only grow larger should central banks press on with QT and reduce their extraordinary involvement and support in financial markets.
While all this is true, we do not believe central banks want to upset the current economic cycle. While the Fed has been hiking it isn’t seeking to cool off an overheating economy, more it is reducing its levels of extraordinary support and accommodation. The European Central Bank (ECB) and the Bank of Japan (BoJ) may not even be afforded the opportunity to commence withdrawal. And so in many ways it really is just a US story, and not one of particularly strong growth, and with a threat of inflation. In other words, it is unlikely that central banks will be forced to move quicker and earlier than what consensus already has priced. If they do, they risk bringing this now elongated cycle to a quick conclusion.
In concluding our analysis, the team noted that a rational investor would acknowledge that:
- If unthinkable central bank support and QE was wonderful for financial markets, then its withdrawal must be something to consider, and it is rational to think it would be at least abrasive.
- High debt and high interest rates do not go hand in hand. As we like to say, these two are not natural dance partners. They cannot and will not co-exist.
- This cycle is elongated and while it is supported by solid and improving corporate fundamentals, our sense is that it may be approaching the beginning of its end.
Overlaying these conclusions with the expensive valuations on offer, it seems there is little upside left in many markets. Considering this backdrop we concluded a further shift towards a more defensive portfolio setting was appropriate.
Rates | Accumulating duration remains a sensible strategy in a multi-sector portfolio. We retain our strategic overweight duration targets for now with the view to increasing them if yields make another break higher. While the Fed continues to be in play, we favour further curve flattening and recommend shifting US duration to the belly of the curve. The ECB and BoJ are likely to remain supportive given the lack of inflation which will support yields in these regions.
Credit | Credit remains supported by solid and improving fundamentals but we acknowledge that valuations are stretched and the technical ‘chase for yield’ support is now altered. Strategic risk reduction and diversification makes sense and our gradual approach to risk reduction, while participating at a reduced level, should continue. Industry selection, curve positioning and bottom-up analysis is key.
Currency | Reflecting the outlook for the US described above, the currency recommendation for the USD is to favour depreciation over the medium term (as the yield curve flattens) but are patient in executing this given the current strong growth narrative. The team also sees opportunities in the EUR provided peripheral risk is contained, and views the JPY as a suitable hedge in a risk-off scenario. Our AUD view remains neutral though we see downside risk should commodities or equity markets move lower.