10 October 2018
Brett Lewthwaite: Global Chief Investment Officer, Fixed Income | Global Co-Head, Fixed Income
As the Macquarie Fixed Income (MFI) team gathered in September for our last Strategic Forum of 2018, the backdrop was one where the challenges and vulnerabilities of the shift from quantitative easing (QE) to quantitative tightening (QT), led foremost by the US Federal Reserve (Fed), were continuing to emerge.
Our analysis of the key macro themes concluded that the global growth outlook remains relatively robust, albeit with regional divergence and momentum beginning to soften. We also concluded that the much-anticipated inflation pressures were most likely to remain contained, although the risks of trade tariff-related stagnation had increased.
The team concluded a key factor in determining the medium-term outlook for the global economy hinges on the extent the Fed continues to hike policy rates. Overall, we favour a gradual and cautious approach by the Fed as the cracks that are emerging in financial markets become more acute. We believe they are closer to pausing in their current tightening cycle than consensus forecasts, which may lead to an environment of converging growth that would potentially be positive for financial markets.
We recognised there is a risk that the US economy continues to outperform, causing the Fed to tighten further than anticipated. This would cause further unintended USD liquidity stress and further strain in already challenged financial markets.
We also reflected on current events related to trade wars, softening Chinese growth, and the upcoming US mid-term elections, all of which need to be carefully considered as they could be pivotal in how financial markets perform for the remainder of 2018.
In this increasingly late-cycle, volatile environment, that is being further challenged by significant structural headwinds, the team recommended maintaining our defensive positioning as we head toward year end.
Current state of play
Our September Strategic Forum occurred following a northern hemisphere summer characterised by the ongoing theme of diverging economic performance.
Divergent growth is in large part a result of US outperformance, resultant in diverging central bank policy, led foremost by the US 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).
Back in May, we highlighted that 2018’s theme had undercurrents summarised quite simply as: If QE lifted all boats then 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 are beginning 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 often are feeling the effects of the insatiable chase for yield ending, best exhibited by the reduction in USD liquidity and those most reliant on USD funding being impacted acutely.
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 was 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.
We began the year with consensus, anticipating synchronised global economic growth that was on its strongest footing since the global financial crisis (GFC). By May this landscape had evolved with global growth positive but softening, and exhibiting a diverging profile led by the US. At our September forum we acknowledged this trend had continued, with global growth robust albeit with slowing momentum driven in part by trade and tariff uncertainty.
An area that requires close attention is China, where current indicators of activity are suggesting a more challenged growth picture. Commodity prices have been softening and China’s Total Social Financing has continued to shift lower such that it is now in contractionary territory. The message from these indicators is that domestic demand is under pressure. On a positive note, other economic data such as China’s PMI remains solid. So far, the People’s Bank of China (PBoC) is delivering a measured response to this pressure seemingly managing the situation rather than responding with a more overt stimulative stance. Nonetheless, the US is pushing hard on China with relation to trade and tariffs, arguably at a time when China is already under domestic pressure. This increases the possibility that the PBoC may be required to be more aggressive on fiscal policy, monetary policy, and/or allowing the currency to weaken. Most market participants expect that China will do whatever it takes to manage the situation and not allow the economy to be harmed. We remain alert to the possibility of a further slowing of Chinese growth and equally are watching for indications as to how China may respond to the prevailing environment.
In summary, while we believe that economic growth is regionally divergent, and is beginning to show signs of slowing from solid levels, we conclude that the now prolonged growth cycle should extend beyond 2018, supported by US fiscal easing. However, we remain alert to the possibility that the flattening and potential inversion of the US yield curve is an indicator that an earlier end to this cycle may be approaching. We concluded that the probability of a recession in early 2019 remains low although the risks are rising, particularly if the Fed continues with its tightening plans through this year and into next.
Despite the consensus fixation on inflation, real evidence remains minimal, excluding the influence of higher oil prices. That said, the optical tightness shown by some labour market indicators are likely to keep markets alert to the threat of demand-led inflation.
In May, MFI’s own inflation models indicated that both US cyclical and structural inflation indicators had been rising modestly and warranted close watching. Since then, cyclical pressures have eased, and the slower moving structural inflation factors have somewhat surprised in that they have also fallen back. We acknowledge that some upside risk to inflation remains, although we believe any pressure is likely to be rather modest. Indeed, our analysis suggests that we may currently be witnessing the peak in US 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 inflation remains elusive. Longer term, we continue to expect the structural influences relating to demographics, digitalisation, and indebtedness to continue to place downward pressure on inflation.
Focusing on central banks, our research and analysis from the May Forum continued to hold true. Our view remains that while the Fed is expected to continue on its path of further gradual interest rate hikes, it no longer appears likely that Europe or Japan will follow anytime soon.
Discussion centered around the Fed, concluding that the market is very confident the Fed will deliver further hikes in September and December. Balancing this is the caution that the yield curve is very flat, and an inversion is one of the key risks to the economy that we believe the Fed is keen to avoid. The team also noted that Fed Chair Powell could be pragmatic, and recognise and take action should the cracks of Fed policy grow larger and more widespread. The Fed has been operating on the basis of transparency and so we are paying close attention to any change in rhetoric from the central bank.
More globally, we acknowledged that there has not been much change in the stance of the other central banks. Expectations around the European Central Bank (ECB) is for QE to end this year but growth and inflation dynamics suggest that rate hikes are still some way off. The PBoC is also expected to remain accommodative with selective easing implemented as required.
Structural backdrop – Is the chase for yield over?
Despite its omission from many market commentaries, structural forces are ultimately the long-term driver of markets. Debt, demographics, digitalisation and the newest addition of QE to QT must always be considered when taking a longer-term view of the outlook for markets. Our Strategic Forum is a great platform for the team to step back and really consider these issues.
We began by acknowledging that the $US20 trillion central bank intervention and unnatural setting of interest rates created the great global chase for yield and has played the dominating role in all fixed income markets since the GFC. It has caused bond yields to remain low, credit spreads to tighten (including troubled creditors, countries included) and risk asset prices to trend higher and higher.
As we entered 2018, our broad view was this ‘chase for yield’ would likely remain a predominant driver of fixed income. However, since January this previously strong technical support has reduced markedly as we had the first real attempt by a major central bank, the Fed, to embark on the shift from QE to QT while also tightening policy. The results, as expected, have been abrasive and are set to accelerate as the ECB ends its QE program in December and the BoJ continues with its stealth taper through widening the band on its yield curve control program.
This situation is best typified by the now attractive yield of ~2.5% available in the shortest dated US Treasury securities. If this short term and high quality yield is available, then it is natural that investors will seek commensurately higher yield for all other higher risk, longer dated and lower quality yielding securities. This attraction combined with the additional borrowing requirements of the US Treasury are resulting in a reduction of USD liquidity.
These abrasive affects are now very visible in areas such as EM. In May local currency EM debt had returned around +1% YTD, by September returns were -10%, an 11% swing in just a few months. That is one big crack!
Many market participants consider the impacts to be temporary and expect the strong technical bid for yield to return. The catalyst for this is unclear and as such we are more attuned to the view that these anomalies are the expected signs of ‘cracks’ in the system with central bank withdrawal at their heart. Upon reflection, it has not surprised us that the central bank tide has not really started going out, and already there are signs of considerable financial market stress in the further reaches or ‘weaker’ hands.
The path forward – A game of ‘musical chairs’
Even though the overall structural force is QE to QT, currently it is primarily just the Fed who has advanced in reducing its balance sheet and hiking rates, with the outcome one of ‘divergence’. It is not clear how much further this divergence theme can go with the team viewing possible scenarios from here as much like a game of musical chairs.
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 one more 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 – and 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 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 appear likely to grow larger should the Fed continue to hike, we may see the Fed slow or pause, this in effect would most likely see 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 the 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 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 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 is to maintain our defensive positioning by accumulating interest rate duration and gradually exiting fully valued credit market segments.
Rates | Recommend maintaining the strategic overweight duration positioning with a view to adding should US yields rise between the 3.00 – 3.25% target area. The extent to which rates can rise is limited, and should further cracks appear yields are likely to fall.
The team is also watching for idiosyncratic opportunities to trade duration. For example, in Europe firmer data should see policy forecasts becoming more optimistic. As a result, we expect small upward pressure in European yields although the relative steepness of the curve should cap any significant sell-off in the long end.
Credit | The credit market continues to be characterised by the polarising factors of strong fundamentals and expensive valuations leading to a rangebound environment for the asset class. Against this backdrop the recommendation is to continue to strategically reduce risk and have a bias towards maintaining liquidity, acknowledging that we are late in the cycle. Focus remains on extracting value through diverse sources such as industry selection, geographic tilts and curve positioning which are combined with our fundamental bottom up research of individual names.
Currency | The divergence theme has played out acutely in the currency markets with the USD strengthening throughout 2018. The team respects this narrative and is of the view the USD could rise further into year-end as the Fed continues to tighten. Augmenting this view is the negative feedback loop whereby dollar strength causes stress in EM resulting in further USD appreciation as capital flows from the region.
The team did caution that longer term headwinds and event risk remain a threat for the USD. Specifically, we are focusing on the unfolding trade negotiations, the upcoming US mid-term elections and any sign of a change in Fed rhetoric.
On the other major currencies our views can be summarised as emerging markets FX is likely to remain under pressure, EUR should be range traded versus the USD with the recovery in the region gradual, JPY to continue to benefit from its safe-haven status and recommend selling AUD on rallies due to the region’s strong reliance on China.
Emerging Markets | We remain cautious on the outlook for emerging markets recognising recent underperformance and that the trend for fundamentals is challenged. There may be a point of convergence for the asset class if the Fed changes course although we would need to see a sustained reversal of the negative momentum, in particular in the currency market as an indicator of an opportunity to take advantage of the much improved relative value on offer in the asset class.