07 Jun 2019
In the space of just 12 months, markets have switched from expecting interest rate rises to expecting interest rate falls. Broadly speaking, this means 2019 should be a good year for fixed income. But investors are treading a fine line and need to differentiate between fixed income strategies
A year is a long time in financial markets and there are few better examples of this than the past 12 months.
This time last year the world was bullish. Many economists were predicting that the world’s major economies were set for a period of co-ordinated global growth. However, they are now forecasting a noticeable slowdown.
In April 2018, the International Monetary Fund (IMF) forecast the world economy would grow 3.9% in 2019. But this month it cut this projection to 3.3%. In the second half of last year global growth fell to 3.2%, down from 3.8% in the first half, according to the IMF.
We have yet to see convincing evidence that the slowdown in China is stabilising. Meanwhile, Argentina and Turkey, which both ended 2017 with robust growth, are now entrenched in recession and remain major concerns.
Within the eurozone, there are also worrying signs. Italy is already in recession and Germany is dangerously close. A year ago, some economists were raising concerns that eurozone growth was stalling after a healthy rise of 2.3% in 2017 – the best in a decade. But few were predicting anything close to a recession, particularly in Germany, Europe’s economic powerhouse.
Given this deteriorating picture, the world’s major central banks have been forced to change their tune. Indeed, over the past 12 months there has been a 180-degree turnaround.
A year ago, the US Federal Reserve was well into a tightening cycle which, it was then thought, had a bit further to run. As late as the end of last year the Fed was still predicting two further quarter point rises in 2019. But now it is forecasting no change this year and only one hike in 2020.
Similarly, a year ago many economists were predicting that the European Central Bank would be on the verge of hiking rates by now. Instead, last month it reignited its Targeted Longer- Term Refinancing Operations (TLTRO). Now it is indicating that it will not raise rates until 2020 at the earliest.
Furthermore, many emerging market central banks are now cutting rates in a sharp reversal of 2018.
Changed expectations
In the world of central banking, these are major turnarounds. So if you are waiting for the next global tightening cycle, don’t hold your breath.
Among the world’s major central banks, the Fed had been leading this global charge. With no rate change this year, 2020 should see the Fed and other major global central banks such as the Bank of England, the ECB and the Bank of Japan forestall further tightening.
So, the next global tightening cycle – which was on the horizon a year ago – now looks to be at least 12-18 months away at the earliest. However, even this is not certain.
What is clear is that central banks are finding it increasingly difficult to meet their remits to control inflation. Take the Fed and its ability to achieve its 2% core inflation target. During the 1990s, analysis shows that the Fed achieved this 2% core inflation target 69% of the time. In the 2000s, the Fed hit this target 43% of the time. But in the past 10 years, in the wake of the financial crisis, it hit its core inflation target just 5% of the time (Figure 1).
Source: Macrobond, BOJ, ECB, FED, PBoC, BoE and Columbia Threadneedle Investments.
Structural issues suppress prices
So what is going wrong? This difficulty controlling inflation tells us that there are structural issues that are keeping prices low. One is the high level of indebtedness. Since the financial crisis, debt levels have been creeping up – whether measured in government or corporate borrowings – as borrowers have gorged on cheap money. Clearly excess borrowing acts as a drag on spending and, therefore, on inflation.
Another structural issue is demographics. Importantly, older households tend to spend less. Ageing populations are particularly evident in core Europe, Japan and even China, with the US not far behind.
Unprecedented stimulus through quantitative easing (QE) programmes (Figure 2) are also clouding the picture.
Source: Macrobond, BOJ, ECB, FED, PBoC, BoE and Columbia Threadneedle Investments.
Global QE in the wake of the financial crisis helped hold off deflation, in effect boosting sizeable interest rate cuts. However, as these programmes have been unwound, they are having the opposite effect, intensifying rate hikes.
Interest rate rises from the Fed since 2015, in historical terms, have been relatively modest and incremental. However, when the unwinding of the Fed balance sheet is also taken into account, analysis by the Federal Reserve Bank of Atlanta shows that the degree of tightening which occurred in the US in this latest cycle is actually greater than in each of the last four tightening cycles.
QE has clearly been a learning curve for all of us, including central bankers, and its full impact is not yet known. But another part of the puzzle may lie in the predictive ability of traditional standard measurement tools such as economic and financial market data.
In a speech earlier this year, Raphael Bostic, President of the Atlanta Fed, spoke of a mismatch between many of these measures and “grassroots intelligence from Main Street and messages from Wall Street”. While businesses were indicating “heightened uncertainty and concern about the economy”, “aggregate economic data” continued “to paint a robust picture”, he said.
This only makes the job of central banks more difficult. Certainly, central banks should pay closer attention to research and intelligence from businesses at the coalface as well as to economic and financial indicators – and increasingly are doing so.
Four preconditions to rate hikes
Irrespective of these issues, we think four economic and financial conditions have to be met before central banks can even begin thinking about hiking rates again. What’s more, how and when these conditions are met will have significant implications for global bond markets and fixed income investment strategies.
The first is that we will have to see a stabilisation in economic growth, particularly in China, core Europe and the US. Only once growth has plateaued in these economies will we begin to see wage inflation stoking consumer inflation. With global growth still heading downward, the bottom of this cycle still looks some way off. And until we reach the bottom, rates are not going to start climbing again.
The second precondition is accommodative financial conditions. At the end of 2018, market volatility caused credit spreads to increase, while equity markets plummeted. This increased the cost of borrowing for corporations and households, while also reducing their confidence in investing. While conditions improved in the first quarter of 2019, we need to see tighter credit spreads and strong equity markets sustained in order to give the economy a boost via improved borrowing and investment conditions. Spreads on single B credits in the US, for example, are around 4%. This is slightly below long-term averages. However, with defaults much lower than in the recent past, we think spreads will have to remain low for interest rates to rise again.
Thirdly, we need to be sure that the huge unwinding of central bank balance sheets is not creating a hangover. It will take time to be sure that the withdrawal of central bank stimulus is not having a negative impact on markets.
Finally, we need to see inflation rise above 2% for a sustained period of time, probably for a couple of quarters. With US inflation currently at 1.9%, this perhaps looks more likely in the US than in Europe where eurozone inflation is 1.5%.
What is clear is that the goalposts have moved for central banks in the past year and meeting these four conditions has become more, not less, challenging. We think, therefore, that it is going to take several more quarters before central banks can even begin to consider tightening again.
A positive year for fixed income
So what does all this mean for fixed income investment strategies? Broadly speaking, 2019 should be a positive year for fixed income as riskfree interest rates remain stable. But investors are treading a fine line. If growth is too weak, it risks weighing on consumer incomes and corporate profits. And when economic growth does eventually resume an upward path, this will bring forward the next tightening cycle. Both scenarios will prove negative for some fixed income investment strategies.
With growth expected to continue contracting this year, we believe now is not a good time to be heavily exposed to the high yield market. As a general rule, in the US at least, high yield bonds need about 3% annual growth to do well. Last year, the US enjoyed its best annual growth spurt in nine years of uninterrupted growth – fuelled by President Donald Trump’s tax cuts. Accordingly, the high yield sector performed strongly up until the third quarter of 2018 as growth remained healthy. However, as the growth outlook began to deteriorate, the high yield sector suffered.
Investors should exercise similar caution in high yield in 2019 as slowing growth will be challenging for some companies and regions. Amid positive but low growth, we instead favour investment grade debt, which tends to perform well in this environment.
When the next global tightening cycle eventually comes, similar caution will be needed as companies with more leveraged balance sheets will find that environment more challenging.
If it’s a co-ordinated cycle, investors should consider shifting exposure to countries that are closer to the end of their rate-hiking cycle. This will probably involve shifts from European to US investment grade bonds.
Regarding central banks, we foresee interest rates in the major global markets remaining stable in 2019. In the best-case scenario for growth, the next wave of interest rate hikes would resume in the first quarter of 2020, but it could certainly take significantly longer for this cycle to begin. And if growth continues to deteriorate, we could see some central banks, in particular the Fed, cutting rates in 2020 rather than raising them.
What is clear is that we have not seen growth bottom out yet and interest rates will not start to resume their upward trend until this bottom has been reached.
So this year we will be looking for signs that corporate investment and industrial activity, both subdued amid fears of global trade wars, are starting to pick up again. If global air freight data, for example, which has been declining for over a year, starts to stabilise or even rebound in the third quarter, then that will be an encouraging sign.
But with many risks and uncertainties remaining, above all investors in the fixed income markets need to stay watchful and nimble.
Important information
The research and analysis included on this website has been produced by Columbia Threadneedle Investments for its own investment management activities, may have been acted upon prior to publication and is made available here incidentally. Any opinions expressed are made as at the date of publication but are subject to change without notice and should not be seen as investment advice. Information obtained from external sources is believed to be reliable but its accuracy or completeness cannot be guaranteed.