In this second of our two-part look at the themes now challenging the Goldilocks narrative, we find a ‘fourth bear’ – inflation – lurking nearby in the woods. And we provide an assessment of how the various threats to the Goldilocks scenario may affect a range of fixed income asset classes.
Where is bear number four?
Absent in the Goldilocks fairy tale, but very real in today’s story, would be a “fourth bear” – inflation – particularly in the US. Inflation risks are indeed skewed to the upside in light of sustained above-trend growth, building wage pressures as companies wrestle with the growing shortage of skilled workers and mounting signs of rising non-labour input costs. This ‘bear’ may be dormant for the time being, but the state of the business cycle and accommodative monetary policy suggests this may not last.
Exhibit 1 illustrates the many assumptions and market-held beliefs and how they have changed since the start of 2018.
Exhibit 1: Market-held beliefs then and now (January 2018-June 2018)
Implications on positioning and where we do and do not yet see opportunity
As we think through our fixed income strategies for the current quarter, we must state that despite all the challenges, not all of them are particularly worrisome.
Global growth remains on a sound footing, at least by the lower standards of the post-crisis era. The closely-followed PMI indicators still signal a solid global expansion despite signs of levelling off. North Asian export data, normally a useful leading indicator of world export volumes and hence aggregate demand, has strengthened as of late.
As for central banks, most remain cautious as they back away from ultra-accommodative policies. The ECB, for example, has signalled that the tapering of its asset purchases will be followed by an extended period, possibly stretching into the fourth quarter of 2019, of an unchanged policy rate. In addition, any meaningful change to the Bank of Japan’s yield curve control policy seems quite a way off. And the Fed has chosen to largely accommodate fiscal stimulus, accepting the risks of a sustained inflation overshoot in exchange for a prolonged expansion.
But even with this in mind, it would be disingenuous not to admit that the global synchronous growth scenario has been replaced by one in which a fiscally fuelled and more indebted US economy has moved to the front of the pack. Whether that fuel turns to fumes sooner rather than later, or the US expansion gets a second wind due to higher productivity and trend growth, remains to be seen.
Fixed income sector views
Emerging market debt – The US policy mix of fiscal stimulus and gradually tightening monetary policy has caused emerging market capital outflows. Central banks in many emerging economies have opted for a tighter monetary policy stance than warranted by the growth backdrop to support their domestic currency and keep inflation well-contained. Emerging economies with large current account deficits and high levels of US dollar-denominated corporate debt have been particularly susceptible to outflows and currency weakness.
We expect this adverse environment to continue. While we are attuned to the risks that protectionism, US inflation surprises and any continued slowing in China hold for the asset class, valuation has arguably re-entered the zone in which we begin to take closer notice. This is particularly the case in multi-sector, unconstrained and absolute-return strategies, where value relative to other asset classes is of particular interest. Before we move back into the asset class broadly, we will need to see three conditions met:
- USD short positioning: We are nearly there. Technicals are key, especially in FX — our first criterion was that the large short USD position should be cleaned out prior to considering a new investment. The market has now built a USD long against Asian currencies and the euro. Surveys show managers are still long EM FX on a net basis. However, June saw the largest drop in long positioning in several years. Indeed, we have tactically invested in some oversold currencies, especially in Asia.
- EM growth thesis: Not yet convinced. EM data has suggested a pause in EM growth acceleration and more recently, we saw a full-on slowdown in, for example, trade volumes and industrial production. To date, we have seen nothing that gives us strong confidence that the slowdown has ceased. However, neither do we see a recession yet: so we are calling this a ‘downshift’. In light of the trade war threat, we consider it even more important to wait for signs that growth will recover prior to drawing a directional conclusion.
- A reprieve from rising US rates: Not even close. At the moment, risks remain skewed toward a continued environment of strong US growth, higher US inflation and an upward march in US interest rates. We do not yet see relief from this scenario. Fed tightening remains the biggest risk to an EM asset recovery.
Global corporate credit – Looking out over the rest of the year, we see a few investment themes materialising. While there are pockets of slowing global growth, near-term recession risks remain low. We therefore expect mergers and acquisitions to continue in both the US and Europe, which could put pressure on BBB-rated issuers and longer-maturity spreads. Given this backdrop, we expect short-dated US investment-grade bonds to do well. Yields in this sector are currently at post-crisis highs.
In Europe, we expect some spread widening amid slowing growth, political headlines and the inevitable end of ECB asset purchases. As for high yield, we prefer the US over Europe as stronger growth and reduced issuance allow this sector to perform. In Europe, we are starting to see some issuer stress as a result of profit warnings and news of tariffs, and the weakest issuers are facing higher refinancing costs as investors demand additional credit risk premia.
US agency mortgage-backed securities (MBS) – Valuations have cheapened and now look attractive. We are looking for entry points for a tactical long versus US Treasuries. The strong relative performance versus credit should continue. We see the sector as offering attractive yields for a shorter-duration, higher-quality and more liquid asset class. Higher mortgage origination rates have led to a slowdown in refinancing supply. This is offsetting somewhat the reduced demand from the Fed’s balance sheet normalisation.
In credit-sensitive residential mortgage-backed securities, credit risk transfer (CRT) spreads moved wider on new supply concerns and overall market volatility. Fundamentally, the outlook is positive for residential credit as delinquencies trend lower, home prices move higher and unemployment remains very low. Commercial mortgage-backed securities (CMBS) spreads have been stable despite equity market volatility and a robust supply calendar. Commercial real estate property prices continue to move higher for all asset types apart from retail shopping centres. Credit performance in CMBS remains strong with rising rents and low vacancy rates. We maintain our overweight positions in CRT and CMBS.
* This is an extract from BNP Paribas Asset Management’s fixed income outlook for Q3 2018
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