How to handle all that negativity

August was a month that saw U.S.-China trade tension intensify and central banks around the world continue to push borrowing costs lower. This resulted in a further decline in risk-free rates around the world and drove the size of negative yielding assets up. While the fixed income market would see some consolidation after a summer of falling yields, the global growth environment could underpin downside risks to interest rates in the long term. This would present a challenge to a growing number of investors around the world who are mandated to invest in fixed income but are expected to deliver a specific return to their clients. 

From tariffs to currency manipulation

The trade war between the U.S. and China went through several twists and turns in August. After the Osaka G20, where the two Presidents agreed to restart negotiations, U.S. President Donald Trump announced on August 1 that the U.S. would impose a 10% tariff on USD 300billion worth of Chinese exports on September 1 that were not subjected to the 25% tariff imposed already in the past 12 months. This was followed by the U.S. dollar and Chinese renminbi exchange rate breaking above 7, a symbolic threshold that the People’s Bank of China has been defending for some time. 

This was swiftly followed by the U.S. Treasury Department labeling China a currency manipulator on August 7. The U.S. then announced part of the USD 300billion Chinese exports will not face higher tariffs until December 15, so to limit the impact on U.S. consumers over the Thanksgiving/Christmas season. China retaliated with more tariffs on U.S. exports, and President Trump hit back with a threat to further escalate the tariff rates on Chinese exports on October 1. 

This series of events is likely to put further pressure on business sentiment. This is partly reflected by the weak performance in global equity markets, with the S&P 500 and MSCI ACWI both down 3% in the month. Corporate credit spreads also widened modestly in August, reflecting market concerns over economic growth and the potential impact on corporate debt servicing ability, especially in the energy sector.

Pieces of political puzzles around the world forming a gloomy picture

Beyond the ongoing trade spat between China and the U.S., political issues are keeping investors cautious. Deterioration in the relationship between Japan and South Korea is impacting bilateral trade and the sharing of intelligence between the two countries. British Prime Minister Boris Johnson is planning to suspend Parliament and raise the risk of a no-deal Brexit on October 31. Meanwhile, protests and violent clashes entered the third month in Hong Kong, with no clear path to a resolution. Investors may breathe a sigh of relief as the Five-Star party managed to form a coalition with the center-left Democratic Party and avoided a political limbo when the country needs a credible budget plan. These events in isolation may not move the global markets, since their economic impacts are typically local, rather than regional or global. However, together they are likely to dampen investor sentiment and encourage them to seek haven in low volatility assets. 

Central banks are rethinking how to save the world

Top central bankers gathered in Jackson Hole for their annual discussion on the global economy and how to set monetary policy. There are two challenges. First, their toolboxes are getting smaller. Several economies, including Europe and Japan, are already adopting zero interest rate policies. They cannot cut rates further without penalizing savers and hurting banks’ profitability, which is important to build their capital buffers. Even in the U.S., if policy rates were to be lowered from 2% to 0%, it may not deliver a sufficient boost to the economy and a fresh round of quantitative easing could be needed. 

Second, their toolboxes may not have the right tools to deal with factors hurting economic growth. You can’t use a fire hose to handle an oil spill. Lower rates are supposed to discourage savings and promote spending and investing. However, protectionist sentiment is hurting business confidence. Chief Executive Officers are not going to invest if they don’t see good prospects in generating returns. Cheap funding costs may not counter such caution. While it can be said that the government and politicians would be more effective in addressing these concerns, central bankers are expected to act to support growth. Nonetheless, central banks are still going to try, and this brings us to a big challenge for global investors—falling risk-free rates and the rise of negative yielding assets. 

Cautious sentiment prompts investors to accept negative yields

Currently, about one-third of developed market government bonds are trading at negative yields. Several countries in Europe, including Germany, Denmark, Finland and the Netherlands, have their whole government bond yield curves in negative territory. The Japanese government issues a 10-year bond and receives 0.3% interest every year from investors. This phenomenon also extends to the corporate bond market. 

Much of the negative yield is currently in Europe and Japan. This development could fundamentally change the investment landscape if the world’s biggest bond market, the U.S., also starts to see negative yields. We are nowhere near this, but we should keep an open mind about it in the long run. Former Federal Reserve (Fed) Chairman Alan Greenspan recently said that there is no barrier to negative yields in the U.S.

This could prompt more institutional investors to review their mandates and take greater risk on bond issuers with riskier credit profiles or allow their capital to be locked up for longer to earn liquidity premiums. This should push capital into high yield corporate credits, asset-backed securities and selected emerging market fixed income. Their valuations may not seem cheap at this point, but the long downhill march in interest rates would continue to push investors into this area. A flexible approach would be necessary to generate return when zero or negative yields become more prominent. 

Global economy:

U.S.-China trade tension took several turns in August with President Trump announcing tariffs will be imposed on the remaining USD 300 billion of Chinese exports. The U.S. Treasury also labeled China as a currency manipulator. Beijing is threatening to retaliate with more tariffs on U.S. exports. A trade deal does not seem likely in the near term.
(GTMA P. 19, 20)

Expectation of a Fed rate cut in September continues to build, while global central banks have been easing monetary policy to support growth. The inversion of the U.S. Treasury (UST) curve has triggered worries over recession, even though current economic indicators remain respectable. Policymakers are also exploring the possibility of stepping up fiscal spending to protect growth. South Korea has already announced an extra budget to offset weaker trade growth.
(GTMA P. 26, 31, 50)

Equities:

Growth worries from trade wars and various political problems weighed on global equities in August. The MSCI All-Country World Index and S&P 500 Index were both down 3% in the month. 2Q U.S. corporate earnings should end at around 5%, led by financials and health care. Margin compression was less severe than expected.
(GTMA P. 33, 42)

In Asia, export-oriented markets, especially Hong Kong and Singapore, have taken a harder hit due to U.S.-China trade tension. Political turmoil in Hong Kong also added pressure on companies exposed to the local economy. In contrast, pressure on China A-shares and India has been mild, due to their domestic demand component, as well as measures from Beijing to boost consumption. (GTMA 40, 41)

Fixed income:

UST yields continue to fall as recession fear builds. The 10-year yield fell by 50bps to below 1.5%. The 30-year yield fell to its historical low and below 2% for the first time. The 10-year yield also fell below the 2-year yield for the first time since the global financial crisis, exacerbating market concerns over recession.
(GTMA P. 47, 49)

The high yield corporate spread widened by 43bps in August given growth concerns, but its negative impact was largely offset by the fall in risk-free rates. Investment grade outperformed High Yield since it benefited from lower Treasury yields but suffered smaller spread widening. Despite a stronger U.S. dollar (USD), sovereign and high-quality USD emerging market debt still generated positive return for investors in August.
(GTMA P. 53-55)

Other assets:

Oil prices continue to be stuck in a range between USD 51-57pb. Growth and demand worries are still the dominant factor capping any upward momentum. Gold continues to perform as interest rates fall, breaking above USD 1,500/oz for the first time since April 2013. Despite gold’s high volatility, investors are using it as a hedge against potential deceleration in growth and prospects for more monetary easing by central banks.
(GTMA P. 64, 65)

The USD grinded higher due to risk aversion, alongside the Japanese yen and Swiss franc. For emerging market currencies, the high beta currencies with weak external positions suffered more, including the Brazilian real, South African rand and Turkish lira. The Chinese renminbi falling below 7 against the USD, and 3.7% in the month, did put pressure on some Asian currencies, but the impact was more manageable.
(GTMA P. 61, 62)

Market Bulletins - August: 

• U.S.-China Trade: Latest 10% Tariff
• Fed rate cut: What does it mean for investors?
• China’s economy and policies: A mid-year review
• Does the yield curve inversion signal trouble ahead?