Bulls dominated bears in fixed income for the first half of the year. But in the third quarter, some economic storm clouds are gathering. Three questions could be at the forefront of investors’ minds as they seek potential fixed income opportunities.
- Will escalating trade tensions cause a global recession?
- Are we at the start of a new easing cycle?
- Where are the potential opportunities in global bond markets?
The global fixed income market has had a good half year, as the tables show. The US Federal Reserve (the Fed) early this year decided to end monetary tightening and that took pressure off the markets. Other major central banks also turned dovish.
Fixed income sector returns for respective periods1
Moving into the third quarter, our Global Fixed Income, Currency & Commodities (GFICC) team sees some economic storm clouds gathering. We’ve identified three questions at the forefront of investors’ minds as they seek potential fixed income opportunities.
Trade tensions are the biggest risk to the global economy…
- Our primary concerns are the trade negotiations between the US and China and then between the US and the rest of the world. We fear that tariff escalation would reduce trade, which could hinder economic growth, and ultimately, bring forward the possibility of recession.
- The recent resumption of trade talks between the US and China did not guarantee a final resolution. To make matters worse, US trade and tariffs have broadened to include other regions and countries.
- Weaknesses have largely been concentrated in trade, manufacturing and investment.
…but consumers and the labour market remain the bright spot
- The US consumer market is in good shape. US household net worth has been increasing after the global financial crisis, reaching about US$110 trillion in the second quarter of 20192. They have also de-leveraged significantly with the household debt service ratio remained low at 9.9% in the second quarter of 2019, versus 13.2% in the fourth quarter of 20072.
- Labour markets remain solid globally. The unemployment rates of both developed and emerging markets are trending down as shown in the line chart3. Wages in developed markets are trending higher while underlying inflation stays stagnant⁴.
Unemployment trending lower globally3
An easing cycle or insurance cuts?
- Should the Fed cut rate at the end of July, this would be deemed the start of a new easing cycle instead of a series of insurance cuts.
- Low inflation and low inflation expectations created a very dovish backdrop, making the Fed and other central banks ready to ease on any slowdown in growth. Trade tensions, alongside slowing momentum in trade, manufacturing and investment, have pushed the global growth outlook below trend.
The Fed still misses the inflation target of 2%5,6
Central banks seem prepared to act
- Inflation has undershot major central banks’ targets for an extended period. A meaningful, coordinated central bank response would certainly cushion a trade-induced slowdown.
- The Fed acknowledged that it is monitoring the trade tensions and stands ready to respond. We expect the Fed to begin cutting rates in the second half of 2019. Our base case is a 10-year US Treasury yield of 1.75%-2.25% by end of 2019. We also expect China’s central bank to respond with its own tools to help stabilise the global economy.
- Every quarter, our GFICC team gathers to formulate our consensus view on the near-term course (next three to six months) of the fixed income markets. After several years of Above Trend Growth as our base-case scenario, Sub Trend Growth has now become our base-case scenario at a 45% probability.
- While we see some economic storm clouds gathering, the combination of Above Trend (25% probability) and Sub Trend Growth (45% probability) total 70%. We are mindful to avoid getting too conservative that we may miss out on investment opportunities.
- Based on investors’ specific investment objectives and risk appetite, potential opportunities could include high-quality duration, such as government bonds, securitised debt and corporates, and research-driven yield such as emerging market (EM) debt7.
- Government bonds
Amid uncertainties in the macro environment, long government bond duration could help tilt portfolios more conservatively and add portfolio resilience.
- Securitised debt
Consumer balance sheet remains healthy, which continues to support securitised debt. Currently, the bias is to add high-quality duration such as AAA asset-backed securities, moderate prepay-protected agency mortgage-backed securities (MBS) and agency commercial MBS.
We believe stable fundamentals and supportive technicals continue to support investment-grade corporate credit. Leverage is more manageable in higher quality corporates such as banks and less cyclical sectors.
- Emerging market (EM) debt
Within the EM space, EM sovereign debt sees support as net supply is likely to remain low for the rest of 2019. Meanwhile, EM debt in local currency could offer investment opportunities with potentially attractive yield relative to those in developed markets.
- Government bonds
Expansions are still vulnerable to policy shifts. The binary outcome of the trade conflict is almost impossible for markets to accurately price. We believe it’s time to be less complacent, get closer to neutral and tilt portfolios more conservatively.