September saw a continuation of summer market themes such as US-China trade tensions, Brexit-related uncertainty and central bank easing. However, markets also contended with some new ones including stress in short-term funding rates and oil price volatility. Heading into the final quarter, we expect some of these themes to persist, others to fade, and as always, new ones to emerge.
1. Monetary Easing Momentum. The US Federal Reserve (Fed) lowered the target range for the funds rate by 25bps to 1.75%-2%. September’s policy action marked the second rate cut as part of what Fed Chairman Jerome Powell has termed a “mid-cycle adjustment”. Prior adjustments have entailed 75bps of easing and so we think the market may be underestimating potential for further near-term cuts. In Europe, outgoing European Central Bank (ECB) President Mario Draghi delivered a package of monetary easing measures while also noting that it is “high time for fiscal policy to take charge”. The Euro area deposit rate was lowered by 10bps to -0.5%, a tiered mechanism for bank deposits subject to a negative rate was introduced, quantitative easing was resumed and forward guidance was strengthened to be state- rather than time-based. More broadly, the proportion of central banks engaged in rate hikes has fallen from 40% in December 2018 to 5% currently1.
2. Trade War Escalation. The US implemented tariffs on around $104bn worth of imports from China on September 1. This is the first tranche of imports to include a large share of consumer products. Oscillating headlines make it difficult to discern whether trade relations are improving. In any case, US firms appear to be taking steps to mitigate the effect of tariffs. Measures cited during second quarter earnings report include renegotiating prices, relocating production and delaying investment2.
3. Brexit Impasse. Prime Minister Boris Johnson suspended Parliament earlier in the month but was later forced to reopen the legislative chamber on a Supreme Court ruling that he had acted unlawfully. At the margin, we think the ruling reduces the risk of a no-deal Brexit as it raises the likelihood that Johnson will seek an extension of the UK’s European Union membership beyond October 31 if a withdrawal agreement is not approved before October 19. We are neutral sterling-denominated issuers, in part due to prolonged political uncertainty.
4. Repo Stress. USD repo and other short-term rates spiked higher around mid-month. Factors behind the rise include shrinking of the Fed’s balance sheet and a resulting decline of reserves (or “liquidity”) in the banking system. Additional drivers include US Treasury supply coinciding with corporate tax payments which resulted in deposit outflows from the system. The Fed is intervening through open market operations in order to keep adequate liquidity in the banking system but such temporary measures may need to be replaced with a more permanent response. We think additional details may be unveiled at the October Fed meeting. As the drivers are largely technical in nature, we think implications for credit markets are limited.
5. Oil Price Volatility. Oil prices increased sharply following an attack on a Saudi Arabian oil refinery. The disruption impacted around 5% of the world’s daily oil production. We used the oil price moves—and resultant outperformance in Energy credits—as an opening to reduce our modest exposure to US high yield energy issuers. Production appears to already be resuming, although elevated geopolitical uncertainty could result in renewed oil price volatility in the coming months.
1 Source: GSAM, Macrobond. Based on three-month rolling change in policy rates at 40 central banks.
2 Source: Goldman Sachs Global Investment Research, S&P 500 Beige Book. Based on company transcripts accessed via FactSet and/or Thomson Reuters. Q2 report is based on excerpts from 60 companies.