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In this Q&A, we discuss key conclusions on the outlook for global economic growth and fixed income markets from the GSAM Fixed Income Strategy Group’s (FISG) quarterly meetings.
The global economy has clearly slowed from 2018 into 2019. We think three main factors contributed to this slowdown: 1) the large tightening of financial conditions in the fourth quarter of last year, driven largely by tighter Federal Reserve (Fed) policy; 2) slower growth in China, which contributed to weakness in Europe and Asia, and; 3) unresolved trade disputes, which weighed on global trade and business sentiment.
In our view, all three factors have evolved in ways that lead us to believe growth is likely to stabilize around current levels for the rest of 2019. The Fed has pivoted from steady rate hikes to a dovish policy stance, and other developed market central banks have followed. China has taken a series of policy support steps to curtail the downward momentum in its economy, which has helped ease the external pressures on Europe and other Asian countries. And the trade backdrop has evolved from deteriorating to improving, with the market now anticipating a US-China trade deal in the next few months.
We believe the global economy has now transitioned from a period of above-trend growth and rapid absorption of slack, particularly in the labor market, to a period of near-trend growth and slower absorption of slack. In our view, the risk of recession in this environment is low as consumers continue to drive economic growth, supported by healthy balance sheets and strong labor markets.
We think 2019 will be an uneventful year for inflation, with only a modest rise in inflation from 2019 into 2020 as the most likely scenario. The risks are tilted toward softer inflation. We see growing signs of an easing in inflation pressures across a number of dimensions: core consumer prices, survey and market-based measures, producer prices, commodities, labor slack and the growth of money supply and credit. In an environment where the market is already concerned about the limited policy options available to central banks, a further deterioration in inflation expectations in Japan and the Euro area raises the risk that deflation could return to being a market concern.
There are two key drivers of nominal government bond yields: near-term monetary policy expectations and the term premium (the compensation required by investors to hold long-term bonds). Dovish central bank guidance has reduced the impetus for higher yields from the first driver. At the same time, low volatility in growth and inflation, along with contained inflation expectations, is helping to keep the term premium low even as quantitative easing is unwound.
In our view, subdued inflation outcomes and—more importantly—muted inflation outlooks are the main motivation for dovish pivots at both the Fed and European Central Bank (ECB) this year, with both central bank and consensus inflation forecasts having converged towards ours (Exhibit 1).
Looking ahead, we expect the Fed and ECB to maintain their patient posture until upward inflationary pressures emerge. However, we equate patience to unchanged policy and we think markets have gone too far in pricing central bank rate cuts (Exhibit 2). As such, we are modestly underweight front-end US rates. We continue to favor European rates relative to other developed market rates—owing to our “lowflation” thesis for the region—though we have scaled back overweight relative value exposures on favorable market moves.
Source: GSAM, Bloomberg, Fed, ECB. As of March 25, 2019. The economic and market forecasts presented herein are for informational purposes as of the date of this presentation. There can be no assurance that the forecasts will be achieved. Please see additional disclosures at the end of this presentation.
We don’t think this is a “Goldilocks” environment where you want to be heavily overweight in riskier sectors of the fixed income market. Corporate credit and emerging market bonds have already rallied significantly this year and the potential for further spread compression is limited. However, we see value in holding moderate, diversified exposure to riskier sectors of the market and collecting the yield premium over government bonds in an environment where we expect stable growth and cautious central banks.
Market pricing doesn’t necessarily reflect the most likely scenario for what the Fed will do; it reflects a range of scenarios and the balance of risks around those scenarios.
We think the market is currently pricing two main scenarios for the Fed. One is a steady-state scenario where the Fed leaves rates unchanged or perhaps raises rates once or twice more through the end of 2020. The second is a recession scenario where the Fed would likely move quickly to cut interest rates to near zero. The weighted average of those two scenarios is roughly two rate cuts, which is close to what the market is pricing.
We think the recession scenario is unlikely. We identify three major causes of US recessions in recent decades: elevated inflation that leads to aggressive tightening of monetary policy, private sector imbalances and supply-side shocks such as a sharp rise in oil prices.
In the current environment, the Fed has turned dovish, which lowers the risk that excessive monetary tightening causes a sharp contraction in activity. Meanwhile, the US private sector appears to be in good financial shape and looks less vulnerable to a sharp decline in asset prices or higher rates than in the last couple of cycles. Supply-side shocks are unpredictable but the sensitivity of the US economy to sharp oil price fluctuations is lower today given reduced energy intensity of the economy and due to a rise in domestic shale production.
Based on the current state of typical recession drivers, we think the most likely scenario is that the long US economic expansion continues and the Fed remains on hold, perhaps raising interest rates once more between now and the end of 2020 (Exhibit 2).
Source: Bloomberg, GSAM, Fed. Market pricing is based on Fed Fund futures contracts. Federal Open Market Committee (FOMC) Median projection reflects the value of the midpoint of the median projected appropriate target range for the federal funds rate. As of March 28, 2019.
Historically, yield curve inversion has been an indicator of recession and one measure of the curve—the spread between the 10-year yield and the 3-month yield—inverted in March for the first time since 2007.
In our view, comparisons with previous inversions are flawed due to the low level of short-term rates relative to prior cycles and given lower term premiums following QE and as a result of lower and more contained inflation expectations. Both dynamics make it easier for the curve to invert. For context, the 3-month US Treasury yield is currently 2.44%; in the last two inversions, the 3-month rate was significantly higher at about 5% during the 2006-2007 inversion and about 6% during the 2000-2001 inversion. As a result, we think the recession signal implied by yield curve inversion is less powerful than in prior cycles.
We think European growth peaked in 2018 and has reverted to its longer-term trend growth level of 1% to 1.5%. The slowdown has occurred more quickly than consensus forecasts suggested and that has raised concerns that a bigger downturn may be underway. We think growth will stabilize soon. Italy, which is technically in recession, remains the biggest risk for the European outlook but we think near-term risks have declined.
From a policy perspective, Europe is looking more and more like Japan. The ECB has been unable to achieve its goal of raising inflation despite increasingly accommodative policy steps, and—barring greater flexibility that would require political support—the central bank now appears to be out of ammunition. The ECB seems to have acknowledged this by downgrading its growth and inflation forecasts at the March meeting (Exhibit 3), without taking any significant new easing steps other than extending the timeline for remaining on hold into 2020.
The questions now are whether the ECB skips tightening entirely during this cycle, whether there will ever be “normalization” in ECB policy and what additional steps the central bank might be able to take to lift inflation. We think the most likely scenario is that the ECB continues with business as usual. The ECB is a treaty organization and that puts significant constraints on its ability to take more extreme or proactive steps to achieve its inflation mandate. If growth stabilizes, we think the ECB will move toward normalizing its rate policy with a modest rate hike in 2020, but the risks to this are skewed toward a later hike or no hike at all.
Source: Bloomberg. ECB, GSAM. As of March 2019.
The main risk is that China’s economy continues to slow despite the policy response. Unresolved trade disputes are another risk. Europe is also vulnerable to renewed political volatility, most likely stemming from Italy.
In our view, China is now the biggest swing factor in the global growth outlook. China itself is a large component of global growth, and Europe and emerging Asian economies are heavily exposed to Chinese demand. The US is more insulated. We think China’s slowdown in 2018 helps to explain many of the recent themes in global growth, including the “US exceptionalism” theme that emerged as US growth outpaced other economies last year, and the weakness in Europe and EM economies in the second half of 2018.
Our base case scenario is that China’s economy stabilizes as the policy steps taken so far begin to support high-frequency indicators of growth in the second quarter. However, China’s policy response has been reactive and incremental. Moreover, credit easing—traditionally a key pillar of policy easing—is smaller in magnitude relative to prior installments of policy support and will also likely take longer to impact growth relative to when the economy was less levered. We think the market has already priced in expectations of stabilization in China, creating the risk that growth disappoints relative to expectations.
Unresolved trade disputes are another risk, for China specifically and for markets sensitive to changes in Chinese demand such as the Euro area and open Asian economies. We think the US and China are motivated to reach a deal on trade, and we see limited risk of escalation in auto tariffs between the US and other large auto-producing countries. Trade risks are likely to diminish further as the US moves closer to its 2020 presidential election. However, the risk scenario of a trade war has essentially materialized and that has had significant spillover effects on global trade activity overall and business confidence and capital spending. As trade tensions ease, we expect these spillover effects to fade, but that could take some time.