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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 Goldman Sachs Asset Management Fixed Income Strategy Group’s (FISG) quarterly meetings.
We see two main changes in the outlook. First, growth looks set to weaken rather than rebound. Manufacturing activity is contracting and verging on recession territory. An escalation in trade tensions, which appeared to be nearing resolution last quarter, is a key driver of the weakness. Second, monetary policy in key advanced economies is in the process of a major shift from gradual normalization to potentially rapid easing.
Overall, we expect trend-like growth over the second half of the year. Export growth, business investment and manufacturing activity look set to remain in low gear, with all three facing headwinds from trade tensions. However, resilient household consumption, service sector activity and policy support will provide some offset.
A cyclical slowdown poses downside risks to an already subdued inflation backdrop. In Europe, market-based measures of medium-term inflation expectations are at historical lows and survey-based measures are below levels preceding quantitative easing (Exhibit 1). In short, both financial markets and agents in the real economy are losing confidence in the European Central Bank’s (ECB) ability to achieve its 2% target.
A downward drift in inflation expectations has also unnerved US Federal Reserve (Fed) officials. At recent meetings, the Federal Open Market Committee (FOMC) expressed concerns around expectations becoming anchored at below-target levels.
Source: Bloomberg, Macrobond. As of June 2019.
The US expansion is now the longest on record. The Fed has pledged to “act as appropriate” to further elongate this uninterrupted stretch of growth and the ECB has committed to use all policy tools at its disposal to support the Euro area economy. Policymakers elsewhere have expressed similar stances, partly in response to the Fed and ECB.
We think there are two main reasons for a prolonged era of policy accommodation. First, contained inflation and falling inflation expectations create room to ease despite low unemployment and growth close to potential. Second, monetary policy is more constrained than it usually would be at this stage of the cycle. This is particularly the case in Europe and Japan where policy rates remain at post-crisis lows and scope for additional quantitative easing is limited, at least based on current asset purchase parameters. We think the two factors combined will allow central banks to be more preemptive about preserving growth than they typically would be at this stage.
Market-implied pricing points to around 90bps of rate cuts by end-2020 (Exhibit 2); up from 40bps in early May. We think easing delivered is more likely to be in the realm of “insurance cuts”, defined as cuts of 25-75bps.
An accumulation of factors compelled the Fed to adopt a dovish bias at its June meeting: a decline in inflation expectations, low inflation readings, growth moderation and trade tensions. Uncertainty around variables such as the neutral policy rate and the unemployment rate below which inflationary pressures emerge also contributed.
The rationale for “insurance cuts” is that proactive—rather than reactive—easing can prevent weakness when an economy is faced with elevated uncertainty such as the US-China trade conflict. Indeed, Fed Chairman Jerome Powell noted last month “an ounce of prevention is worth more than a pound of cure”.
We believe our reasoning for policy easing—slowing growth against a backdrop of subdued inflation and elevated uncertainty—is consistent with the Fed’s reasoning for insurance cuts. By contrast, we think market-implied odds are consistent with a turn in the cycle, which we do not foresee in the near-term.
Source: Bloomberg. As of July 5, 2019.
Directionally, we are close to neutral US rates. Anticipated Fed easing weighs against being underweight, while our perception of recession risk being lower than bond market pricing prevents us from being overweight. For similar reasons we are neutral the US dollar. Meanwhile, we think a dovish Fed and ongoing economic expansion will allow for select emerging market currencies to appreciate.
Elsewhere, consensus expectations for Euro area growth, inflation and monetary policy have converged towards ours. The resultant rally in core European rates proved beneficial for our relative value overweight exposures. Looking ahead, we maintain our tepid macro outlook for the region and in turn our bias to be overweight rates on a relative value basis. However, we also recognize that near-term outperformance may be limited without a material dovish surprise from the ECB or a substantial decline in the economic data.
In the UK, we think the market assigns an overly bearish probability to a political tail risk scenario. In our view, institutional constraints make an elongation of the Brexit process more likely than a “no deal” exit from the European Union. As such, the UK curve appears too flat and UK real yields look too low relative to macro indicators including a positive output gap, around-target inflation, firming wages and around-trend growth.
Despite a pullback in May amid renewed trade tensions, spread sectors posted solid returns for the second quarter, largely in response to central bank dovishness. Given ongoing (albeit slowing) growth we remain overweight corporate and securitized credit. We also continue to pair spread sector positions with duration as a hedge against risk-off episodes. Within US corporate credit, we are more focused on carry and roll opportunities arising from curve steepness than positioning for broad-based spread compression.
We also find investment opportunities arising from market dislocations. For example, a rally in US rates in response to a changed Fed outlook has incentivized mortgage refinancing activity (Exhibit 3, left chart). The markets perception of refinancing risks has resulted in Agency MBS underperformance relative to US rates (Exhibit 3, right chart). We think recent spread widening is excessive relative to associated refinancing risks and consider valuations to be at levels that present an opening to add tactical exposure.
In Europe, a rally in rates and spreads has propelled euro-denominated debt trading with negative yields to record highs; this universe has broadened out to include bonds with longer maturities across sovereign debt and lower ratings within investment grade corporate credit. As a result, we see value in gaining exposure to European high yield corporate credit. This sector offers comparable yields to its US counterpart (on a currency-adjusted basis) and an attractive spread premium to its investment grade counterpart.
Left Chart Source: GSAM. As of June 17, 2019. Based on a weighted average for loans over a 26 month time period (Jan-17 to Feb-19). Right Chart Source: JP Morgan, GSAM. As of June 27, 2019. Past performance does not guarantee future results, which may vary.
Low and stable inflation is an advanced-economy phenomenon that has been in play since prior to the current expansion. As a result, financial imbalances have been the main source of recent recessions, rather than runaway inflation and subsequent excessive monetary tightening. During the post-crisis period we have observed a sectoral shift in financial balances: private sector debt in relation to incomes has moderated while public sector or central bank balance sheets have expanded. A breakdown of private sector balances reveals household deleveraging but corporate sector re-leveraging.
We think that there are macro imbalances (such as Italy’s fiscal trajectory) and micro dynamics (such as deterioration in investment grade credit quality and issuer-friendly loan issuance) that bear monitoring. However, we think imminent challenges are unlikely.
In the near-term, we think the primary risk is prolonged political and policy uncertainty which can undermine growth through sentiment channels. Over the medium- to long-term, low policy rates and limited capacity or willingness for fiscal expansion may constrain the ability of conventional policy to stimulate economies. In this situation, policymakers may be more willing to push policy boundaries, for example, through additional asset purchases or changed policy targets and frameworks.