September 2019 Perspective: Economic and Investment Outlook

09.13.2019 - Ronald J. Sanchez, CFA

We See Smoke, but Is There Fire?

A quick survey around the global policy mix reveals a lot about the way markets have behaved this year. There has been a pronounced and unexpected increase in uncertainty around trade and global growth. With US and China trade tensions approaching a one-year anniversary earlier this summer, investors, and the public more generally, may have hoped to be celebrating a conclusion to trade negotiations by now.

Instead, a new round of tariffs announced on August 1 directed at consumer goods generated headlines that President Trump may have finally gone too far, reducing his political goodwill with those close to him. The tension between the two economic powerhouses may finally be bleeding into slowing global trade data and weakening growth. Throw in monetary policy, which has at times been stubbornly hawkish, and you have the recipe for heightened volatility in financial markets.

Despite this backdrop, it might be surprising to realize that the S&P 500 is essentially flat since the end of the third quarter of 2018 thanks to a strong start this year. What this emphasizes is that the past 12 months have been a bumpy ride, characterized by frequent spikes of volatility and two notable periods of severe downside moves. It has been extraordinarily challenging for market participants to assess this fluid and uncertain global economic and policy environment.

View from the Interest Rate Complex

The same characterization cannot be applied to global bond markets, where the interest rate complex has seen yields decline precipitously and persistently over the past year. The magnitude of the move is nothing short of astonishing. Over the past year, the 10-year US Treasury has actually declined by more than its current level, shaving 175% in yield to fall below 1.50% at the time of this writing.

Unrelenting demand for income and safety has led to bonds outperforming equities during this period. Moreover, the rally has resulted in many bond markets with negative yields, exacerbating an issue which has plagued markets for years now. An accounting of sovereign bond yields globally shows that issues with negative yields have doubled to over $17 trillion.

Low absolute yields are nothing new in the post-Great Financial Crisis period, but 10-years in, one must wonder what interest rates are telling us. The global bond market is the largest and deepest capital market and represents the best barometer for the health of the global economy. Global central banks’ foray into unconventional monetary policy and ensuing asset purchase programs in the wake of the financial crisis left banks with historically bloated balance sheets and helped drive rates artificially lower. In an environment where the search for yield-producing assets has increased, we must therefore strive to appreciate and understand the acute changes in fixed income markets.

How Did We Get Here?

It was not supposed to go like this. After a decade of near-zero interest rates, we believed the Federal Reserve, along with other global central banks, had embarked on a course to normalize monetary policy. The Federal Funds rate was expected to keep rising as inflation slowly returned to its 2% target. The income was back in fixed income and investors were adjusting to cash as an interest-generating portfolio allocation.

This narrative was derailed this year as 2019 brought capitulation across the global fixed income complex. Rather than normalizing to the upside, global yields have plummeted dramatically, leaving the US Treasury market now as one of the few positive-yielding developed markets.

What Bond Markets Are Telling Us: Our Framework

Globalization has decreased the ability to look at markets through one lens, leaving us to decompose the various aspects that have contributed to the current environment through a more holistic framework, as follows:

  • Slow Economic Growth

Growth prospects have clearly taken a turn for the worse, both domestically and internationally. Looking back to 2018, it looked like the US was primed to accelerate on the heels of expansionary fiscal policy and resynchronized global growth. To the contrary, the stimulus measures now appear to have provided only a one-time boost and the promise of animal spirits percolating through the economy has evaporated. Now, businesses are left with shaky confidence and a reluctance to make meaningful capital investments under the overhanging cloud of trade policy uncertainty. 2018’s GDP growth of 3% looks more like an outlier, and a return to the muddle-through 2% range to which we have become accustomed since 2008 leaves us in reluctantly familiar territory.

  • Looser Monetary Policy

Abroad, a sluggish growth backdrop and tangible risk of recession has made it impossible for central banks to normalize policy. By necessity, monetary policy will remain accommodative relative to history, and there is no clear path to higher rates anytime soon. Investors have priced this belief into markets, as evidenced by the German yield curve being entirely in negative-yielding territory (CHART 1).

  • Low Inflation

As US inflation continues to fall short of the Fed’s 2% target, we wonder if lower inflation is here to stay. Lower inflation expectations are reflected in fixed income markets via lower rates, and more specifically can be implied from forward markets where inflation expectations, even five years in the future, are still below the 2% threshold. Global inflation trends, just like growth, have been even more challenged abroad. There is no better poster child than Japan, which has battled with weak inflation for the better part of two decades.

  • Flat Yield Curve

Few finance topics have garnered more attention in 2019 than the state of the yield curve. Treasury yields have collapsed as investors tried to front-run anticipated Fed rate cuts, fueling Treasury returns in excess of the S&P 500 on both a year-to-date and one-year basis.

The 2-year/10-year part of the yield curve briefly inverted, flashing a well-studied and well-known recession warning. We believe flat yield curves and periods of inversion are likely here to stay and may increase in frequency given the proximity to the zero-boundary. This is especially so given the persistence of lower inflation, both in the US and internationally.

  • Demand for Yield and Safe Assets

Another dynamic worth focusing on is the technical backdrop with fund flows. The years following the financial crisis saw massive flows into bond mutual funds and ETFs as investors sought safety and income. The widely held expectation, known as the ‘Great Rotation,’ was that this condition would eventually reverse when the economy recovered. But fund flows have yet to subside, and the persistent buying of bonds has been a major factor in keeping interest rates subdued (CHART 2).

To that end, US Treasuries remain the largest, most liquid safe asset in the world, but they are not alone. To opportunistic global investors constantly seeking yield, Treasuries—even at historically low yields—offer an obvious advantage to negative yields seen in other traditional safe-haven assets like German bunds and Japanese government bonds. This illustrates an important tenet of markets today; they are indeed more global than ever.

  • Graying Demographics

As the global population ages, there is an increasing number of savers boosting demand for safe-haven and income-producing assets like government debt. In the US, demographics have consistently looked better than the rest of the developed world, but this was predicated on immigration-led growth. As voices espousing a more nativist populism have grown in strength, the ability to see demographics as a driver of higher potential growth in the US has waned. This has led to increasing demand for fixed income instruments, combined with a weaker growth backdrop, lowering yields.

Our View: We Are Mindful of Warning Signals, but Do Not See an Imminent Recession 

Left with such stark signals from bond markets, one may endeavor to make sense of it all. But making inferences from today’s market based on historical observations is increasingly challenging. Never in history have we seen trillions of dollars of negative-yielding debt. Never in history have central banks accumulated such vast balance sheets.

In the past, we have taken a yield curve inversion as a signal for an impending recession, but now we need to appreciate the complexity of this environment and employ a multi-dimensional framework. Market signals need to be assessed in the context of a highly complex, interconnected global financial system. Central banks cannot conduct monetary policy in a vacuum and investors should not consider assets in isolation.

As we think about debt markets today, we believe that global interest rates have been driven by the confluence of individual factors we highlighted. Aggregated through our framework, we are left to digest slowing growth, constantly evolving monetary policy, deflationary technological advancements, seemingly unending flows into bond funds, an inverted yield curve, a globally interconnected rate complex and an aging population. In our view, these factors are not only operating in tandem, but are more permanent in nature. We refer to this as bond market capitulation, meaning bond investors now universally acknowledge that real rates at or below zero are warranted. Given this collective view, we would expect a period of low or modest market returns going forward.

While we continue to view the yield curve through our lens—which is to say we do not necessarily see an imminent recession—we are mindful of the warning signal given by yield curve inversion. Obviously, only time will tell if we can continue “muddle-through” economic growth or if a recession is looming, but we believe it is the former environment that persists. However, given the implications of what is unfolding in the global interest rate complex, we continue to monitor both global financial markets and underlying economies for clues.

This communication is intended solely to provide general information. The information and opinions stated are as of September 13, 2019 and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. 
Historical performance does not guarantee future results and results may differ over future time periods. 

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