Four out of four
May 10, 2019

View from the Bond Market, by Chris Iggo, Chief Investment Officer Fixed Income, AXA Investment Managers

On and on

Ups and downs

Yields lower

Sentiment weak

Political risks

Asset price inflation

Summer time blues?

Domination 

The global economy has been in a long expansion. But there have been plenty of mini-cycles, which impact investment returns. The macro data tells us we are in an advanced slowdown – especially on the manufacturing side. This may not be representative of broader economic activity, but it has been enough to usher in a new phase of monetary dovishness. This has boosted returns from government bonds and generally been supportive of fixed income and equities. The risk is that the cycle is more vulnerable to a shock. Markets have got expensive again and the US-China trade war is not good for sentiment. The odds are that the cycle persists, and we avoid a bear market for now, but the summer months have a habit of disappointing.    

On and on –  The National Bureau of Economic Research (NBER) is the agency in the United States that determines periods of economic recession and expansion, measured by identifying peaks and troughs in broad economic activity. Contrary to some popular views, there is no fixed definition of economic activity and the NBER uses a range of economic indicators to judge when it thinks a recession starts and ends. More commonly, people use a rule of thumb that suggests that two consecutive quarters of negative GDP growth are necessary to a period to be classed as a recession. No matter. The current US expansion is long on most measures. The NBER dates the end of the last recession to June 2009 so we are coming up to the tenth anniversary of the current US expansion. Unless something really bad happens in the next few weeks, this will make it the longest expansion in the NBER's chronology going back to 1857.  

Ups and downs – Yet within that long expansion there have been clear mini-cycles which are much more important for investment strategy. There have been three distinct cycles if we use the ISM manufacturing index as a higher frequency guide as to where we are in the economic cycle. There was a strong recovery from 2009 to a local peak in activity in 2011. This was followed by the first of three slowdowns, corresponding to the intensification of the European sovereign crisis and amplified by the fact that the global economy was still suffering from weaknesses in bank and other balance sheets. The ECB came to the rescue and the second mini-expansion got going in 2013, peaking in the third quarter of 2014. That was followed by the second slowdown which was a result of the slowdown in China and falling oil and commodity prices. The third cycle began at the start of 2016 and recently peaked last summer and has been the strongest and most globally synchronised of these post-GFC mini cycles. Yet for the last 10 months we have been slowing again. Higher US rates and protectionism have been the culprits of this most recent slowdown. By the look of the data, it's not over. The purchasing manager indices for the major economies mostly continued to fall in April.

Yields lower –  Central banks have responded to this. The most dramatic has been the US Federal Reserve (Fed) which reversed its tightening stance in January. However, the ECB has extended its dovish guidance, the Bank of England has backed away from suggestions that it needed to raise rates a little, the People's Bank of China has eased, and there have been dovish signals by other central banks (New Zealand actually cut interest rates last week). This has been positive for bonds.  The peak in bond yields came not long after the signal from the ISM that the mini-cycle had topped out – ten-year core government bond yields hit their high in mid-October last year and have been on a constant path lower since. This has helped longer duration fixed income strategies. An index of five- to ten-year German government bonds has registered a total return of 3.9 percent since mid-October (October 15 2018 to May 8 2019, according to the ICE BofAML index data) while similar maturity US Treasuries have registered total return of 6.3 percent (who said you can't make money in government bonds anymore?) While not all macro data has been saying the same thing, one of the most trusted cyclical indicators – the ISM – has been suggesting we are in a "slowdown" phase and, more importantly, central banks have responded to that. Hence the good performance of rates.    

Sentiment weak –  But we are not in recession and therefore credit has also been able to continue to perform well after the valuation adjustment the market went through in Q4 of last year. You don't need me to tell you that jobs market data in most economies remains strong and is supporting consumer spending. At the same time monetary conditions are very accommodative and the fiscal pendulum has swung to being more positive in recent quarters. So, macro is not all bad and corporate earnings have remained fairly buoyant on the whole. But this week's wobbles in risk markets are a warning sign. Rates have responded to the slowdown in growth and now we are in a position where the global economy is more vulnerable to a shock. The ISM index was at 52.8 in April, the Euro-zone manufacturing index is already well below 50. No wonder that equities and credit have responded negatively to the news from Washington that tariffs on Chinese imports to the US have been increased and will remain at a higher level until a deal is done with Beijing (which could happen at any time). Unfortunately, the markets seem to understand what tariffs do better than President Trump – there are only losers in the short-term as US importers face higher costs and thus either have to raise prices on customers in the US, accept lower profit margins, or get their Chinese suppliers to cut prices (with knock-on implications for their profits). Yes, maybe the US Treasury gets some extra revenue from the collection of tariffs, but this is likely to be offset by other negative economic implications. An economic shock coming on the back of almost a year's worth of slowing activity in the global industrial traded goods sector could be enough to send the ISM down further and create a more sustained widening of credit spreads and concerns about the ability of the cycle to expand beyond the record duration.

Political risks – In today's world you never know how much of the market reaction to things is fear about a genuine deterioration of fundamentals, or a response to the uncertainty created by a prolific user of Twitter. The "art of the deal" scenario is that Trump is upping the pressure on China, creating global market uncertainty, and lower equity markets, in the hope that the Chinese will agree to a deal that will be favourable to Trump. If not, Trump will step up pressure on the Fed again and call for them to cut rates. Either way, there will be an opportunity to buy risk again and the President will take all the credit for another bull run in the S&P, hoping to boost his 2020 re-election chances if he decides to run again. But sentiment is not just about short-term responses to Twitter comments and bad news headlines. Beneath the headlines there are genuine concerns about the global economy's fundamentals – it is not yet clear whether Chinese policy makers have arrested the slowdown in growth, Europe continues to fail to show any meaningful signs of a cyclical pick-up, Brexit is still not done and is creating a policy vacuum in the UK, and debt levels are high everywhere. While there is a lot of liquidity on the one hand, investors are not confident about the outlook on the other.    

Asset price inflation – It doesn't help that markets are optically very expensive. In the bond market yields are closing in on historic lows in Europe and are within one or two rate cuts away in the UK and US. Credit spreads were recently back to the levels they were at in the early part of 2018.  Outright yields in European investment grade credit are just 75 basis points (bps) and even in the US, the credit market only offers just over 100 bps pick-up over cash.  On the equity side ratings aren't quite as elevated as they were back in early 2018 but the S&P 500 is trading above 18.5x earnings at a time when the earnings cycle is likely to weaken. In the investment framework I use, it's looking like there are negative signals coming from sentiment, from the macro outlook, and from valuations. In the fixed income markets the technical trends are still positive with net issuance not exactly swamping the market in either government or corporate space. This all adds up to a significant risk of some further downside in risk assets (sell in May and go away as they used to say) or at least a requirement to look for some hedges to portfolios that are weighted towards risk.

Summer time blues?  –  Still there is no panic yet. Returns have been better already this year than they were in 2018. High-yield and emerging market bonds have been good performers while treasuries have responded to the easier interest rate environment. Equity indices have registered double digit growth. There is little risk of any monetary tightening anytime soon while the financial system is certainly more robust than it was ten years ago. There is every chance that the NBER won't need to convene its dating committee for a little while longer. However, I think it makes sense to take on board that valuations are not cheap and that the macro cycle is going through one of its period downturns. Add to that the policy and political risk and the loss of momentum in returns in credit and equity markets and it makes for a period of capital preservation in my view ahead of what is likely to be another opportunity to put cash into the market at better levels. I am not trying to market time here, just weighing up the factors that I think might impact on returns in the short term. For choice, I still like emerging market debt and long duration in government bonds, with a shorter duration exposure to high-yield where the carry is still reasonably attractive.

Domination – The players and fans of the two Manchester clubs can enjoy an extended holiday this year given that City and United are the two clubs out of the top six in the Premier League that won't be contesting a European final. What a week that was! The comebacks from Liverpool and Spurs were truly historic while Chelsea players had to keep their nerve to win that penalty shoot-out. Hopefully the car-crash that is Brexit won't have put off the rest of Europe from enjoying what should be two great finals. In some respects, this is the outcome of the huge amount of money that has gone into the English game in recent years, through lucrative television deals and the globalization of the coverage. As a league, there is more money in the Premier League than anywhere else and that is not likely to change. So, the best players will be attracted to England and the Premier League will become even more competitive. Look how hard it has been for any team to retain the championship (give you a clue who the last team to do that was 😉) and if City do that this weekend it will be some achievement given how close Liverpool will have pushed them. Maybe City won't win it, which proves the point. That level of competition will get even more intense. The Spanish giants are fading, Juventus has reached its limits and PSG seem forever to be falling short of European glory despite their treasure chest. Even the glorious Ajax team of this year will find it hard to go again if they lose, as seems likely, some of their best players. So overall, it's been an exciting season for neutrals, a terribly disappointing one for me. It will be a muted finale at Old Trafford tomorrow and we can just hope that the pre-season sees some serious re-building. For the rest, good luck in Madrid and Baku. We may be leaving Europe politically, but in football terms we are going out with a bang.   

Have a great weekend,

Chris

 





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View from the Bond Market, by Chris Iggo, Chief Investment Officer Fixed Income, AXA Investment Managers

On and on

Ups and downs

Yields lower

Sentiment weak

Political risks

Asset price inflation

Summer time blues?

Domination 

The global economy has been in a long expansion. But there have been plenty of mini-cycles, which impact investment returns. The macro data tells us we are in an advanced slowdown – especially on the manufacturing side. This may not be representative of broader economic activity, but it has been enough to usher in a new phase of monetary dovishness. This has boosted returns from government bonds and generally been supportive of fixed income and equities. The risk is that the cycle is more vulnerable to a shock. Markets have got expensive again and the US-China trade war is not good for sentiment. The odds are that the cycle persists, and we avoid a bear market for now, but the summer months have a habit of disappointing.    

On and on –  The National Bureau of Economic Research (NBER) is the agency in the United States that determines periods of economic recession and expansion, measured by identifying peaks and troughs in broad economic activity. Contrary to some popular views, there is no fixed definition of economic activity and the NBER uses a range of economic indicators to judge when it thinks a recession starts and ends. More commonly, people use a rule of thumb that suggests that two consecutive quarters of negative GDP growth are necessary to a period to be classed as a recession. No matter. The current US expansion is long on most measures. The NBER dates the end of the last recession to June 2009 so we are coming up to the tenth anniversary of the current US expansion. Unless something really bad happens in the next few weeks, this will make it the longest expansion in the NBER's chronology going back to 1857.  

Ups and downs – Yet within that long expansion there have been clear mini-cycles which are much more important for investment strategy. There have been three distinct cycles if we use the ISM manufacturing index as a higher frequency guide as to where we are in the economic cycle. There was a strong recovery from 2009 to a local peak in activity in 2011. This was followed by the first of three slowdowns, corresponding to the intensification of the European sovereign crisis and amplified by the fact that the global economy was still suffering from weaknesses in bank and other balance sheets. The ECB came to the rescue and the second mini-expansion got going in 2013, peaking in the third quarter of 2014. That was followed by the second slowdown which was a result of the slowdown in China and falling oil and commodity prices. The third cycle began at the start of 2016 and recently peaked last summer and has been the strongest and most globally synchronised of these post-GFC mini cycles. Yet for the last 10 months we have been slowing again. Higher US rates and protectionism have been the culprits of this most recent slowdown. By the look of the data, it's not over. The purchasing manager indices for the major economies mostly continued to fall in April.

Yields lower –  Central banks have responded to this. The most dramatic has been the US Federal Reserve (Fed) which reversed its tightening stance in January. However, the ECB has extended its dovish guidance, the Bank of England has backed away from suggestions that it needed to raise rates a little, the People's Bank of China has eased, and there have been dovish signals by other central banks (New Zealand actually cut interest rates last week). This has been positive for bonds.  The peak in bond yields came not long after the signal from the ISM that the mini-cycle had topped out – ten-year core government bond yields hit their high in mid-October last year and have been on a constant path lower since. This has helped longer duration fixed income strategies. An index of five- to ten-year German government bonds has registered a total return of 3.9 percent since mid-October (October 15 2018 to May 8 2019, according to the ICE BofAML index data) while similar maturity US Treasuries have registered total return of 6.3 percent (who said you can't make money in government bonds anymore?) While not all macro data has been saying the same thing, one of the most trusted cyclical indicators – the ISM – has been suggesting we are in a "slowdown" phase and, more importantly, central banks have responded to that. Hence the good performance of rates.    

Sentiment weak –  But we are not in recession and therefore credit has also been able to continue to perform well after the valuation adjustment the market went through in Q4 of last year. You don't need me to tell you that jobs market data in most economies remains strong and is supporting consumer spending. At the same time monetary conditions are very accommodative and the fiscal pendulum has swung to being more positive in recent quarters. So, macro is not all bad and corporate earnings have remained fairly buoyant on the whole. But this week's wobbles in risk markets are a warning sign. Rates have responded to the slowdown in growth and now we are in a position where the global economy is more vulnerable to a shock. The ISM index was at 52.8 in April, the Euro-zone manufacturing index is already well below 50. No wonder that equities and credit have responded negatively to the news from Washington that tariffs on Chinese imports to the US have been increased and will remain at a higher level until a deal is done with Beijing (which could happen at any time). Unfortunately, the markets seem to understand what tariffs do better than President Trump – there are only losers in the short-term as US importers face higher costs and thus either have to raise prices on customers in the US, accept lower profit margins, or get their Chinese suppliers to cut prices (with knock-on implications for their profits). Yes, maybe the US Treasury gets some extra revenue from the collection of tariffs, but this is likely to be offset by other negative economic implications. An economic shock coming on the back of almost a year's worth of slowing activity in the global industrial traded goods sector could be enough to send the ISM down further and create a more sustained widening of credit spreads and concerns about the ability of the cycle to expand beyond the record duration.

Political risks – In today's world you never know how much of the market reaction to things is fear about a genuine deterioration of fundamentals, or a response to the uncertainty created by a prolific user of Twitter. The "art of the deal" scenario is that Trump is upping the pressure on China, creating global market uncertainty, and lower equity markets, in the hope that the Chinese will agree to a deal that will be favourable to Trump. If not, Trump will step up pressure on the Fed again and call for them to cut rates. Either way, there will be an opportunity to buy risk again and the President will take all the credit for another bull run in the S&P, hoping to boost his 2020 re-election chances if he decides to run again. But sentiment is not just about short-term responses to Twitter comments and bad news headlines. Beneath the headlines there are genuine concerns about the global economy's fundamentals – it is not yet clear whether Chinese policy makers have arrested the slowdown in growth, Europe continues to fail to show any meaningful signs of a cyclical pick-up, Brexit is still not done and is creating a policy vacuum in the UK, and debt levels are high everywhere. While there is a lot of liquidity on the one hand, investors are not confident about the outlook on the other.    

Asset price inflation – It doesn't help that markets are optically very expensive. In the bond market yields are closing in on historic lows in Europe and are within one or two rate cuts away in the UK and US. Credit spreads were recently back to the levels they were at in the early part of 2018.  Outright yields in European investment grade credit are just 75 basis points (bps) and even in the US, the credit market only offers just over 100 bps pick-up over cash.  On the equity side ratings aren't quite as elevated as they were back in early 2018 but the S&P 500 is trading above 18.5x earnings at a time when the earnings cycle is likely to weaken. In the investment framework I use, it's looking like there are negative signals coming from sentiment, from the macro outlook, and from valuations. In the fixed income markets the technical trends are still positive with net issuance not exactly swamping the market in either government or corporate space. This all adds up to a significant risk of some further downside in risk assets (sell in May and go away as they used to say) or at least a requirement to look for some hedges to portfolios that are weighted towards risk.

Summer time blues?  –  Still there is no panic yet. Returns have been better already this year than they were in 2018. High-yield and emerging market bonds have been good performers while treasuries have responded to the easier interest rate environment. Equity indices have registered double digit growth. There is little risk of any monetary tightening anytime soon while the financial system is certainly more robust than it was ten years ago. There is every chance that the NBER won't need to convene its dating committee for a little while longer. However, I think it makes sense to take on board that valuations are not cheap and that the macro cycle is going through one of its period downturns. Add to that the policy and political risk and the loss of momentum in returns in credit and equity markets and it makes for a period of capital preservation in my view ahead of what is likely to be another opportunity to put cash into the market at better levels. I am not trying to market time here, just weighing up the factors that I think might impact on returns in the short term. For choice, I still like emerging market debt and long duration in government bonds, with a shorter duration exposure to high-yield where the carry is still reasonably attractive.

Domination – The players and fans of the two Manchester clubs can enjoy an extended holiday this year given that City and United are the two clubs out of the top six in the Premier League that won't be contesting a European final. What a week that was! The comebacks from Liverpool and Spurs were truly historic while Chelsea players had to keep their nerve to win that penalty shoot-out. Hopefully the car-crash that is Brexit won't have put off the rest of Europe from enjoying what should be two great finals. In some respects, this is the outcome of the huge amount of money that has gone into the English game in recent years, through lucrative television deals and the globalization of the coverage. As a league, there is more money in the Premier League than anywhere else and that is not likely to change. So, the best players will be attracted to England and the Premier League will become even more competitive. Look how hard it has been for any team to retain the championship (give you a clue who the last team to do that was 😉) and if City do that this weekend it will be some achievement given how close Liverpool will have pushed them. Maybe City won't win it, which proves the point. That level of competition will get even more intense. The Spanish giants are fading, Juventus has reached its limits and PSG seem forever to be falling short of European glory despite their treasure chest. Even the glorious Ajax team of this year will find it hard to go again if they lose, as seems likely, some of their best players. So overall, it's been an exciting season for neutrals, a terribly disappointing one for me. It will be a muted finale at Old Trafford tomorrow and we can just hope that the pre-season sees some serious re-building. For the rest, good luck in Madrid and Baku. We may be leaving Europe politically, but in football terms we are going out with a bang.   

Have a great weekend,

Chris

 



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