Yes, yield curve inversions are ominous, but a recession is not a foregone conclusion. First, even if we do see a recession, there has historically been a 12–24 month lag between the inversion and the downturn. Moreover, yields are being dragged down by political and geopolitical tensions, including worries about the impact the US-China trade war is having on growth. European growth, and Germany in particular, continues to slow, with a contraction in Europe’s largest economy during the second quarter. This has sent German Bund yields ever deeper into negative territory, dragging down sovereign debt worldwide, including the US, with them.
We believe that markets are painting too negative a scenario, and that the US economy remains relatively solid, given a still-robust labor market, a healthy consumer, and gradually rising core inflation. Nonetheless, we expect the Federal Reserve to remain under pressure due to external factors, such as trade, and ease one or two more times this year. This could lead to disappointment and some retracement in yields, but we do not expect a sharp back-up. In Europe, while the European Central Bank (ECB) appears to have less ammunition at its disposal, the determination of ECB President Mario Draghi – and that of his successor Christine Lagarde – should not be underestimated. As such, a rate cut, possible bank deposit “tiering”1 and even renewed asset purchases are likely in September.
One year into the trade dispute, we do not expect a swift resolution, as we see little political incentive for President Trump to ease pressure on China. At the same time, Trump needs to be careful with the US economy, as a significant slowdown in an election year would be unwelcome. As such, we expect some form of short-term détente, but no grand agreement until 2020.
Conversely to bonds, equity markets have taken a much more sanguine approach to recent developments, choosing to focus on possible trade truces and central bank easing rather than growth fears. Indeed, while risk appetite remains fragile, and investors have shied away from European assets due to political tensions, equities have shown some resilience, while bonds and safe havens such as the Japanese yen, the Swiss franc or gold continue to rally. We expect markets to grind higher in the coming months, amid higher volatility, as long as earnings show some decent growth.
ASSET CLASS DETAILS
Equity markets have been more optimistic about the recent re-escalation in the US-China trade war and ensuing global growth fears. Indeed, while markets corrected on the initial announcement, we have not seen the extreme moves witnessed in sovereign bond markets. In our view, risk appetite remains fragile, aware that reversals are possible and likely at any moment, so more volatility should be expected. Nonetheless, we believe that markets can make their way higher in the coming months.
US markets tend to be seen as more defensive and should show some resilience in a tricky environment, especially given higher growth and earnings. But higher valuations can act as a cap on performance. European assets remain shunned as political and growth fears take over. The Brexit saga, domestic political tensions in Italy, and Germany growth worries have kept investors at bay, a trend which is likely to continue in the short term. A possible German fiscal stimulus package, the ECB managing to weaken the euro, or better Brexit news could bring a welcome relief to these markets. Emerging markets remain vulnerable to trade tensions as well as idiosyncratic events, but should follow the rest of the world higher, though to a lesser extent.
Sovereign debt yields have continued their relentless march downward, on thinner liquidity, central bank support expectations, trade woes and growth fears. The search for yield has also contributed to lower US yields, with the 10-year trading below 1.50%, while the 30-year breached 2% to reach an all-time low. German Bund yields continue to defy gravity, trading around -0.69% for 10-year bonds and dragging the rest of the universe with them – negative yielding debt now totals about USD16 trillion. While we find the move extreme, we expect a stabilization, and possibly some retracement if central banks are less dovish than markets hope for, but we do not expect a sharp back-up in the short term.
The inversion of the yield curve is a worrisome sign, but a recession is not a foregone conclusion, given the additional factors bringing yields down. In the short term, we could see the curve flatten as the front end falls on rate cuts and investors move further out in the search for yield, keeping the longer end down as well.
Credit spreads have widened somewhat on growth fears, but should remain contained. As could be expected, high yield has suffered more than investment grade, and we maintain a preference for the more defensive segment given the growth environment. Emerging market debt has held up well given idiosyncratic events. Yield-providing hard currency bonds should remain in demand as long as the US dollar remains stable.
Currencies have remained broadly stable, although the US dollar (USD) has strengthened somewhat on safe haven demand. Even though President Trump wishes for a softer USD, trade and growth worries have kept the greenback underpinned. EURUSD remains in a 1.10–1.13 range, despite the ECB’s dovish tone and expected additional stimulus in September. Cable (GBPUSD) has also remained in a tight range around 1.21, with markets pricing a higher risk of no-deal Brexit since the summer. The Chinese yuan weakened past 7 in the latest trade escalation, with some spillover onto other regional currencies. Argentina contagion was limited, but emerging market currencies could struggle with a stronger USD.
Growth and trade fears continue to be the dominant drivers of commodity markets, with oil prices dropping, despite OPEC trying to curb production and Middle East geopolitical tensions. We expect this trend to persist for now, and believe that shale production can also act as a cap in the longer term. Gold continues to see safe haven demand amid lower rates and rate cut expectations, despite some USD strength. With ongoing growth fears and trade uncertainty, the momentum is likely to continue.
We continue to see a place for alternatives in portfolios, as we look for de-correlating and diversifying strategies to complement traditional asset classes, particularly with liquid alternatives.
Equity securities are volatile and can decline significantly in response to broad market and economic conditions.
Fixed income securities may carry one or more of the following risks: credit, interest rate (as interest rates rise bond prices usually fall), inflation and liquidity.
Commodity-related investments, including derivatives, may be affected by a number of factors including commodity prices, world events, import controls, and economic conditions and therefore may involve substantial risk of loss.
Currency exchange rates between the US dollar and foreign currencies may cause the value of the investments to decline.
Alternative investments involve unique risks that may be different from those associated with traditional investments, including illiquidity and the potential for amplified losses or gains. Investors should fully understand the risks associated with any investment prior to investing.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed may change based on market and other conditions.
All investing involves risk, including the risk of loss. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments.