Fixed Income Specialist, Saxo Bank
Summary: The economy is turning, the late cycle is coming to an end, and the big remaining question will be what options central banks can deploy should sentiment turn more negative into 2019.
The end of this year leaves us with a great many questions. Is the selloff that we are seeing only the beginning? Are emerging markets out of the woods? Is the slowdown in growth going to continue in 2019? Will the conflict between China and US resolve itself? What about political instability in Europe?
These are the questions whose answers will determine portfolio performance in 2019.
While we cannot predict exactly how things will turn out next year, we can make an educated guess by looking at two key things: central bank policy and credit spread directionality.
Hawkish Powell to turn dovish in 2019
We started 2018 with a new Federal Reserve chair, and since his first speech the market understood that the path ahead was one of interest rates hikes and disinvestment. Jerome Powell has kept his word, and what we have seen throughout the whole year was a hawkish Fed concerned by overshooting inflation and economic expansion.
Things, however, have recently taken a turn and amid a sell-off in the equity market and a slowdown in global economic growth, investors speculate that the hawkish approach of the Fed will end with markets expecting only a single hike in 2019.
Speculation on a dovish Fed has been enough to push the 10-year US Treasury yield back below the 3% level, which marked a local high after eight years of sub-3% yields. This caused a further flattening of the yield curve and an inversion in the short part of the curve between two- and five-year maturities.
Our expectations regarding US monetary policy depend on economic performance. The central bank’s continued data-dependence was made abundantly clear at the December 19 Fed meeting where Powell responded to questions about falling equity prices by referring to economic growth and unemployment numbers. This means that that until the Fed sees a slowdown in US economic data, forward guidance will remain hawkish – unfortunately causing more panic among investors.
On the other hand, if the trade war headlines don’t relent and the market continues to fall, we can expect Powell to slow his policy normalisation roll.
We believe that an inversion of the yield curve is inevitable no matter what the Fed does or doesn’t do. If short-term interest rates rise because the economy is growing, we can expect the short part of the curve to rise faster than the long; conversely, if the Fed slows its rate hikes due to trade at equity market turmoil, we can expect the longer part of the curve to fall faster than the short one.
Europe playing a cautious hand
In Europe, things have gone in a different direction. The year started relatively well, with European Central Bank president Draghi promising to stop asset purchases under the QE programme and to begin hiking interest rates, but political risks within the European Union have been too severe to allow such a course of action.
While Brexit has been priced into the market since the vote in 2016, volatility started to rise amid the Italian elections in May and recently peaked amid news regarding the Gilets Jaunes movement in France, as well as Angela Merkel’s resignation as CDU leader in Germany and the continuous rise of populist parties in Spain.
After Draghi’s speech on December 13, it became clear that the ECB is playing its cards cautiously; the only thing that can do to aid the economy and stabilise the market is to keep its enormous balance sheet invested for longer. Although the ECB wraps up asset purchases this month, it has made it clear it that will keep interest rates low for as long as is needed (although it has specified that it won’t hike until summer 2019, but investors speculate that it will not do so until 2020) and that reinvestment of principal maturities will be reinvested beyond rate hikes.
This means that bond valuations in the euro area will be supported throughout 2019, and this represent a buy opportunity for many of those credits that have widened amid recent volatility.
Storm clouds facing high-yield bonds and leveraged loans
As you can see from the graph below, both European and US high yield credit spreads have been widening over the past couple of years. This has been due to various factors including as risk-off sentiment among investors, which has pushed them to dump risky assets purchases while rates were at record lows.
Rising interest rates in the US have not only caused the cost of funding to rise, they have also pushed investors to realise that their risky assets could become extremely volatile if the economy turned. Additionally, with interest rates rising it has started to be easier for investors to find quality assets with interesting returns.
In Europe, high-yield spreads have been widening faster than in the US despite rates holding steady. This has mainly been due to political instability in various European countries, including Brexit.
Assuming a stabilising trend into next year, the ECB’s continued support of the European recovery could leave selective high-yield European credits ripe for allocation.
With the high-yield space slowing down, and large amounts of leverage debt in the system, we expect high-yield bonds to continue to suffer. In our view, the investment grade space offers more opportunity.
The economy is turning and the late cycle is coming to an end. As we head into the New Year, it’s not hard to envisage a situation in which sentiment and circumstances turn more negative still, with central banks having fewer cards to play than they once did.