The perfect storm
“Bottom Line: there's no such thing as a good or bad idea regardless of price!” - Howard Marks
In recent months, capital markets have been grappling with a slowdown in economic growth. One of the areas where we have seen this quite pronounced is in government bonds, as across the board interest rates have dropped significantly.
The magnitude and speed of the adjustment can be explained by the various drivers that make up the term structure of interest rates, all moving in the same direction at the same time – the perfect storm.
Inflation expectations have been revised significantly lower over the course of Q4 2018. In our view, this is mainly driven by the 35 per cent plunge in oil prices. A shock of this magnitude is bound to exert a meaningful impact on near-term inflation prospects via both direct and indirect effects on consumer expenditures (e.g. petrol or processed food).
Indeed, the latest US inflation report did come in softer, driven by a fall in the energy sub-components. Longer term however, the disinflationary effects should largely wash out from the inflation numbers due to base effects.
Meanwhile, upside surprises in non-farm payrolls and wage growth mean that a tightening labour market should continue to support US core inflation over the medium term. On balance, we think that inflation expectations have adjusted too far, given the incoming macro data.
Turning to the second driver, we've observed that markets have dramatically scaled back expectations for the trajectory of monetary policy rates. This re-pricing appears most evident in the US, where investors are now anticipating rate cuts from the Federal Reserve (Fed) by early 2020, as opposed to rate hikes previously. To us, the drastic revisions are likely to be a response to the shift in language from the Fed in combination with activity indicators softening.
Industrial/manufacturing data from the euro zone and China have been disappointing throughout Q4, pointing towards further downside in growth for Q1 2019.
Meanwhile, in the US, the positive growth impulse from fiscal stimulus is widely expected to fade this year. Together, these factors have resulted in growth expectations being revised downwards – hence revisions to the anticipated path for monetary policy.
For now, we interpret the latest data as pointing towards a further slowdown in growth, rather than an outright recession in 2019. This will likely prompt a temporary pause from the Fed, as hinted by the dovish tone of recent meetings. However, monetary easing from the Fed looks unlikely in the context of the current macro environment, where labour market conditions remain healthy and inflation remains barely on target. Overall, we think that investors have likely adjusted their rate expectations too far down.
Given our views that both inflation and the trajectory for monetary policy have adjusted too far down, we see scope for a rebound in both measures as sentiment recovers. Hence, we have initiated a tactical underweight in developed government bonds in client portfolios.
At current levels, the compensation to investors for holding duration risk is very small, especially in the US. Here, we made a conscious decision to exclude UK gilts from this move to avoid taking on any event risk from Brexit. Overall, we retain a pro-risk tilt within our tactical positioning, leaning towards equities, with a preference for Emerging Markets Equities, while being underweight investment grade credit.
:: Claire McCombe is a private banker with Barclays Wealth & Investments NI