Convergence Returns to the Fore
Jim Cielinski, Global Head of Fixed Income, provides his perspective on some of the key macroeconomic factors that are driving fixed income markets.
- A softening in trade has been blamed for much of the global slowdown, but there is more behind it; while trade’s near-term impact on growth may be overestimated, investors could be underestimating some of the second-round effects.
- With the Fed’s pivot to a more accommodative stance, practically the entire developed world is now in easing mode, bringing policy convergence back to the fore.
- Policy normalization, as we know it, is dead. The ability of central banks to normalize today, at a time when the real equilibrium rate is so low, calls into question the efficacy of traditional monetary policy responses.
Jim Cielinski: Does the slowdown that we are seeing reflect the fading globalization? I think it partly does, but this slowdown was real and entrenched even before a lot of the trade friction I think began to heat up. So, I think we are seeing a fading of the fiscal stimulus from Trump. We have actually seen slow growth almost everywhere else in the world. China has struggled, EM [emerging markets] has struggled and Europe has struggled, so I don’t think this is new. This has been with us now for the better part of a year and a half outside the U.S. So trade frictions have certainly helped this along now; it’s probably retarded growth somewhat, but I don’t think it’s the full story.
Are we overestimating the impact of global trade? Look, I think it’s been used as a good part of the story for why there is a slowdown, but I think we are overestimating its near-term impact on growth. We are probably underestimating how badly it could go wrong if everything goes wrong, so that risk is still out there. But when I think of global trade, globalization, it is much broader than just trade. We have the demographic story, we have low productivity, low inflation. So many sectors are heading in the same direction. Those are the trends that are actually driving markets, and it’s actually driving central bank policy now because they are concerned about a lot of these trends that are leading to the slow-growth and low-inflation environment.
The Federal Reserve, along with other central banks, have become much more dovish. When I look at this, it is one of the most important shifts we have seen for markets. Relative to the underlying fundamentals, this is perhaps one of the most dramatic shifts in policy expectations that we have ever seen. I don’t think they are about to admit that they made a mistake. I believe that they feel like we were at full employment in the U.S., we were right to worry about inflation pressures and it’s trade that got in the way. Now whether that’s true or not, it does give them cover. I think what you’ll see, though, is real concern in the Fed that their models simply aren’t working. They would have seen inflation last year if their models were working. So I think as you get concerns around trade, it makes them quite quick to pull back on these fundamental beliefs. So it’s a big shift. They’re not about to go into a tightening cycle anytime soon, and now we have the whole world in easing mode.
Is policy normalization dead? I think as we know it, it certainly is. We saw in the last year that almost no one can get off zero, and those that did quickly found the breaking point to be much lower in rates than they expected. So that ability to normalize now when the real equilibrium rate is so low I think really calls into question what policy can do and what policy needs to do going forward. We are already back in convergence mode. We’ve had divergence for a brief period, where the U.S. central bank was moving in a different direction; quite an unusual period, though, in that no other central banks really got off the ground. And now with everybody easing once again, we are seeing that convergence. We are also seeing a lot of questions about what happens if growth really slows. So, the first step I think would be to pull out the same bag of tricks that they used last time, whether it’s quantitative easing, negative rates (in the case of Europe) or buying corporate bonds. So all of those can be used again, but they’re less effective, I think, the second time around and there are limits to how much further we can go. So I think we do need to start considering what other policy steps are out there, and I think regime shifts around policy can be big drivers of markets. They’re often some of the most important things that we see in markets. So, fiscal policy has to augment monetary policy I think to be effective and this creates some political challenges. It creates challenges based on law and rule, for example, in Europe. And it kind of ties in closely to what populism can do or should do.
So, where can investors find yield today? I believe the search for yield, which has been one of the biggest themes in recent years (it’s only been for brief respites that we’ve moved away from that theme), is fully back on now as rates have come down and are likely to stay low and credit spreads have tightened. Investors and clients will look for that balance, I think, of relative safety and good yield. And yes there are still places to find that. I think credit, when you look at credit, low real yields often lead to very low defaults and couple that with easy monetary policy, I think you can see an elongated credit cycle that makes credit attractive generally, but also areas like mortgage credit, where there hasn’t been a big expansion, look very attractive.
Emerging markets, I think, are looking more attractive. There is yield in some surprising places. For many clients they will see it in the long end of the yield curve where you can get, I think, some good diversification in your portfolio. But also in the front end of safe markets, such as the U.S., yields are relatively attractive. I don’t see this as a trend that’s going away any time soon, and investors should just ask what they are looking for, what their objectives are and if they do that I think you will see many pockets of value across the world.
Credit Spread is the difference in yield between securities with similar maturity but different credit quality.
Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.
Fixed income securities are subject to interest rate, inflation, credit and default risk. As interest rates rise, bond prices usually fall, and vice versa. High-yield bonds, or “junk” bonds, involve a greater risk of default and price volatility. Foreign securities, including sovereign debt, are subject to currency fluctuations, political and economic uncertainty, increased volatility and lower liquidity, all of which are magnified in emerging markets.