Have We Returned to a Goldilocks Economy?
Jim Cielinski, Global Head of Fixed Income, provides his perspective on some of the key macroeconomic factors that are driving fixed income markets.
- Markets are eager to price in another Goldilocks period, but the ability to navigate the narrow course where growth and inflation are just right will be extremely difficult.
- Absent a policy mistake by the Fed, the odds of recession in 2019 appear low; however, we are mindful of factors that may tip the balance in 2020.
- While rates are low, fixed income still offers diversification benefits to a portfolio, particularly as the cycle progresses.
Jim Cielinski: So the markets are certainly eager to price in a Goldilocks period. That just means there is little inflation, growth is slow to moderate but not decelerating, and there is hardly any volatility. But that stands, you know, on a knife edge, and it worked in the past, because I think central banks were always there at the ready, always willing to really stimulate the economies. You had trillions of dollars of additional stimulus that came in from the Bank of Japan, the U.S. Fed and the ECB, right? So what you are missing this time is the tool kit, right? The ECB really can’t do much, the Bank of Japan has already done most of what it is going to do and the Fed is only pausing. So they are not kind of going back to big time easing or monetary stimulus. So that ability to navigate that narrow course where growth is just right, inflation is just right, I think will be much harder as we go forward.
I think last year you almost had too much growth, too many inflationary fears in the U.S. And so you could argue that the porridge, you know, if you are Goldilocks, it was too hot last year. So I think now that we have worked our way through that, you are seeing growth moderate. It is important that it doesn’t slow down too much. I think so far, so good, right? So we see the slowdown, it is very global. But the U.S. is coming from a stronger point, and I think it will be able to stabilize at these lower levels, although it will be touch and go given the global weakness.
It is hard to see a material bear market without some kind of recession, and I still think the recession odds are low. But look, they are bigger than they were, and we see pressures, I think, emanating from several sources. One, debt continues to grow, but now that is happening at a point where the monetary stimulus probably isn’t a tailwind. But also things like margin improvement are dissipating, right? So profit growth is still there, but as margins weaken and as debt grows, I think you are really exposing a lot of markets to any kind of shock. It is interesting to me that we flip back and forth from fearing too high of an inflation rate to almost recession. And there are a number of leading indicators at recession that would tell us that we should be wary. But if you look at some of the coincident and lagging indicators, we still would have at least a year, I think. And absent a policy mistake, that was probably one of the biggest fears for what could drive us to recession. So I think we avoid it for 2019. As we move into 2020, watching things like credit growth and margin deterioration and what happens globally, which will impact the U.S., I would say those are the things that we must watch to kind of see if 2020 is going to be more of an issue.
When I look at what the important swing factors for this year are, I must say that China is right up there. In addition to the trade protectionism, we have a whole array of easy measures that they have done, but they are actually about 20% of what they have done in past easing cycles. So don’t get confused by the sheer number. The magnitude of what they are doing is actually still relatively small; their hands are tied. So I don’t think it will stop the slowdown that we are seeing in China. I think it will continue to be, obviously, growing stronger than many regions of the world, but the slowdown is going to have an impact on global trade. So I don’t think we are out of the woods, and I think what happens in China will dictate what risk assets do to at least some extent later in the year.
So when I think of what this means for interest rates, I really look at the Fed now being on hold. But the market has repriced that, right, and equally the downward move in inflation pressures has been, I think, reflected through a much lower term premium. So I think we have seen volatility in rates. For me, you will need another leg of the slowdown to really get materially lower from here. I think the next step for the Fed, first of all, they are unlikely to tighten, I think, this year unless inflation picks up. The evidence right now is that that is not going to happen. The next step, though, will not be that they lower rates to kind of be the lender of last resort, it will be something different. It will be a slowdown that probably prompts that. So could their next move actually be an ease? I think at this stage, you look at the global slowdown and say, “Yeah, it is probably greater than a 50% chance that their next move is an ease, and that this cycle could very well be over.”
So when I look outside the U.S., you have seen a very similar decline in rates, so this is a global phenomenon. Yields, for example, in Germany are back close to zero. Japanese yields never really moved much off of zero, so I think that means two things. One, the potential for big upside is probably somewhat limited and two, it probably does make the U.S., which it has done for some time, look relatively attractive. And rates are low, rates are going to stay low, right? But I think the key for fixed income investors is to also recognize that even at low yields, there is a diversification impact, right? And particularly as you get late in a cycle, owning fixed income and owning high-quality fixed income, whether it is short, medium or long duration, can provide important diversification benefits to portfolios.
When you look at the backdrop for corporate credit, I think it is more difficult than it normally is to say, “This sector or this region are going to be particularly good or bad.” What you are seeing now is divergence in behavior. I think many issuers are cautious, right? They recognize the risk, and they are beginning to look toward opportunities to, I think, either de-lever or be quite cautious with the balance sheet. Other companies are actually still thinking there is a lot of growth ahead, rates are low, let me continue to lever up. So for me it is less about which sector, which region, it is more about finding those credits and finding those risks that are, I think, behaving prudently and in a way that is more bondholder friendly. I think I see a lot of those across the globe, but equally, I think on almost every region I see some potential trouble spots that if you did get that recession would really come back to haunt you. So security selection, it is always key, it is probably more key today than it normally is.
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