We think the bond market has moved too far and too fast. This optimistic growth expectation is based on policies that probably won’t be enacted for another 12-18 months. Given the strong interparty tensions across the political spectrum, and even the disagreements regarding increased deficits, it seems likely these policies will be watered down by the time they are eventually enacted. READ MORE.
Our thesis since the financial crisis has been that the global recovery would be ongoing but very slow by historical standards. As we came into 2016, our view remained that US and global growth were going to be steady but unspectacular and that it would be sufficient to give us some ongoing forward momentum. Combined with a backdrop of subdued global inflation, central banks would increase accommodative monetary policies and this would help provide the support for an ongoing recovery. Our working premise has been a trend growth rate of roughly 1.5% for the US and just under 3% for the global economy.
In order to take advantage of the ongoing global and US recoveries, the preponderant amount of our risk budget was devoted to spread product, in the belief that slow growth, if sustained, would be sufficient to bring down credit spreads. We have also utilized macro strategies, particularly overweights to duration that have helped protect the portfolio during risk-off periods, while also benefiting from the slow pace of interest-rate normalization.
Just like Brexit, the election of Donald Trump was a potential watershed event.
The Trump reflation trade has been driven by expectations of quicker growth and higher inflation and was contingent upon sweeping tax reform and stimulative infrastructure and defense spending. This optimistic growth expectation is based on policies that probably won’t be enacted for another 12-18 months. Given the strong interparty tensions across the political spectrum, and even the intraparty disagreements regarding increased deficits, it seems likely these policies will be watered down by the time they are eventually enacted.
Can the global and US economies remain vibrant?
It was not quite a year ago that optimism about US growth led the Federal Reserve (Fed) to forecast four rate hikes in 2016, only to see China fears and global growth concerns lead to a very different outcome. There is still an unbelievably strong sentiment that equities and risk will keep going up, the US dollar will be stronger, and rates are going higher. All of these consensus trades may turn out to be right but they are just very crowded.
We think the bond market has moved too far and too fast. The evolution of Trump’s economic policies will be crucial. Our view is that the jury is still very much out. Igniting US growth in the context of a very weak global environment has proven exceedingly difficult. Trump’s trade and immigration policies are potentially negative for global growth and we’ve seen some controversial early actions in these areas by the administration. These are the types of actions that caused the markets concerns during the campaign but seemed to be overlooked immediately after the election. The implications of labeling China a currency manipulator and the erection of trade barriers may reinforce the global risk-off episodes we have seen intermittently over the last five years.
A hawkish Fed?
Another reason why we believe that US growth may disappoint the optimistic forecasts is because the Fed is poised to offset fiscal stimulus with tighter monetary policy. As a consequence, Fed communications will likely have a hawkish tilt this year. The US is now close to the Fed’s unemployment and inflation mandates and Fed Chair Janet Yellen has said that “Fiscal policy is not obviously needed to provide stimulus to help us get back to full employment.” This tighter monetary policy stance will only be necessary, however, if fiscal policy is loosened and growth picks up, but current conditions don’t warrant it yet.
Absent concrete evidence of higher inflation, the Fed is not under immediate pressure to hike rates. The sharp fall in inflation expectations at that beginning of last year forced the Fed to make a dovish pivot and hike only once instead of the planned four times. Inflation expectations have since increased since the election and are currently well above their lows and now just sit comfortably in the middle of their range over the last few years. So while inflation expectations are no longer constraining the Fed from hiking, neither are they motivating the Fed into accelerating the pace of hikes.
In a disinflationary environment, the benefits of the negative correlation between risk assets and high-quality bonds is a powerful benefit for investors. In a “taper-tantrum,” or rapid switch to an inflationary regime, the correlations would likely turn positive. While this scenario is not a given, the higher probability means that duration might have to be reconsidered. Similarly, the environment that has been so favorable to emerging markets is becoming more vulnerable.
Over time, the fundamentals of growth and inflation drive interest rates and spreads. We are optimistic that the global and US recoveries will eventually see better growth outcomes, but this improvement is likely to be gradual. We still expect slow but sustainable growth for the foreseeable future but global debt loads are already high and will continue to rise. This is a cautionary sign that further improvement will continue to rely on more central bank support. But now that central banks are beginning to reduce the amount of accommodation they provided previously, the question remains whether the global recovery will be self-sustaining.
In this environment, spread product figures to do better than Treasury or sovereign bonds. If global and US growth improve more meaningfully, outperformance of spread product should be even more pronounced.
Our base case for US growth remains in the 1.5% trend, and while we are clearly heeding potential policy changes, we need to see more evidence.
On the non-US portion of global growth, we are much more concerned. We worry about the slowdown in Chinese growth, which was attenuated this year by the withdrawal of once massive stimulus. The early improvement in non-China emerging countries may now come under stress from US trade policies and the potential change in Fed policy.
European growth, a bright spot so far the last two years, is now faced with the uncertainty of both Brexit and the potential for a continuation of the anti-globalization politics.
The current slow growth and low inflation backdrops both in the US and abroad have not changed. Markets have priced in the expectation of an imminent and radical shift in US growth. We don’t dismiss this possibility, but we also recognize that disappointment would prove painful. While we intend to improve our prospects under a stronger US growth scenario, it is more important to remain flexible so that we will be able to react to alternative scenarios.
The initiatives Trump has outlined for his first 100 days constitute a clear break with the pro-globalization policies of the past 30 years. It is far from clear to us, however, how this will play out. There are strong potential risks, and the optimistic scenario being priced into today’s markets may be overdone.