Market Outlook: Global Fixed Income

Focus on Growth

We believe global growth will remain positive in 2019, as U.S. growth moderates slightly and Europe and emerging markets (EM) regain their footing. We also acknowledge four major global risks which may challenge this view. These are a collapse in US-China relations, the Federal Reserve (Fed) overtightening, Italy’s governance pulling away from European Union (EU) fiscal norms and the UK separating from the EU via a “hard Brexit.”

The market, however, is pricing each of these scenarios for extremely negative outcomes. We believe there is room for less pessimism — even some optimism — regarding each of these factors.

U.S. Outlook

Western Asset expects likely slower growth for the US in 2019 as some of the fortuitous factors recently boosting growth begin to fade. While 3%-4% growth in some recent quarters has garnered headlines, average growth for all of 2017-2018 is a more modest 2.8%, albeit still up from 1.9% over 2015-2016. Given the 2017 tax bill’s incentives, one would think capital spending would continue to hum, but recent capital goods data has been spotty. Meanwhile, homebuilding looks to have embarked on a downtrend. If foreign trade and inventories do indeed revert to 2015-2016 trends and either equipment investment or housing sputter, economic growth could drop to the 2.0%-2.25% range. We think the claims of runaway growth are exaggerated and that we will likely see more modest performance in 2019, along with continued low inflation.

The Fed’s renewed focus on contained inflation, risk management and a lack of certainty about equilibrium or neutral rates suggests a more dovish direction moving forward. What’s more, Fed Chair Jerome Powell just declared that the Fed is very near the neutral range (thought to be a fed funds rate of 2.5%-3.5%). We’re optimistic that the new tone will prove helpful, but it’s too soon to tell. More importantly, monetary policy has been tightening for two years and fiscal stimulus is waning. We think as the Fed comes to face more seriously a moderating growth and inflation outlook, a pause will be both signaled and warranted.

European Outlook

In hindsight it was the very strong performance of the eurozone economy from mid-2016 to early-2018 that sowed the seeds for the disappointing outcome in 2018. The bar for the eurozone was raised and expectations grew that the strong performance would continue. The slowdown in eurozone economic growth since the start of 2018 stems from a loss of momentum in global activity. Fears over trade wars have led to a weaker global growth impulse and the stronger outcome for the U.S. has not been as supportive of growth for other countries. This global slowdown has been exacerbated by contraction of the German economy in 3Q18, mainly stemming from a large fall in auto production due to new tighter emission tests. Forward-looking surveys have weakened but importantly point to a moderation in growth, not a move toward much weaker growth outcomes.

Looking ahead, we believe that eurozone growth in 2019 (1.8%) will remain above trend (1.25%) and this will foster further falls in unemployment and a gradual rise in wages and core inflation, allowing the European Central Bank to continue down its path toward policy normalization.

Japanese Outlook

The Japanese economy posted a -1.2% GDP contraction in 3Q18, but we believe that this should be transitory due to a series of natural disasters, such as the severe floods in the western part of Japan and the earthquake in Hokkaido. We believe the economy will continue to grow above potential until 4Q19 when the consumption tax is set to increase from 8% to 10%. Robust capital expenditures and continuing positive investment sentiment and steady growth in exports will also likely drive the economy forward in the coming quarters. Moreover, the administration of Prime Minister Shinzo Abe has started to address demographic challenges with the reform of labor markets including foreign workers in Japan, which should be positive over the longer term.

The greatest downside risk to the economy would be an acceleration in weakening external demand due to increasing trade tension between the U.S.  and China. That stated, we believe the Bank of Japan is committed to supporting domestic economic activity via its current monetary policy approach. At this moment, we do not see anything that would push the Japanese economy into a recession.

Emerging Markets Outlook

We believe EM is the most undervalued asset class. Extreme market pessimism pulled the entire asset class downward in 2018 despite important positives in the sector, such as remarkably subdued inflation and resilient sovereign and corporate balance sheets.

Consider the following statistics:  index yield spreads between EM debt and developed market (DM) debt are near 2008 and 2016 levels; currency levels are 35% lower than just five years ago, and the real yield of EM debt is at a 15-year wide versus the real yield of DM debt. While the path to improving risk sentiment may well still be volatile, we believe EM would be the biggest beneficiary of any attenuation of the global risks.

Emerging Markets (EM), the Most Undervalued Asset Class
Real Yield Differential (EM vs. DM)
Source: Bloomberg, HSBC as of Oct. 31, 2018. EM real yield is derived from government yields and inflation using the Purchasing Power Parity (PPP)-weighted average of Brazil, China India, Indonesia, Mexico, Poland, Russia, S. Africa, and Turkey. DM real yield is derived from government yields and inflation using the PPP-weighted average of Germany, Japan, UK, and the US. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

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Definitions

A basis point is one one-hundredth (1/100, or 0.01) of one percent.

"Brexit" is a shorthand term referring to the UK vote to exit the European Union.

Developed markets refers to countries that have sound, well-established economies and are therefore thought to offer safer, more stable investment opportunities than developing markets.

Emerging markets (EM) are nations with social or business activity in the process of rapid growth and industrialization. These nations are sometimes also referred to as developing or less developed countries.

The European Central Bank (ECB) is responsible for the monetary system of the European Union (EU) and the euro currency.

The European Union (EU) is an economic and political union established in 1993 by members of the European Community. The EU now comprises 28 countries after its expansion to include numerous Central and Eastern European nations.

The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

The neutral rate is the federal reserve targe rate that is consistent full employment and capacity utilization and stable prices. It is also called the terminal rate or neutral interest rate.

Real yields are calculated by adjusting stated yields to compensate for inflation expectations over the time period during which the yields are expected to be paid.

A spread is the difference in yield between two different types of fixed income securities with similar maturities


Disclosures

Currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

Yields represent past performance and there is no guarantee they will continue to be paid.

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  • Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.

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