Market Outlook: Global Fixed Income

The Limits of U.S. Growth

By Jack McIntyre, Global Fixed Income Portfolio Manager
One of the major global macro themes of 2018 centered on robust U.S. economic growth relative to the rest of the world. Supercharged U.S. growth and countertrend dollar strength were the consequences of late-cycle stimulus. We think divergence in relative growth has its limits, and therefore expect these growth rates to converge in 2019. Federal Reserve (Fed) policymaking and relations between the U.S. and China should be the greatest determinants of global economic growth in 2019.  

The Fed as Hegemon

The Fed remains the hegemon of global monetary policy, thanks in large part to the world’s heavy reliance upon dollar funding. A great deal of time was spent analyzing the comments Fed Chair Jerome Powell made during his first year at the helm of the central bank, whether it was about emerging markets being “well placed” to navigate tightening U.S. monetary policy, hawkishness due to the relative strength of the U.S. economy, or the Fed’s neutral rate. We expect investors to continue scrutinizing how Powell and the rest of the Federal Open Market Committee (FOMC) regard these factors in 2019. The Fed has two paths to follow in 2019: either hike rates 1-2 times or 3-4 times before taking a pause in its current tightening cycle. We think it would be prudent for the Fed to pause after 1-2 rate hikes in 2019 in order for the lag effects to work their way through the economy. Furthermore, the Fed will continue to normalize its balance sheet behind the scenes in 2019, which implies additional tightening. 

The health of the U.S. economy will undoubtedly continue to have the greatest influence on a Powell-led Fed in 2019. At Brandywine Global, we expect U.S. economic growth to come off its lofty levels. The supercharged effects of tax cut stimulus should start to wear off in 2019. We have also already started to notice that some important sectors of the U.S. economy looked soft in late 2018; this weakness should extend into 2019. In the domestic banking system, narrow money growth has slowed, the personal savings rate remains elevated, and household credit has not picked up. Mortgage applications have been off around 20% year-on-year, new home sales have softened, auto sales have been flat-to-down for three years, and consumer confidence has softened. We would not be surprised to see a gradual deceleration in U.S. gross domestic product (GDP) growth, which could fall from current levels around 3.5% to something around 2.0-2.5% by the end of 2019.

U.S. corporate profit margins have already been getting squeezed, and another round of tariffs—which are set to be implemented in January 2019—could exacerbate that problem. In 2019, equity and bond investors will be evaluating whether companies can pass on higher input costs vis-à-vis rising wages and tariffs to their customers. The Fed will also be watching rising input costs closely, as this function will impact its neutral rate and tightening schedule.  If companies cannot pass these costs along to the customer, then we expect the neutral rate to remain lower and for the Fed to back off additional rate hikes sooner than expected. This scenario could be potentially bullish for the Treasury market, bearish for equity investors, and bearish for the dollar. 

Global Trade

We expect to see a continued ramping up of stimulus policies in China in 2019, which should offset any draft in trade if the country does not reach a détente with the U.S. The stimulus response in China throughout 2018 has been underwhelming, which leads us to believe that the country’s leadership may be storing dry powder if the U.S. enacts additional protectionist measures.  We believe the Chinese government and the People’s Bank of China have the resources to do whatever it takes in 2019 to accelerate growth. We anticipate that significant policy initiatives in China will be expansionary in 2019, and as a result, economic growth should modestly register above expectations.

The future of trade will also inevitably affect export-centric economies like Japan and the Eurozone. In 2019, we will be looking at the world from the perspective of the G3 versus the G20—much like we did in 2018. While the European Central Bank (ECB) has every intention of sounding more hawkish in 2019, we think this will be ultimately very difficult for President Mario Draghi, as the Eurozone is expected to slow throughout the year. Hawkishness will be even more difficult for the Bank of Japan (BoJ), though the central bank could pull back on yield curve control in 2019. If U.S. economic growth is expected to slow in 2019, then where will we find those pockets of economic activities? 

Ultimately, our 2019 outlook will be an extension of our current thinking. There are pockets of the global bond and currency markets that exhibit price dislocations, where asset prices do not reflect actual fundamentals. For example, we believe Swedish krona valuations—particularly relative to the euro—simply do not reflect the strength of the underlying economy. Compared to the ECB, Sweden’s Riksbank has turned less dovish, and the data should continue to support its shift in rhetoric. So while we expect G3 growth to moderate, that shouldn’t be the case for the broader G20. Looking at the real 10-year government bond yields within emerging and developed markets, these valuation anomalies become clear:

Real 10-Year Government Yields
Emerging Markets versus Developed Markets
Soure: Macrobond as of 11/30/18. Reflects GDP-weighted average of the real yields (based on Consumer Price Indexes) for countries in each category. 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.
Global Headline Inflation
Emerging Markets versus Advanced Economies
Source: Haver Analytics. Reflects year-over-year % change in CPI for countries in each category, weighted by GDP. 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.

Together, these charts show that the inflation expectations priced into emerging market bonds are just too high relative to actual inflation rates, while expectations for the developed world are low. We think adjusting inflation expectations in 2019 will compress this spread.

There are risks to our scenario. The first downside risk involves the Fed, and if it were to tighten too much, causing something to “break” in the U.S. economy, whether it is increasing corporate borrowing costs, an uptick in default rates, falling corporate profits, a prolonged equity market selloff, or renewed dollar strength. There could be a silver lining in this downside scenario, as some of these indicators could convince Powell and the FOMC to dial down its policy rate increases. The most bearish outcome would be a combination of an overly hawkish Fed along with an escalation from trade tension to an all-out economic Cold War between the U.S. and China. How these issues get resolved over the course of 2019 will be central to global asset market performance and our investment outlook.  

 

2019 Investment Outlooks
Brandywine Global
The Limits of U.S. Growth
Clarion Partners
An Extended Business Cycle
ClearBridge
Liquidity is the Question
EnTrustPermal
A Plethora of Risks
Martin Currie
Current Volatility, Long-Term Opportunity
QS Investors
Choppy Markets Ahead
RARE Infrastructure
Time to Get Defensive?
Royce & Associates
A Shift Toward Cyclicals
Western Asset
Focus on Growth

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Definitions

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

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 Federal Open Market Committee (FOMC) is a policy-making body of the Federal Reserve System responsible for the formulation of a policy designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

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 Fed’s neutral rate is the rate that is consistent full employment and capacity utilization and stable prices. It is also called the terminal rate or neutral interest rate.

G3 refers to the world's top three developed economies: US, Europe and Japan.

Gross Domestic Product (“GDP”) is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.

The Group of Twenty (also known as the G-20 or G20) is an international forum for the governments and central bank governors from 20 major economies. The members include 19 individual countries—Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, the United Kingdom and the United States—along with the European Union (EU). The EU is represented by the European Commission and by the European Central Bank.

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


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