The RBA may push rates to further historic lows in an attempt to create the macroeconomic conditions that will provide a lift in inflation. This leaves it vulnerable to a further deterioration of the global backdrop, where softening tailwinds, intensifying headwinds, and the return of trade uncertainties may result in a drag on growth.
2019 started very strongly, up until the end of April. Markets remained optimistic with a policy response coming together in the form of the Fed’s ‘patience’, China’s stimulus and some progress on the China-US trade deal – and a consensus formed that this is just another ‘mid-cycle slowdown’. Then we entered the month of May, where global rates markets turned abruptly into risk-off mode as the combination of macro concerns, risks of trade war and geopolitical uncertainty delivered the perfect storm. What is worrying is that this has all come at a time when the global economy continues to slow.
The US economy has been resilient up to now; however, persistent themes of softening tailwinds in the form of declining fiscal stimulus and strengthening headwinds in the form of trade tensions and China slowdown are now a threat. Together with the macroeconomic policy supports coming from the Fed’s pivot and China’s fiscal easing, we anticipated the US expansion could weather this storm. Indeed, as recently as a month ago, we were confident that a pickup in global growth would take hold later this year.
We are now less certain, with the signs of an inflection point in the global business cycle remaining quite elusive. If trade uncertainties persist, over time the drag on growth from trade frictions would likely manifest itself in diminished capital investment and lower overall economic output, posing a material risk to what is now a very long US expansion. The business sector response, rather than the direct impact of higher tariffs, poses the greatest threat to the global growth outlook.
Although gauging the size of this new drag is difficult, the policy reaction function seems far more straightforward. China is committed to maintaining growth and will likely respond to any slowing with further easing. In the US, the Fed is ready to respond to slowing GDP and help re-centre inflation. Alongside policy supports, healthy private sector fundamentals underlie the view that the latest shocks won’t tip the global economy into recession. However, even a healthy expansion can be thrown off course if buffeted by a large enough shock. It also doesn’t mean markets won’t look to price the chance of a more severe downturn in the global economy. If policy easing was to eventuate, it would be in response to weaker growth outcomes. This presumably biases the Fed towards a larger easing cycle relative to one that is based only on the need for insurance cuts.
Given this view we have been positioning the portfolio with longer duration, especially in the US where yields moved higher as the Fed tightened and there is more room for growth to disappoint. The portfolio has been biased towards a steeper US curve as the US economic cycle ages and the market moves to price a lower cash rate to support growth.
We have also continued to hold our long duration position in Australia and have added to this over the course of the month. Our recent work on Australia had us looking for the unemployment rate to rise this year, which would not be consistent with achieving RBA inflation outcomes. It is questionable whether a cut in the cash rate to 1% will be enough to deliver the macroeconomic outcomes necessary to deliver a pick-up in inflation. In addition, an already weak domestic backdrop leaves the RBA very vulnerable to a further deterioration of the global backdrop. There is the possibility that over the next few months some economic data (business confidence, housing) will turn more positive given the election result and recent fiscal policy decisions. We will be observing how large a stimulus package the newly elected Liberal-National Coalition government is willing to entertain and how quickly it can be delivered. However, we have seen globally that a shift lower in the Phillips curve means that lower rates of unemployment are now necessary to deliver targeted inflation outcomes. This is also true for Australia. Along with structural headwinds facing the domestic economy – a deleveraging of household balance sheets, persistently low-income growth, and a recalibration of lending standards – all this is consistent with a long period of low rates.
Elsewhere, we continue to hold exposure to inflation linked bonds in both Australia and the US, though we have reduced our US position. Australian inflation exposure remains cheap vs the RBA inflation target and is likely to perform if the RBA eases policy. In Europe we are maintaining a flattening view as the Eurozone looks set to be a taker of global growth once again where weakness in the US and China should weigh on activity.
Credit markets have been caught in the middle this year, having rallied despite the weakening macro outlook as central banks managed to suppress market volatility and pump up valuations once again. With the trade war escalation, fundamentals have gained the upper hand forcing credit markets to underperform. We have been happy to hold higher quality carry and have been cautious in building any significant credit exposure at this point in the cycle. We are concerned that at some point risky assets will be tested with a much weaker growth outlook leading to a valuation adjustment in assets such as US high yield. This leaves us defensively positioned in credit – maintaining high quality carry in assets like Australian credit, mortgages and higher yielding assets, while managing downside risk via a short position in US high yield. We are looking for opportunities to diversify exposures across higher quality assets, and potentially reinvest in credit markets should valuations continue to reprice to more attractive levels.
Published by Kellie Wood, Portfolio Manager, Fixed Income, Schroders