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Ever since the global financial crisis erupted 10 years ago we’ve asserted that the recovery of global markets would require a slow healing process over several years. This restoration of global markets is ongoing and we expect it to progress as it has thus far: unevenly. The bumpy road presented itself recently in the form of several EM challenges and pervasive uncertainty surrounding the escalating trade tensions. Yet we continue to be optimistic about both US and global growth increasing, though we note the recent divergence of US growth outpacing overall global growth. We are vigilant regarding the potential impact of the trade pressures, but don’t feel that tariffs will have a lasting impact on inflation either at home or abroad. Our base case continues to be that if we’re correct about the eventual success of the global recovery, spread sectors should offer the best fixed-income investment opportunities. Despite the recent challenges to our view, we continue to see EM as the most attractive asset class.
Market Review
- Global growth has improved from low levels, but there was a notable divergence between US growth (stronger) and growth in other parts of the world (weaker) relative to expectations.
- European growth disappointed as it downshifted recently to more reasonable levels after being well above trend. The European Central Bank (ECB) responded to slowing growth decisively with a very dovish reaction.
US Economic Outlook
- US interest rates—raised in June by the Federal Reserve (Fed) in response to better US growth and positive fiscal policy (tax cuts)—will remain very attractive relative to all other interest rates in the developed world.
- Better global growth suggests a decline in the US dollar over the longer term.
- US inflation is picking up from very low levels as core Personal Consumption Expenditures (PCE) finally reached the Fed’s target (not ceiling) of 2%, which is positive but the uptrend is still mild.
- We think the Fed will be very circumspect in moving rates higher given the current outlook.
Global Economic Outlook
- Despite improving economic momentum globally, inflation rates are moving up very slowly even in the face of improving employment conditions.
- Our view is that global growth is stabilizing in the sub 4% range, which we believe can be a sustainable pace.
- Global inflation finally increased from about zero two years ago, and continues to move up slowly and should stabilize.
- The global debt loads and changing demographics globally continue to be a secular headwind impeding global growth, but we believe they also serve to temper any meaningful upshift in global inflation.
- The uncertainty regarding trade tensions persists; fears about how the trade path will develop have a significant impact on the outlook for capital spending and real investment all over the world.
- Europe: Growth slowed from a very high level, as it was above trend; core inflation continues to be extremely slow to rise.
- Japan: Despite a disappointing first quarter, second quarter growth improved. Core inflation continues to be extraordinarily subdued, with no discernible uptrend visible.
- China: Growth will decelerate slightly, and we recognize the risks associated with the ongoing trade tensions that may present further challenges.
Investment Themes
- Sector performance so far this year has been poor, but spread products should be the primary beneficiary of the current global growth scenario moving forward.
- High-yield: Spread sectors have narrowed; we continue to look at specific components and currently favor long BBs over BBBs.
- Investment-grade: Spreads have widened; valuations are now more attractive yet we remain neutral overall. We continue to favor energy-related issuance.
- Non-agency mortgages: Agency credit risk transfers (CRTs) have performed well and we continue to favor CRTs based on the improvements in the fundamentals of the US housing market.
- EM: While emerging markets (EM) were challenged so far this year—facing headwinds from higher US rates, a higher US dollar, downshifting European, Chinese and Japanese growth, higher oil prices and trade war escalations—we still believe this area benefits from very strong fundamentals, including very low inflation, and has now overshot to the downside.
Q&A Highlights
- Long duration US government bonds continue to be an attractive hedge relative to the rates available in the rest of the developed world.
- Regarding Italy, our view is that conditions have improved but we still need to be thoughtful about our investments there; the determination of the Italian government to stay within the EU fiscal parameters is a positive.
- A meaningful breakdown in NAFTA could be very difficult for the economic progress of the US, Canada and Mexico. We expect the AMLO Administration to try to have a more prudent economic policy and relationship with the United States. Early signs so far have led us to be optimistic.
- While trade tensions are currently front and center in the news, tariffs thus far are not meaningfully disruptive to global trade.
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