US growth peaks – and more volatility to come

Outlook and strategy 

Having been startled by the Fed’s apparent hawkishness in early October, markets now assign a small chance of the Fed easing in 2019. This abrupt turnaround in expectations has been driven by concern about the pace and magnitude of US growth deceleration, given unresolved trade tension between the US and China and the rapid tightening in financial conditions courtesy of market gyrations. Helped by a falling oil price, markets have quickly shifted from worrying about upside inflation to worrying about downside growth. 

Beyond the US, the global economy has broadly been weakening for some time. However, we don’t think the economic cycle is over yet. Our recession indicators still put the most likely timing for the start of a possible US recession 12-18 months away, though this has become more probable. But we’ve clearly seen the US growth peak, and we are in the volatile late stage of the cycle. 

There is a circularity in the way financial conditions and the real economy interact – markets react to changes in the economy, but in turn the economy (via funding costs, wealth effects and sentiment) is influenced by what’s happening in markets. With monetary multipliers low (ie a lack of credit growth even with ample availability), this in turn makes policy dependent on markets. 

Central banks have been deliberately removing their accommodation, both via conventional tightening and by buying and holding fewer financial assets, essentially trying to repair the disconnect between the real economy and markets that has persisted over recent years. Global liquidity has fallen materially and is one of the reasons risky assets have been under pressure lately. An obvious circuit-breaker to the recent volatility would be a more dovish shift by central banks, responding to spillbacks both from a weakening global economy and market disruption. Unattended, it’s possible an emergency easing may be required to arrest a financial accident. 

Our view has evolved over several months. We have downshifted our view on the US economy because of the impact of trade wars and feedback from tighter financial conditions, impacting manufacturing and housing in particular. Yet despite the deceleration, the US economy remains robust and still likely to generate above potential growth over the course of 2019. We have similarly downshifted our inflation view, though still expect core inflation to pick back up above 2% driven by a tight labour market. The Fed is likely to pause tightening to review the unfolding data, but could well deliver further modest tightening. 

Elsewhere, the other key issue is China’s ongoing slowdown, fueled by both the internal crackdown on the shadow banking system and the trade war. To date the policy response has been somewhat muted. Interestingly, Australia’s key exports – iron ore and coal – have held up well as oil and industrial metals prices have fallen. Australia has had its own modest credit crunch that continues to pressure the housing market, which along with muted wage inflation, will keep the RBA from tightening anytime soon. 

The near-term set up for markets looks somewhat positive after the recent washout. It’s unlikely we get a strong growth reacceleration, but more attractive risky asset valuations and a possible dovish shift by central banks should provide support. Whereas previously we were looking for higher bond yields alongside tighter policy to unhinge risky assets, now the opportunity looks to be in selectively adding to assets that have underperformed. 

Having started the quarter with duration about 1 year shorter than benchmark, we added back considerably to be only 0.1 years shorter at year end. The buying was in both Australia and particularly the US, mostly over the month of November. This buying coincided with US yields in the upper part of their range (ie decent if not outstanding value), the downgrade in our cycle view, and some strong sentiment and momentum indicators. This leaves us a little overweight Australian interest rate risk, neutral in the US and short in Europe, where value remains poorest. Although we hold a much-reduced aggregate duration position versus the benchmark now, in addition to the country positions, we have largely kept in place both yield curve flatteners and inflation-linked exposures, and look for moderate repricing in each. We still expect to be adding considerably more duration to the portfolio on opportunity through 2019, as the US economic cycle ages further. 

Coming off very expensive levels, some value has now reappeared in credit. And while there are specific concerns about the quality of issuance in the US leveraged loan market, the quantity of BBB supply markets have absorbed in recent years, and possible defaults in certain sectors, it’s hard to see a general deterioration in credit fundamentals just yet. Given this, and supported by our earlier comments on both the timing of recession (still some way off) and a possible dovish central bank shift, we see adding to credit as the best opportunity at present. We entered the quarter underweight credit risk, and to date, we have both tentatively bought back a little of our US high yield short and added to Australian investment grade exposure. We are looking for further signs of market capitulation to add more. Having said this, given the stage of the US cycle, we are not expecting to build up a very significant credit holding at this point, and will look to preserve its quality. 

While markets never run according to script, some of our expectations for a more volatile environment have begun to play out. Our defensive positioning has helped us navigate the volatility, and we are cautiously responding to several opportunities where value has opened up. It’s environments like this where a soundly-managed defensively-oriented fixed income strategy repays it value to broader portfolios.