Remaining steady amid multiple global shifts
Although the Fed has softened its stance and the labour market remains tight, the outlook for a strong US rebound in growth remains muted. Coupled with European elections nearing and anticipated slower growth in China, the outlook is neutral and portfolio decisions continue to prepare for what may come next.
Outlook and strategy
The global economy is still in a state of tension. The slowdown of the past six months comes following a period of respectable growth across most economies, albeit this growth is not rapid enough to generate much inflation or restore policy settings to ‘normal’. And it comes at a time when old imbalances (high debt levels) remain and new market risks have built.
US growth has softened, but the domestic economy remains ok, and we expect it to pick up again later in the year once the dovish Fed stance allows financial conditions to recover and some of the negative trade effects to roll through. With the labour market already tight, however, a big rebound in growth is unlikely in the absence of productivity lifting. Although we believe we are in the late stage of the US cycle, this suggests an ongoing extension of the already-long cycle, though we are monitoring our recession models closely.
Given this outlook we see US yields range-bound for a while as a patient Fed should alleviate any near-term recessionary concerns, but equally growth is unlikely to rebound strongly and drive a rapid move upwards in yields. However, a growth pickup into an already fully employed economy and a more reactive rather than pre-emptive policy approach by the Fed should see inflation lift; we continue to hold US inflation exposure and alongside this have now positioned for higher yields in the back end of the US yield curve.
China’s authorities are reluctantly easing and while this is helpful in supporting national and global growth, we think the gradualist approach to stimulus won’t drive the type of strong rebound in China that we’ve seen previously. This is particularly important both for Europe and Australia. Europe seems to be a ‘taker’ of global growth once again – recent weakness in the US and China will continue to weigh on activity. Unlike in China and the US, Europe’s monetary policy options look limited. The Italian budget standoff and looming European elections means fiscal policy is unlikely to take up the reins. We expect to see a further extension on forward guidance from the ECB as the growth and inflation outlook continues to deteriorate. With markets pricing in further easing from the ECB, we have repositioned our short in Europe to the front of the curve.
Australia has not been immune to the global slowdown. Domestically we have seen a moderation in the growth outlook, with key downside risks to housing and consumption growth. Consumers have been drawing down their savings rate when times have been good and house prices have been rising. Now that house prices are falling, the wealth effect may go into reverse and, without wages growth, the already challenged consumer looks quite negative. The labour market remains the crucial indicator for the outlook. The portfolio has maintained a long duration position in Australia given these downside risks to the Australian cycle.
February was a strong month for credit markets, which ended with spreads in the lower half of their six-month ranges. Credit has rebounded solidly from Q4 weakness with Fed tightening risks having recently receded, hopes of the US and China reaching a trade deal, and corporate results holding up (though expected to weaken over 2019). However, valuations are now back in expensive territory. Our assessment of the time to US recession and underlying credit fundamentals means we are happy to hold higher quality credit for carry but are cautious in building a significant exposure to credit at this point in the cycle. At some point, risky assets could face the headwind of either much weaker growth, or rising rates. Our portfolios are positioned long higher-quality Australian investment grade credit and short riskier US high yield, and we are remaining cautious in anticipation of opportunities to position the portfolio more constructively.
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