Weaker than expected U.S. growth. Fading political risk in Europe and lower inflation expectations. Bond investors certainly had no reason to complain about a lack of news flow lately. And then, there is the speculation about when and how the European Central Bank (ECB) might follow the U.S. Federal Reserve (Fed) in scaling back its unprecedented monetary stimulus.
Against this backdrop, neither a return to historic yield lows nor a strong sell-off in fixed-income markets is expected. In the U.S., Trumphoria has faded and been replaced by skepticism about any significant policy changes. Meanwhile, the Fed has stayed the course, despite another disappointing first quarter in terms of economic growth. It raised rates in June, and will probably do so two more times in the coming 12 months. By the end of the year, outgoing Fed chair Janet Yellen might also provide further details on how the Fed plans to reduce its balance sheet – effectively substituting further rate hikes. Underlying economic momentum looks solid in the Eurozone. China, too, looks stable.
All told, it is no wonder that Goldilocks economics has become fashionable again. Like the porridge in the children's tale, the global economy appears neither too hot nor too cold. From a market perspective, the Goldilocks metaphor is quite apt, at least for corporate credit.
Not so for government bonds. We would expect rates across much of the developed world to rise from here. As a result, total returns for long-dated U.S. Treasuries and German Bunds are likely to be negative, or at best close to zero over the next 12 months. Even riskier sovereign borrowers such as Italy and Spain, whose spreads have already been squeezed, might not deliver positive total returns on their 10-year bonds.
On the other hand, this lowers the likelihood of central banks turning hawkish. We would argue that after the financial crisis, central banks have improved their communication policy. As a result, the world may have become less prone to monetary-policy shocks relative to shocks which hit the real economy, such as oil-price movements. Of course, only time will tell how the unprecedented experiment with quantitative easing (QE) will end. In the meantime, though, we see opportunities in all credit asset classes.
While duration will weigh on absolute returns, we stick to our positive outlook for investment-grade (IG) credit in both the U.S. and Europe. On a risk-adjusted basis, IG still presents very good value for money. On both sides of the Atlantic, the story is well supported by inflows and low supply. U.S. credit fundamentals are mostly stable and could benefit from policy changes such as tax cuts and deregulation. The Eurozone economy is also improving.
We prefer financials, such as banks and Real Estate Investment Trusts (REITs) in the U.S., and banks and insurers in Europe. We are also positive on U.S. technology, while underweight in U.S. utilities, retailers, consumer non-cyclicals, as well as the European telecom, basic-materials and energy segments.
We remain constructive for high yield but see no further tightening from here. China and further oil-price declines are the biggest risk factors, while absolute yield levels are also a concern. Selection is key.
Finally, we expect emerging markets to be the most interesting asset class. This goes for sovereigns as well as corporates. Asia in particular looks well supported by the global economic recovery and continuous inflows. Things are good – for now. But, as investors in emerging markets in particular know, goldilocks scenarios rarely last forever.
For oil exporters such as Russia, further declines in the oil price pose the most immediate risk. Beyond that, it is worth remembering that the last time people were talking Goldilocks economics was in the years immediately preceding the global financial crisis. And in early versions of the tale, Goldilocks is not a little beautiful girl. Instead, the intruder who eats the three bears' porridge is an old, wrinkled spinster – a bit like the current, long-lived recovery.
The U.S. yield curve steepened after last November's election. It has since flattened again, as confidence in the new administration has waned.
Sources: Bloomberg Finance L.P., Deutsche Asset Management Investment GmbH; as of 6/28/17
Borrowing in foreign currency has gotten cheaper for emerging markets. Good solvency indicators and low issuance helped. The hunt for yield continues.
Sources: Bloomberg Finance L.P., J.P. Morgan Chase & Co; as of 6/28/17
*The J.P. Morgan Emerging Markets Bond Global Diversified Sovereign Spread Index depicts the spread of hard-currency-denominated sovereign bonds from the emerging markets vs. U.S. Treasuries of the same maturity.
Nothing lasts forever. Since 2014, we have strategically favored a stronger U.S. dollar (USD) compared to the euro. We are now revising our strategic call to $1.10 per euro. The case for the euro is easy to make. Since 2012, the Eurozone is running a sizeable external surplus at an annualized rate of more than €350bn in goods and services. Contrast this with the large and persistent current-account deficit of the U.S. economy. Over the next 12 months, interest-rate differentials could also turn in the euro's favor. Already, there are growing signs that the ECB's governing council starts looking for an exit from its quantitative-easing (QE) program. Foreign-exchange rates tend to move in cycles. We may already have seen the inflection point.
Why only $1.10 per euro and no further? Because we believe markets are beginning to expect too much, too quickly from the Eurozone. To be sure, political risks in Europe have receded following recent elections, notably in France. By contrast, U.S. politics looks more unsettled than at any point in living memory. However, the European common currency remains a very vulnerable project. Until there is clearer evidence of its structural flaws getting addressed, more signs of comparative economic strength or a more hawkish ECB, we are not ready to revise our call further just yet. Following the German elections, there might be scope for a grand bargain – with plenty of political drama along the way.
Thanks to rising competitiveness and an increase in domestic savings, the Eurozone as a whole is running sizeable current-account surpluses.
Source: Bloomberg Finance L.P.; as of 6/21/17