The first quarter of 2019 marked the end to the series of nasty surprises that stacked up at the end of 2018, and risk premiums fell back sharply at the start of this year for several reasons after a disastrous fourth quarter 2018 for financial assets overall.
On the macroeconomic arena, the end of the US cycle is postponed as shown by stabilizing leading indicators. However, the recovery in risky assets had little impact on US Treasury valuations with the 10-year fluctuating around 2.60% until February, when the Fed confirmed the accommodative take already on display in late 2018, leading to a fresh substantial easing.
These two forces – fundamental and monetary – that triggered an easing in risk and term premiums are potent enough to last into the second quarter.
Meanwhile in China, aggressive government fiscal and monetary policy provided stimulus in the country, as authorities announced fiscal measures for companies worth 2% of GDP at the National People’s Congress. A cut in VAT rate also aims to revitalize economic activity and make China more competitive as compared to its other countries.
Support from central banks
Tension between the two sides in the US-China trade war seems to have eased, but severe discord remains on certain issues, and this question could raise its ugly head again during the second quarter. There is now a significant chance of a no-deal Brexit after Theresa May failed to garner support for her deal from either her government or Parliament as a whole. With the UK economy beginning to feel the effects of these uncertainties, the Gilt continued to gain sharply. Looking to monetary policy, the Federal Reserve announced that balance sheet run-down will soon come to an end in the months ahead. The decision is in line with recent comments by Chair Jerome Powell suggesting a target size for the balance sheet in the ballpark of 16-17% of GDP. This acts as a strong support for US interest rates particularly as the interest rate hike cycle now seems to be almost finished. Meanwhile, the ECB surprised the market by further postponing any normalization of monetary policy in light of economic weakness in the area, and even kicked off a fresh two-year bank funding program to maintain accommodative financial conditions. These moves pushed the German 10-year towards zero for the first time since 2016.
Interest rates low on a longterm basis
These two forces – fundamental and monetary – that triggered an easing in risk and term premiums are potent enough to last into the second quarter. World growth remains positive, albeit fragile, and neither China nor the US is sinking into a distinctive slowdown for now. Central banks are reassured as inflation remains in check and they continue to flood the financial system with liquidity, and this financial repression will continue to promote investors’ blind quest for yield, particularly where money market rates are zero or negative. We expect the 10-year US Treasury note to remain close to current levels out to end-June 2019, and do not anticipate a rise in European long-term rates either. The ECB still needs to reinvest proceeds and this continues to underpin the market, while banks will continue to step up their sovereign debt purchases with the new TLTRO. Despite this, the Italian sovereign situation still remains a concern for 2019 although the proportion of debt held by foreign investors has fallen considerably. We remain negative on Italian debt and neutralize maturities up to two years. However, our stance on Spain and Portugal remains positive.
We expect the 10-year US Treasury note to remain close to current levels out to end-June 2019, and do not anticipate a rise in European long-term rates either.
Sound outlook for emerging debt
Given the prospect of low interest rates over the long term, we think that emerging market bonds will continue to attract international investors, even on local debt, as arguments supporting this asset class are definitely making an appearance again this year: the dollar and oil are stabilizing while not hitting new highs and the trade war is less likely to hamper the growth trend. In our view, sovereign yields on some emerging countries adjusted for volatility still harbor a lot of value. Central banks are well aware of their weak economies and flagging world
trade momentum, so they will be extremely watchful for any warning signs of a turnaround in the cycle. The financial system is still vulnerable to external shocks but is better able to cope with political uncertainties this year. Listless volumes are another expression of weakness, and the excesses of the first quarter will be tempered one way or another this quarter. We expect to see more volatility again and a weaker correlation between performances from the various asset classes from the second quarter onwards as investors seek to safeguard against certain risks and better single out sources of yield. Brexit will be a major source of concern and a worst case scenario cannot be ruled out.