q4 2019 economic outlook survival guide to the global …€¦ · q4 2019 economic outlook survival...

Q4 2019 ECONOMIC OUTLOOK

Survival guide to the global slowdownLow interest rates, higher volatility and eroding fundamentals all mean investors could require a more sophisticated tool kit.

Lara RhameChief U.S. Economist

Lara is Chief U.S. Economist at FS Investments, where she analyzes developments in the global and U.S. economies and financial markets. Her fresh take on macroeconomic issues helps to inform and develop the firm’s long-term views on the economy, investment trends and issues facing investors. Lara is committed to the Philadelphia community and serves on the board of both the Economy League of Greater Philadelphia and Starr Garden Park.

FS Investment Solutions, LLC 201 Rouse Boulevard, Philadelphia, PA 19112 www.fsinvestmentsolutions.com 877-628-8575 Member FINRA/SIPC© 2019 FS Investments www.fsinvestments.com

This information is educational in nature and does not constitute a financial promotion, investment advice or an inducement or incitement to participate in any product, offering or investment. FS Investments is not adopting, making a recommendation for or endorsing any investment strategy or particular security. All views, opinions and positions expressed herein are that of the author and do not necessarily reflect the views, opinions or positions of FS Investments. All opinions are subject to change without notice, and you should always obtain current information and perform due diligence before participating in any investment. FS Investments does not provide legal or tax advice and the information herein should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact any investment result. FS Investments cannot guarantee that the information herein is accurate, complete, or timely. FS Investments makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information.

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Robert Hoffman, CFA Executive Director

Lara Rhame Chief U.S. Economist

Andrew Korz Associate

Kara O’Halloran, CFA Associate

Contact [email protected]

http://www.fsinvestmentsolutions.com

http://www.fsinvestments.com


Investment Research FS Investments 1

Survival guide to a global slowdownExecutive summary Global growth is slowing, and interest rates have plunged. The U.S. economy is still in its record-setting expansion, but vulnerabilities have increased due to the corrosive impact of policy uncertainty. We offer a survival guide to this increasingly challenging landscape, including the top indicators we are watching. We don’t forecast a recession over the next two years, but low interest rates, higher volatility and eroding fundamentals all mean investors could require a more sophisticated tool kit.

Global growth hits the skids The global economy decelerated sharply over the past quarter, increasing the headwinds facing U.S. growth. Germany and the U.K. both experienced negative growth in the second quarter, and global measures of industrial production and sentiment are moving lower. The OECD recently downgraded its global growth estimate to 2.9%, the slowest since 2009, which was the last year of the Great Recession. China’s growth is expected to slow to 6.1%, the lowest in decades. This has rightly raised the question of whether this global slowdown will be the final straw that breaks the record-long U.S. expansion.

Back in the U.S., growth in 2019 has evolved broadly as we had expected. GDP in the first half averaged 2.6%, down from the blistering pace of 2.9% growth in 2018. But growth continues to decelerate. We still expect GDP of roughly two and a quarter percent in 2019, which implies growth of 1.7% in the second half of the year. Markets are naturally challenged by slowing growth, but given estimates of the U.S. underlying potential growth rate of 1.9%, our outlook for 2019 is hardly pessimistic.

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2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

U.S. GROWTH IS LOSING MOMENTUM

% quarter/quarter% year/year

Source: Bureau of Economic Analysis



Looking beyond the next quarter, however, the picture is certainly complicated enough to require a survival guide. One fresh concern is that U.S. growth has become significantly lopsided. In Q2, consumer spending grew 4.7%, while the entire rest of the economy contracted 3.7%.

The consumer will make or break the expansion Increasingly, the fate of our expansion lies in the hands of the consumer. Consumption makes up 69% of the entire U.S. economy, dwarfing other sectors, and a necessary condition for recessions in the past has been a contraction in household spending. This puts the consumer squarely in the spotlight of our outlook.

Happily, the consumer is well supported, and the outlook remains positive. One of the clearest signs that the volatility that has afflicted Wall Street has not hit Main Street is strong levels of consumer confidence. Two key measures of consumer sentiment remain near expansion highs, and one of our favorite bellwether indexes – the spread of consumer expectations to present situations – remains elevated as well. Global trade tensions could put a significant dent in consumer sentiment, particularly as the next tranche of tariffs stands to include many consumer goods. However, looking ahead, we expect the consumer to only bend and not break.

The labor market is another critical sector that will influence household spending and, therefore, the trajectory of the economy over the coming quarter. Initial jobless claims remains our favorite indicator both for the labor market, in general, and as a potential warning sign that a recession is coming. Currently, initial claims rest near multidecade lows, a reflection of the tight labor market and a sign that despite heightened uncertainty around trade and global growth, companies have not yet resorted to layoffs.

In contrast to the upbeat picture of consumer confidence and the labor market, business sentiment is wilting under the strain of slower global growth and last quarter’s further escalation of U.S.-China trade tensions. Yet even here, the impact has been uneven. Measures of manufacturing sentiment have soured notably over the past quarter, with the ISM Manufacturing Index moving below the 50/50 boom/bust line for the first time since 2016, while the nonmanufacturing measure that reflects services has fared better. To us, a more severe erosion in business sentiment is one of the biggest risks to our view, particularly as we enter 2020 and election rhetoric could make the regulatory outlook highly uncertain.

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2014 2015 2016 2017 2018 2019

THE CONSUMER IS THE ENGINE OF GROWTH FOR THE ECONOMY

Total GDP

Personal consumption spending

Source: Bureau of Economic Analysis, indexed to Q2 2014 = 100.



Put together, this creates a landscape of an economy that we expect to slow further but we expect will avoid a recession, at least in 2020. Growth could swoon to an uncomfortably slow pace, however, and could even include a quarter of negative growth. Investors are too focused on whether or not the economy is going into a recession (bad outcome) or not (good outcome). They are missing the most likely outcome: sluggish growth that avoids a recession but still causes equity market valuations to recalibrate and bogs yields down at or near historic lows.

Global pessimism is creeping in This outlook for slowing growth that avoids a recession gets riskier as the non-U.S. developed world decelerates. We have long noted that trade uncertainty is the biggest risk to U.S. growth. Over the past quarter, trade tensions escalated further, and a fresh round of tariffs is expected to more significantly impact households in Q4.

Trade-related uncertainty has impacted non-U.S. developed economies, with a reverberated impact to the U.S. investor through lower global interest rates. Indeed, one of the most notable trends of Q3 was the plunge in international interest rates. This was partly driven by global central banks swinging toward easier policies, and partly because global growth has broadly disappointed. There remains the critical question of how far global central banks are willing to engage in further rate cuts, and the overarching doubt about how impactful these will be in stimulating growth in the face of uncertainty.

Yield curve inversion is another sign of global pessimism, as the 3M-10Y spread has been negative for almost all of the last four months. While we agree markets are correctly forecasting a slowdown, we think there are three reasons to rethink yield curve inversion in this cycle. We are watching the signal the yield curve is sending closely, but think the interpretation may need to be more nuanced.

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2012 2013 2014 2015 2016 2017 2018 2019

GLOBAL PRODUCTION AND TRADE HAVE LEVELED OFF

World exports

World imports

World industrial production

Source: Netherlands Bureau for Economic Policy Analysis; Jan. 2012 = 100.



Finally, other international factors have added to the volatile nature of the global climate. China’s devaluation of the yuan in late August caused the dollar to surge on a trade-weighted basis. Currencies are now front and center in the political debate, with speculation that the U.S. may even push for intervention to weaken the dollar in the coming months. This new front in the trade war needs to be closely monitored.

Survival of the steadiest This, then, is the landscape that investors need to survive. What is in the tool kit of the investor to manage an environment of slow global growth, low interest rates and higher volatility? Slower global growth will ratchet up uncertainty and pressure on the profit outlook for large multinational companies. Central bank policies may – or may not – reignite growth but will definitely keep interest rates low. We expect the U.S. economy to avoid a recession but to be increasingly lopsided. In this environment, month by month, the data could easily temporarily surprise to the downside, causing alarm bells to sound and, feeding back into higher volatility.

Managing this volatility will be increasingly difficult. For equities, stock buybacks were a support for valuations throughout 2018, yet the first half of 2019 saw the pace of buybacks slow. This support for equity prices is eroding at the same time as global growth is looking increasingly shaky and trade uncertainty is as high as it has been during the past two years. While equities have strong year-to-date gains, the S&P 500 is up only 2.0% from a year ago.1

Traditional fixed income markets have traditionally offered shelter from the storm of volatility and, on the surface, assets like the Barclays Agg have performed very well this year. And yet, these gains have been almost entirely managed through price appreciation. Going forward, low interest rates are going to limit returns from income. Even worse, the dark side of duration became painfully evident as volatility has risen significantly in the traditional space, negating one of the primary reasons to seek an income-driven allocation.

1 September 20, 2019 vs. September 20, 2018.



Consumer confidence: Will consumers bend or break? KEY TAKEAWAYS • The consumer is the primary engine of U.S. growth. • Consumer confidence remains near expansion highs. • We expect the consumer to bend, not break.

The consumer is the single largest sector of the economy and is increasingly isolated as the driver of growth keeping the U.S. economic expansion from ending. Household spending is supported by strong domestic fundamentals, but external headwinds are accumulating rapidly. We maintain our outlook that Main Street is more isolated from volatility than Wall Street, but we may be in store for some slowing in consumption. Whether the consumer bends in the face of headwinds, or breaks, will be central to the broader economic outlook.

At a macro level, the U.S. consumer has reason to be happy. The labor market is tight, and wage growth has finally picked up some speed and is the highest in 10 years. Years of solid asset appreciation have caused household wealth to increase to a fresh high. Finally, though we are arguably late in the economic cycle, the consumer does not appear overleveraged, and the savings rate is at 7.5%, higher than during the prior expansion. All of this offers both a solid foundation for consumption and some insulation in the face of slower global growth and rising uncertainties.

This is not to downplay the looming risk of fresh tariffs that are planned as early as October 1 and, as announced, include a significant number of consumer goods that could directly impact households.

We will be watching our single favorite indicator of consumer sentiment: a simple spread between the Conference Board’s Present Situations Index and Expectations Index. Historically, this has had a good track record of timing the start of a recession. At present, this spread rests near cycle highs. This could offer an early warning to see whether households are radically cutting back spending, which could put our entire economic expansion at risk.

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CONSUMER CONFIDENCE IS STRONG

Conference Board (lhs) Univ. of Michigan (rhs)

Source: Conference Board, University of Michigan.

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CONSUMER CONFIDENCE SPREAD REMAINS ELEVATED

Source: Conference Board, NBER. Shaded areas represent NBER recessions.Note: Consumer confidence spread indicates the Present Situations Index minus the Expectations Index.



Initial jobless claims: Our favorite leading indicator KEY TAKEAWAYS • Spikes in initial claims often precede a recession. • Happily, initial claims rest near four-decade lows. • A strong labor market supports household spending.

Initial jobless claims continues to be one of our favorite leading indicators of a turn in the business cycle. Happily, initial claims rest near multidecade lows, a reflection of the tight labor market and a sign that, despite weakening business sentiment and heightened policy uncertainty, companies have not yet resorted to layoffs at a macro level. Should the economy slow further – as we expect – concerns about a recession will remain top of mind. We will keep you updated on this little indicator that sends a big signal.

By virtually every measure, the labor market remains strong. The unemployment rate is 3.7%, just off the cycle low of 3.6%, itself the lowest since 1969. During the third quarter, the pace of hiring slowed, as nonfarm payroll gains averaged 145,000, down from the 12-month average of 173,000 per month. However, the slower growth of our labor force means that fewer new jobs are required to hold the unemployment rate at its current level. However, slowing payroll growth has ignited questions of the health of the broader economy.

For this reason, looking at layoffs is perhaps an even better indication of business sentiment and the economy. Initial claims for unemployment insurance, when a worker applies for state-sponsored unemployment benefits, typically bottom 9–24 months before a recession begins. A 25% increase in initial claims over an 8-week period would be a clear warning sign that broad-based uncertainty is causing companies to increase layoffs. Should claims rise over 275,000 for several months, we would become more pessimistic about our growth outlook.

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UNEMPLOYMENT RATE

Jobless rate

Fed estimate of long-run equilibrium

Source: Bureau of Labor Statistics, Federal Reserve.

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INITIAL JOBLESS CLAIMS

Source: Department of Labor, NBER. Shaded areas represent NBER recessions.



Business sentiment: The mood soursKEY TAKEAWAYS • Sentiment is wilting in the face of trade uncertainty. • Impact is uneven, with manufacturing hit hardest. • So far, pessimism hasn’t translated into layoffs.

Perhaps one of the most concerning developments over the past quarter has been the plunge in manufacturing sentiment, and a broader decline in business confidence and activity. For some time now, manufacturers have been navigating higher costs due to tariffs on inputs. However, uncertainty has risen and the global growth slowdown is more pronounced – adding to the strain.

The adverse impact on business sentiment has been uneven, with manufacturing showing the greatest pessimism. In August the ISM dropped to 49.1, its first time below the 50/50 expansion/contraction line since 2016. A confluence of factors caused business sentiment to sour. Trade tensions have been elevated for years but surged once again in the third quarter. This coincided with the surprising and significant deterioration in developed economy growth.

Non-manufacturing business sentiment – mainly services – has fared better, but is still weakened from its recent highs. The average of the three months ending in August was 55.1 vs. 58.2 over the prior year.

Other measures of confidence, like the NFIB Small Business Optimism Index, are mirroring the services sector with a recent downturn that is not yet severe.

Weak sentiment has moved in line with slowing industrial output, which is now up only 0.4% y/y and itself reflects the global trend of weakening output. The manufacturing sector is a much smaller portion of the U.S. economy than the services sector, contributing only 13% to overall growth versus 70% for services. It is also relatively more exposed to factors like weak global growth and the strong dollar, which make U.S. goods relatively expensive on the global market.

We have seen manufacturing experience bouts of weakness before. Indeed, this is the third significant downturn in manufacturing sentiment for this expansion. The first coincided with the recession in Europe in 2012, and the second was a result of weakness in the energy sector in 2015–2016. The broader U.S. economy weathered these more localized storms but did experience broadly weaker growth each time.

We will be watching the ISM business sentiment indicators closely, although we acknowledge that previously we were focused on investment trends. Now we add a focus on businesses’ employment intentions.

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ISM BUSINESS SENTIMENT INDICATORS

Manufacturing Non-manufacturing

Source: Institute of Supply Management.

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NONRESIDENTIAL STRUCTURES INVESTMENT

Mining exploration, shafts & wells (lhs) All other (rhs)

Source: Macrobond, BEA.

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ISM BUSINESS SENTIMENT INDICATORS

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Source: Institute of Supply Management.



Trade tensions: It’s really about the uncertainty KEY TAKEAWAYS • Trade tensions are still the single largest risk

to growth. • The new tranche of tariffs could impact consumers. • Trade tensions will continue to add volatility.

It is hard to name a more corrosive influence on U.S. growth over the past two years than trade-related uncertainty, which has continued to ratchet higher. Trade policy uncertainty has sparked significant volatility on Wall Street, although so far Main Street has remained relatively unscathed. We continue to put low odds on a lasting, enforceable trade deal within the next year, and see trade as a continued headwind to growth.

Over the past quarter, U.S. trade tensions with China were once again inflamed as the White House increased tariffs from 25% to 30% on $270 billion of goods, and a new tranche of tariffs was announced to take effect on October 1 of this year (some of which were delayed until December 15).

Looking ahead, we don’t expect trade uncertainty to be resolved anytime soon. The elections are still a year away, but trade will likely be a key topic with inflamed rhetoric. Regardless of the election outcome, it is hard to imagine long-simmering issues of the U.S.-China

relationship being pushed back under a placid surface again.

It is difficult to measure the direct economic impact of the actual trade measures that have been implemented. We can expect consumer prices to rise as tariffs impact a growing swath of consumer goods. But knowing exactly how much of the price increase will hit the household pocketbook is difficult to model.

More important is the continued strain caused by uncertainty. A recent study by the Federal Reserve showed that the uncertainty alone, before the actual dollars and cents of tariffs hit the economy or prices, is enough to cause businesses to choose caution over investment and adversely impact other economic activity.

Finally, trade tensions continue to have a significant impact on financial markets. Headlines about U.S.-China trade relations are often the key driver of equities on a day-to-day basis. In early August, the announcement of fresh tariffs caused interest rates to fall sharply and markets to price in further Fed rate cuts. All of this caused a rise in bond market volatility as well. We expect trade-related news will be at the top of our watchlist for the foreseeable future.

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INDEX OF TRADE POLICY UNCERTAINTY

Source: Federal Reserve; Dario Caldara, et al, “Does Trade Policy Uncertainty Affect Global Economic Activity?,” FEDS Notes, September 4, 2019.

HOUSEHOLDS: HERE COME TARIFFS

$ billions Proposed Categories

$34 Increase to 30% on Oct. 1, 2019*

Industrial machinery, capital goods


Electrical equipment, capital goods


Furniture, electronics, autos, leather goods, capital goods

$10415% on Sep. 1, 2019 (not yet implemented)

Apparel, footw ear, electronics, TVs/monitors

$156 15% on Dec. 15, 2019

Cell phones, computers, toys, electronics

Note: value of goods and percentages of tariffs are approximate.* tariffs are already being levied.



Low global rates: Developed world has a problemKEY TAKEAWAYS • Global interest rates plunged in Q3. • Central bank easing may struggle to help growth. • We expect yields to remain low for some time.

Falling global growth and low global interest rates were a key influence on the U.S. economy and investors over the past quarter. It is worth considering both the spheres of influence international macroeconomic trends have on the U.S. economy and the challenges we expect in the coming quarter.

The developed world has a problem. We have often discussed the multidecade trend of slower structural growth, driven by aging demographics and slower productivity growth. On top of that, however, the trade-related decline in output and other policy uncertainty (Brexit springs to mind) have caused growth to slow sharply, causing monetary policymakers to swing into action. But what action is there to undertake?

In Q3, central banks began (Fed, ECB, Australia, NZ) or are expected to begin (Japan) cutting policy rates, and interest rates plunged in Q3. Central banks that had been expected to wind down unconventional policies like quantitative easing have started ramping them back up. However, policies that were utilized during the financial crises have not proven effective at jump-starting the economy.

What they have done is push interest rates to new lows. In Q3, the 10-year U.S. Treasury came within 15 bps of the post-WWII low experienced in 2016 (flight to quality post-Brexit). In Germany, 10-year government yields moved to an all-time low of -71 bps, although they have since recovered somewhat. The amount of negative-yielding debt outstanding briefly surged to over $17 trillion. In this topsy-turvy world, several large corporate bond issuances made headlines with a negative yield.

Yet there remains the critical question of how far global central banks are willing to engage in further rate cuts, and how impactful these will be in stimulating growth in the face of uncertainty. For the Fed, the markets became too pessimistic and had priced in a rate cut at each of the meetings left in 2019. Since then, partly in response to Fed guidance about a more modest “mid-cycle adjustment,” markets have reversed some of those expectations.

U.S. government bond yields remain the highest in the G7, but this global trend of lower rates will continue to drive demand for U.S. Treasuries and keep yields low. Indeed, risks seem skewed toward a more significant downside surprise abroad triggering another move lower in U.S. yields, even if the U.S. economic expansion lasts as we expect.

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GLOBAL NEGATIVE-YIELDING DEBT

Source: Bloomberg Finance, L.P., $ trillions.

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10-YEAR SOVEREIGN YIELD CHANGES, YTD

U.S.U.K.GermanyJapan

Source: Macrobond.

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Yield curve: Rethinking inversionKEY TAKEAWAYS • Yield curve inversion shows bond market pessimism.• Yet for three reasons, inversion may be different now.• The yield curve remains high on our watchlist.

The yield curve inversion – when short-term rates are higher than long-term rates – has been fairly consistent since May 22, 2019, in the 3-month Treasury bill versus the 10-year Treasury note yields part of the curve. This has raised alarm bells for investors for good reason: Yield curve inversion typically precedes recession. Yet we see three reasons why yield curve inversion may not be telegraphing with the same precision now as in prior cycles.

First, yield curve inversion has historically occurred because short-term rates are rising as a result of Fed rate hikes, a policy to restrain economic growth. This time, however, the Fed is cutting rates. Yield curve inversion is occurring because long-term rates have plunged, which reflects pessimism about future growth prospects. But much of this pressure is coming from abroad, particularly Germany, where data has been weak and the 10-year bond yield fell to -71 bps in Q3, a historic low.

Second, yield curve inversion is not as robust as prior episodes. The 3M-10Y spread is inverted, but the 2Y-10Y is not. This also speaks to the unique nature of this period, where a variety of factors are influencing rates beyond domestic monetary policy.

Finally, this expansion has not been the same as prior expansions. In decades past, a more classic boom-bust cycle of capex spending drove growth, which was highly interest-rate sensitive. Now, the expansion has been largely fueled by the consumer. Moreover, while rate hikes did impact some interest-rate-sensitive sectors like the housing market, rates remain near historic lows. The rate hikes of 2016–2018 were more gradual and may not have done as much to impede growth as prior rate hike cycles.

We will continue to watch yield curve inversion closely, as this is the manifestation of what analysts call “bond market pessimism.” Remember, there is no reason why yield curve inversion, in and of itself, causes a recession. Yet the historic relationship is undeniable. Markets are pricing for a slowdown, and we agree. But yield curve inversion has specifically heightened expectations of a recession. We think, this time around, the signal may require a more nuanced interpretation.

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PROBABILITY OF RECESSION WITHIN 1 YEAR, IMPLIED BY YIELD CURVE

Source: Federal Reserve Bank of Cleveland.

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YIELD CURVE HAS FLATTENED

3M-10Y spread2Y-10Y spread

Source: Federal Reserve, NBER. Shaded areas represent NBER recessions.

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The U.S. dollar: Dollar drama adds volatilityKEY TAKEAWAYS • The dollar is at multidecade highs. • A strong dollar is a headwind to growth. • Notoriously volatile FX markets may add uncertainty.

The U.S. dollar hit a multidecade high versus a trade-weighted basket of currencies in Q3, pushed in part by China’s devaluation of the yuan. This has increased speculation the U.S. may intervene to weaken the dollar. We don’t expect a significant shift in U.S. dollar policy, but FX markets are notoriously volatile and could amplify other market uncertainty. And keep in mind that all else equal, a strong dollar is a headwind for U.S. growth.

There are numerous ways to measure the value of the dollar, but the Fed’s measure of the broad trade-weighted basket is one of the most closely followed. The index goes back to 1997 and hit its all-time high in Q3. In late August, China devalued the yuan to the lowest since 2008 in direct retaliation for a new set of tariffs announced by the White House. This opened up another front in the trade war with China, which weakened its currency as much as 4.3% from the beginning of Q3 to early September.

A strong dollar acts as a headwind for U.S. growth, all else equal. It makes our exports more expensive for

foreign buyers and weakens dollar-denominated profits of companies selling U.S. services abroad. The strong dollar has drawn strong rhetoric from the U.S. administration, despite the fact that part of the dollar strength is due to a relatively better-performing economy and interest rates that are higher than most other developed economies. Indeed, an irony is that in times of global uncertainty, dollar-denominated assets are in higher demand as a safer asset, which reinforces dollar strength.

Despite threats that the U.S. could intervene to weaken the dollar, that is not our expectation. One hurdle to intervention is the lack of tools to make it effective and meaningfully shift the value of the dollar in markets. The U.S. Treasury has only a limited amount of FX reserves to utilize in a market that is trillions of dollars large. The Fed could help, but this could raise a host of further questions about Fed independence, which is already a hot-button topic, particularly because the Fed is supposed to focus on domestic conditions.

We do expect the rhetoric around dollar strength to remain heated. FX markets are notoriously volatile and could add to the broader policy uncertainty that is affecting global growth.

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USD TRADE-WEIGHTED INDEX

Source: Federal Reserve.

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MONTHLY U.S. TRADE BALANCE (EX PETROLEUM)

Source: U.S. Census Bureau, $ billions.



Fixed income: The dark side of duration KEY TAKEAWAYS • Strong returns have come mostly from price gains. • Over the long run, returns follow interest rates. • High duration means more vulnerability to volatility.

Traditional fixed income assets have performed well this year, although those gains have been almost entirely managed through price appreciation. Going forward, low interest rates are going to limit returns from income. Even worse, the dark side of duration may become painfully evident as volatility has risen significantly, negating one of the primary reasons to seek an income-driven allocation.

So far in 2019, the 10-year Treasury yield is down almost 100 bps year to date,2 with August experiencing a 52 bps plunge. This has fueled strong returns, but looking more closely at where returns have come from should raise an alarm.

In the past, when interest rates were higher, a 6%–7% return was achieved through income. This aligns with the role of traditional bond investments in a portfolio – to be a shelter from the storm with steady, stable gains to offset volatility from the equity market. Yet as yields have fallen, the erosion in income has become severe.

2 Federal Reserve, as of September 21, 2019.

This year, the extraordinary gain in bond prices has masked what is meager income.

This poses two problems: First, the outlook for future returns hinges almost entirely on further price gains, but how much further do investors expect yields to fall? Significant pessimism is already priced into markets. In fact, markets may be caught wrong-footed if growth continues as we expect.

Second, the Barclays Agg has a duration of 5.8, meaning that the price sensitivity to changes in interest rates is 6X. The dark side of duration could become increasingly apparent, and core fixed income could start to experience volatility that feels like an equity investment. The MOVE Index of one-month forward Treasury market volatility (similar to the VIX index for equities) hit a 3-year high in August.

Over the long term, fixed income returns closely mirror interest rates. We are in a discrete period where price has had an exceptional move, but looking ahead, returns will once again align with the low interest rate environment. This realignment will likely come with surprising volatility for an allocation typically intended to smooth overall returns, which could be a key challenge in Q4.

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BARCLAYS AGG RETURN CONTRIBUTION

Income return Price return

Source: Bloomberg Finance, L.P.



Equities: Potential roadblocks ahead KEY TAKEAWAYS • Fundamentals have deteriorated somewhat. • Level of buyback support is uncertain going forward. • Central bank recalibration has aided stocks in 2019.

Despite robust returns this year, equity fundamentals have deteriorated. The deceleration in global growth and heightened U.S.-China trade tensions have clearly had an impact on companies’ operating performance. S&P 500 companies posted a meager 2.6% year-over-year EPS growth that, while slightly better than expected, represents a significant decline from 2018. Analysts expect a further weakening of earnings in Q3 as global economic data has continued to be shaky, and there remains no end in sight to the trade conflict.

One tailwind for equities is the trend in share buybacks. Buyback activity has been elevated during most of the current cycle but reached new highs after the TCJA of 2017 provided companies an influx of cash. 2018 was a banner year for repurchases, which totaled over $800B, and that was just for the S&P 500. The trend has consistently helped boost equity returns. Since 2009, the S&P 500 Buyback Index has outperformed the broader index by 113 percentage points. However, there are signs this support may be fading. Buyback activity declined in the first two quarters of 2019, especially in Q2, when buybacks as a percentage of equity market cap fell below post-crisis averages.

On top of these offsetting factors, May and August experienced severe volatility sparked by spikes in trade-related uncertainty. Yet the S&P 500 has still managed to gain over 20% YTD. Two things are important to note: One, while the 2019 return looks stellar, the 1-year return is just 5.6%, much closer to what we would expect given the market environment. Second, we attribute much of these gains to a recalibration of global central bank expectations. Markets went from expecting rate hikes at the end of last year to pricing in more than 100 bps of rate cuts by the end of 2020.

This about-face in expectations drove a temporary reversal in the relationship between stocks and bonds. Slowing global growth drove long-term bond yields down, while the prospect for accommodative central bank policy gave equities a lift. We would expect equities and bonds to continue reverting to a more traditional, negatively correlated relationship.

With earnings pressured by growth headwinds and trade tensions, we see markets as likely to experience heightened volatility but do not necessarily see a full-blown correction. The U.S. economy, while slowing, continues to provide a solid backdrop. Looking ahead, uncertainties like trade, geopolitics and central bank policy stand to provide markets with added instability.

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S&P 500 BUYBACK ACTIVITYQuarterly buybacks ($B) (lhs)Trailing 12-mo. buybacks, % of market cap (rhs)

Source: Bloomberg Finance, L.P., Macrobond.

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CORRELATION, S&P 500 TO 10-YEAR TREASURY YIELD

Source: Bloomberg Finance, L.P. Rolling 30-day correlation shown.

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