Executive Summary ► We believe the balance of risks to global growth is mildly skewed to the upside in the second half of 2015……..
By David Leduc, CFA and Thomas Higgins, PhD
► The positive effects of lower energy prices, improving labor markets, and easy financial conditions should boost growth in Developed Markets.
► This will be partially offset by the negative effects of lower commodity prices, structural bottlenecks, and tighter external financing conditions in Emerging Markets.
► Financial market volatility may result from implementation risks associated with harsh Greek fiscal reforms and potential Federal Reserve interest rate hikes.
► These bouts of volatility may create opportunities in areas of the fixed income markets where valuations cheapen, but fundamentals remain sound.
Risks Mildly Skewed to the Upside in Second Half of 2015
We believe the balance of risks to global growth is mildly skewed to the upside in the second half of 2015 as the positive effects of lower energy prices, improving labor markets, and easy financial conditions in Developed Markets (DM) offset the negative effects of lower commodity prices, structural bottlenecks, and tighter external financing conditions in Emerging Markets (EM). In the text that follows, we will discuss our biggest hits and misses on the global outlook for the first half. Then we will go into greater detail on why we remain confident about a reacceleration in global growth the second half and what opportunities this may present to global investors in the fixed income markets.
Biggest First Half Hits and Misses and the Outlook
Growth in DM countries came in below our expectations in the first half of 2015, mostly due to a mediocre performance in the United States during the first quarter. The weakness was primarily driven by temporary factors including harsh winter weather, work stoppages at West Coast Ports, and quirks in GDP seasonal adjustment factors. However, the stronger U.S. dollar and aggressive cutbacks in investment spending in the oil sector also weighed on activity. The growth picture has already begun to improve with real GDP increasing at an annual rate of 2.3% in the second quarter. Looking ahead, we believe growth will accelerate to an average annual rate of above 3% in the second half of the year driven mostly by the consumer and housing sectors, but also some stabilization in investment in the energy sector.
By contrast, growth in the euro area (EA) and Japan surprised us on the upside in the first half of the year, but may plateau in the second half as the largest boost from quantitative easing (QE) in the form of lower interest rates and the weaker currencies may be behind us. In addition, Greece is likely to remain a source of uncertainty for the EA as leaders struggle to implement harsh new fiscal reforms. Even so, it is unlikely to meaningfully alter the global outlook given that the economy accounts for less than three-tenths of global GDP on a purchasing power parity basis and exposure to Greece by private investors has been dramatically reduced. Thus, we are forecasting that DM growth will increase by roughly 2% in 2015 before accelerating somewhat to 2.3% in 2016.
The story in EM countries is similarly mixed with China adopting fiscal and monetary stimulus to keep growth near their target of “around 7%,” while Latin America and the Middle East continue to struggle with the impact of lower commodity prices and geopolitical risks. Although the stabilization in Chinese growth probably is not sustainable given the ongoing rebalancing away from investment and toward consumption, we expect to see the EM growth picture improve in in 2016 due to positive spillovers from DM economies and improving growth prospects in certain distressed economies, such as Russia and Brazil. Therefore, we are projecting an increase in EM growth from 4.1% in 2015 to 4.5% in 2016. Yet, the heady days of the last decade when GDP growth averaged above 6% in EM economies are probably behind us for now. Overall, we are projecting global growth will increase 3.1% this year to 3.6% in 2016.
Our view on global inflation is relatively benign with stabilizing oil prices boosting headline inflation rates in DM economies, while core inflation rates excluding food and energy remain largely subdued. However, low productivity rates in some DM countries, particularly the U.S., raise the risk that inflation outlook could change more rapidly if wage growth continues to accelerate. For this reason and the fact that zero interest rates are probably no longer justified by domestic economic fundamentals, we continue to expect the U.S. Federal Reserve to hike short-term interest rates later this year. While our call for a June rate hike proved premature, the Fed has clearly begun to prepare investors for a policy change before year end. On the other hand, we anticipate that the European Central Bank (ECB) and the Bank of Japan (BoJ) will push forward with monetary easing. The divergence of monetary policy between the G-3 will remain supportive of the U.S. dollar and should lead U.S. Treasury yields to underperform other global markets. We also expect an increase in market volatility as we approach Fed lift-off from the zero-bound, but historical experience suggests it will be temporary. Even so, these bouts of volatility may create opportunities in areas of the fixed income markets where valuations cheapen, but fundamentals remain sound.
Looking for Value in Fixed Income Market
We had already trimmed our risk budgets ahead of this anticipated period of Fed-induced volatility due to concerns about less attractive valuations in the fixed income sector and expectations of Fed interest rate hikes earlier in the year. However, when volatility emerged from an unrelated source, most notably Greece in late June, we decided to swap out of some of our peripheral debt positions and to add to U.S. investment grade financials since they had little to no exposure to the country. For now, we remain cautious on other peripheral Europe debt markets given concerns about slowing euro area growth and the fact that implementation risks associated with harsh fiscal reforms in Greece could still lead to contagion. When the Fed finally does begin to hike rates, we anticipate another period of global market volatility.
However, we expect it to be relatively short-lived and much less violent than when the Fed first announced it was tapering QE. Back then, the Merrill Lynch Options Volatility Estimate (MOVE), which measures implied volatility in the U.S. Treasury market, increased from a low of less than 50 to nearly 120 as the market brought forward the timing of eventual Fed tightening and Treasury yields spiked from 1.66% in May to nearly 3% by early September. However, this time around, Treasuries are much closer to fair value and the Fed has repeatedly said that interest rate hikes are likely to proceed at a “gradual pace,” which suggests the increase in volatility should be less dramatic. One lesson the Fed might learn from the tapering tantrum episode may be that waiting too long between the announcement of a policy change and the actual execution of that policy change can contribute to investor uncertainty and thus worsen market volatility. Indeed, during the seven month delay between the QE tapering announcement in June 2013 and the actual scaling back of Fed asset purchases in February 2014, volatility picked-up around the time of each Fed meeting and remained elevated in between. Yet, once the tapering process was underway, market volatility began to subside again and Treasuries rallied.
Amongst the hardest sectors hit by the taper tantrum were Emerging Markets (EM) as investors worried that higher U.S. interest rates would result in a reversal of record capital inflows. This put upward pressure on local EM rates and downward pressure on their currencies exacerbating a slowdown that was already underway. However, those EM countries with stronger economic fundamentals, deeper financial markets, and a tighter macroprudential policy stance fared better. In particular, countries with larger current account surpluses, stronger fiscal balances, lower inflation, and more foreign exchange reserves experienced smaller depreciations in their currencies and a smaller rise in local interest rates. Even so, we remain cautious on the EM asset class given that the slowdown in growth in many larger EM economies, including China and Brazil, seems more structural than cyclical in nature, which may imply valuations could cheapen further.
As for other sectors of the fixed income markets, we remain underweight duration in the short-end of the U.S. Treasury curve based on the belief that the market will continue to re-price the closer we get to Fed lift-off. This will likely result in a flatter U.S. Treasury curve implying short-term rates will rise faster than long-term rates. We also expect U.S. rates to underperform Australian and German rates as central banks in both countries remain more dovish than the Fed.
We are anticipating some further strengthening of the U.S. dollar, though not to the same degree as was experienced in the second half of 2014 when the U.S. currency rose roughly 15% on a trade-weighted basis and even more so against certain crosses, such as the euro and yen. Finally, we may see U.S. corporate spreads come under further pressure, particularly given lower broker dealer inventories of corporate bonds and higher corporate issuance. Yet, spread widening may present an opportunity to add to certain areas of the U.S. investment grade and high yield markets where fundamentals are still healthy.
Source: BONDWorld.it
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