In the World
Markets bounced back from December’s steep sell-off, embodying the old adage that good things come to those who wait. A dovish pivot by the Federal Reserve – with a focus on “patience” in Fed officials’ comments as well as the official statement in January – combined with optimism over U.S-China trade negotiations bolstered investor sentiment and contributed to impressive gains in equities. The U.S. led the rally in developed markets as the S&P 500 index rose 8.0%, marking its best January in over 30 years; MSCI Emerging Markets Index also surged 8.8%. Still, U.S. stocks remained nearly 8% below their 2018 peak in September. The robust “risk-on” sentiment reverberated across other asset classes: Credit spreads tightened, with lower-credit-quality corporate debt outperforming higher-quality; emerging market currencies appreciated against the U.S. dollar; and U.S. inflation expectations rose. Brent crude oil prices also rallied over the month, recovering to $62 per barrel on the back of OPEC production cuts and new U.S. sanctions on Venezuela’s oil industry. However, even as sentiment improved, bond yields fell across many developed economies as corporate earnings were mixed and evidence grew of a slowdown in global economies. The dovish tilt from the Fed and other central banks also contributed to the move lower in rates.
The Fed preached “patience” in light of tighter financial conditions and only modest inflation. The Fed indicated that the case for raising rates had recently “weakened somewhat” and that it would be patient in assessing the need for any further hikes. The Federal Open Market Committee (FOMC) went so far as to remove language calling for “some further gradual increases” in its official statement and signaled it would be flexible with the wind-down of its balance sheet. The shift in tone from December – when the Fed indicated a bias to tighten further and referred to balance-sheet reduction on “autopilot” – helped spur the rally in global equities. The Fed’s caution followed a string of weak economic data globally. China grew at 6.6% in 2018 – its slowest pace in nearly three decades – and Germany’s economic growth slipped to a slower-than-expected 1.5%. Business activity reflected in Purchasing Managers’ Indexes (PMIs) also pointed to a broad-based slowdown: Euro area PMIs edged lower, while manufacturing PMIs in the U.S. and China fell sharply. The European Central Bank (ECB) flagged risks that “have moved to the downside,” citing trade tensions, Brexit and market volatility. Still, continued labor market strength helped mitigate some concern. The U.S. added 312,000 jobs in December, and wages grew at the quickest pace since 2009; in Europe, unemployment fell to 7.9%, its lowest level since October 2008.
U.S.-China trade progress, a political crisis in Venezuela and the reopening of Brexit negotiations captured headlines. There was some optimism around U.S.-China trade negotiations as high-level delegates from Beijing and Washington met to advance trade talks following the 90-day “truce” in December. Complicating matters somewhat, however, the U.S. Justice Department brought criminal charges against Chinese telecommunications company Huawei for allegedly stealing trade secrets and evading U.S. economic sanctions on Iran, among other charges. Meanwhile, U.S. President Donald Trump reopened the government after its longest shutdown in history, and agreed to temporary funding through February 15 in exchange for negotiations on immigration legislation. In Venezuela, following the inauguration of incumbent President Nicolás Maduro, opposition leader and head of the National Assembly Juan Guaidó declared himself interim president. He was swiftly recognized by many countries, including the U.S., Brazil and Canada, while Russia and China reiterated their support for Maduro. In Britain, the government held a series of votes: Parliament voted down Prime Minister Theresa May’s negotiated withdrawal agreement with the European Union, failed to pass a no-confidence motion to remove May from office, and ruled out a “no- deal” Brexit.
In the Markets
Developed market stocks1 recovered sharply in January, rising 7.8% as investors cheered the improving outlook for U.S.-China trade, a dovish shift in Federal Reserve policy and strong U.S. economic data. U.S. equities2 climbed 8.0% and reversed most of December’s tumble. European3 equities increased 6.2% as global markets rallied, but enthusiasm was dampened by softer economic data, Brexit drama and news that Italy entered a technical recession in the second half of 2018. Japanese equities4 rose 3.8%, sluggishly following global equities, but mixed economic data and the Bank of Japan’s downgrade to its inflation outlook weighed on local markets.
Emerging market5 equities continued to outperform developed markets, rising 8.8% in January. In Brazil6, stocks surged 10.8% as markets cheered positive progress reports for pension reform and the inauguration of President Jair Bolsonaro. Chinese7 equities increased 3.6% due to the positive developments in trade talks and domestic stimulus measures, which helped offset mixed economic data. In India8, stocks underperformed EM and DM equities, rising only 0.5%, as the recovery in energy prices weighed on local markets; Russian9 equities rallied 6.7% alongside strong gains in oil and the ruble.
DEVELOPED MARKET DEBT
Developed market yields broadly fell in January, as central banks adopted more cautionary rhetoric toward monetary policy. In its latest statement, the Fed outlined a “patient” stance on the future path of rate hikes, noting mounting uncertainties over the growth outlook. The dovish tone pushed U.S. yields lower, with the 10-year Treasury yield falling five basis points (bps) to 2.64%. Similar concerns were highlighted by European Central Bank (ECB) President Mario Draghi, who noted that economic risks had “moved to the downside.” The German 10-year bund yield fell 9 bps to 0.15%, while the 10-year UK yield fell 6 bps to 1.22% on heightened Brexit uncertainty. Rates in Japan also generally fell across the curve, though the 10-year government bond yield ended about unchanged at 0.01%.
Global inflation-linked bond (ILB) markets gained overall, and outperformed their nominal counterparts in January. A moderation in developed market interest rates and a strong recovery in oil prices helped drive returns. In the U.S., dovish comments from the Fed led to a drop in real rates, while breakeven inflation expectations (BEI) ascended on the back of a firm December CPI report and a rally in energy and equity markets. U.S. 10-year breakeven inflation ended the month at 1.86%, rebounding from its lows early in the month. U.K. linkers also posted strong gains, but underperformed their nominal counterparts. U.K. breakevens began the month higher, in line with energy prices, before dropping mid-month following a weaker Retail Price Index (RPI) report and tamer Brexit headlines. At the same time, he House of Lords released its RPI Inquiry Report, which criticized the U.K. Statistics Authority’s inaction on RPI reform, casting uncertainty over the popular inflation measure.
Global investment grade credit10 spreads tightened 16 bps in January, and the sector returned 2.12%, outperforming like-duration global government bonds by 1.22%. Positive technicals and a modestly less pessimistic growth outlook played a role in spreads tightening. On the technical side, moderating new issue supply and expectations of foreign demand improved as currency hedging costs declined. The energy sector outperformed other markets as oil prices recovered somewhat from declines in fourth quarter 2018.
Global high yield bond spreads tightened 86 bps in January,11 and the sector returned 4.10% for the month, outperforming like-duration Treasuries by 3.64%. The main catalyst for the rally likely came from more dovish Fed statements, solid earnings results that beat expectations and improved U.S.-China trade sentiment. The rally helped offset a considerable portion of the decline in the last quarter of 2018. In January, the higher quality BB segment returned 3.73%, while CCC rated bonds returned 5.16%.
EMERGING MARKET DEBT
Emerging market (EM) debt posted robust returns across sub-sectors in January. External debt returned 4.42%,12 driven primarily by a 57-bp tightening in spreads and aided by a modest decline in U.S. Treasury yields. Local debt posted even stronger performance of 5.46%,13 driven by lower index yields and stronger EM currencies versus the U.S. dollar. EM risk sentiment was broadly improved by optimistic headlines on U.S.-China trade talks, as well as the strongly dovish turn from the Fed. Venezuela was a notable outperformer in external debt, as the country’s political crisis raised odds of a new regime coming in that would be able to restructure its debt.
Agency MBS14 returned 0.79% and outperformed like-duration Treasuries by 0.32%. MBS had a good month as markets rebounded broadly, volatility fell and the Fed reaffirmed it would pause its rate hikes. In addition, the Fed was expected to leave its terminal balance sheet much larger than previously expected at around $3.5 trillion, when it announces its plan in the coming months. Despite increased supply from the Fed’s ongoing unwinding, MBS was supported by broad- based buying from overseas, hedge funds, REITs, banks and money managers. Higher coupons outperformed lower coupons; Ginnie Mae MBS outperformed Fannie Mae MBS; and 15-year MBS underperformed 30-year MBS. Gross MBS issuance declined 9% from December, and prepayment speeds decreased 7% in December (most recent data). Non-agency residential MBS spreads tightened during January, while non-agency commercial MBS15 returned 1.2%, outperforming like-duration Treasuries by 52 bps.
The Bloomberg Barclays Municipal Bond Index started the year on a positive note with a return of 0.76% in January. Overall, munis outperformed the U.S. Treasury index for the month, but MMD/UST performance was mixed for different maturities: five- and 10-year yield ratios strengthened while 30-year ratios weakened. High yield munis (as represented by the Bloomberg Barclays High Yield Municipal Bond Index) started 2019 slightly behind the investment grade muni market with a January return of 0.67%, supported by positive returns in the lease-backed and general obligation sectors. January’s supply of $24 billion was up 9% from the previous month and 12% year-over-year. New issuance remained muted to start the year, despite favorable dynamics for issuers. Muni fund flows were positive in January: Aggregate inflows totaled $3.99 billion for the month, demonstrating strong demand after the period of outflows at the end of 2018.
The U.S. dollar ended the month 0.6% weaker against its G10 counterparts alongside cautionary rhetoric from the Fed, despite robust labor market data. The dovish turn, along with fears of a global growth slowdown, contributed to a strengthening in the Japanese yen of 0.7% against the dollar. The British pound appreciated 2.8% against the greenback as expectations rose for a Brexit extension. Even as the pound rallied against the dollar, the euro weakened 0.2%, and the ECB acknowledged continued weakness in the bloc’s economies. Meanwhile, the Canadian dollar appreciated 3.9% to become the best-performing currency, supported by higher oil prices and hawkish rhetoric from the Bank of Canada.
In energy, oil broke its three-month losing streak and posted a strong start to the year. Renewed risk sentiment, December’s OPEC production cut and geopolitical tensions all supported prices. The apparent softening in U.S.-China trade frictions and the Fed’s dovish shift helped alleviate concerns around growth in oil demand. Supply disruptions in Libya and escalating tensions between the U.S. and Venezuela further supported prices. Natural gas, after rising mid-month amid extreme cold weather, reversed course on warmer forecasts. The agricultural sector posted positive returns: Grains moved modestly higher on expectations of an improved trading landscape; concerns over adverse weather conditions in Brazil further bolstered soybean prices; and a cold snap in the U.S. and tightening supplies in the Black Sea region benefited wheat. Sugar rose with higher oil prices, which bolsters the outlook for cane-based ethanol demand in Brazil. Coffee prices gained amid a heatwave in Brazil that threatened prospects for a record harvest. Base metals were stronger over the month, with the recovery in risk assets providing optimism despite still weak economic data from China. Precious metals rose on lower real yields.
Based on PIMCO’s cyclical outlook from December 2018.
In the U.S., after an expansion of close to 3% in 2018, we look for growth to slow to a below-consensus 2.0%–2.5% range in 2019. The drop reflects the recent tightening of financial conditions, fading fiscal stimulus and slower growth in China and elsewhere. Growth momentum is likely to moderate during the year, converging to trend growth of just below 2% in the second half. Headline inflation looks set to drop sharply over the next several months, reflecting base effects and the recent plunge in oil prices, while core CPI of about 2% is expected to trend sideways. While another opportunistic hike is possible, we expect the current level of the fed funds rate is at or near the terminal level of this hiking cycle.
For the eurozone, we expect growth to slow to a below-consensus 1.0%–1.5% in 2019 from close to 2% in 2018. Our downward revision from our outlook in September reflects the tightening in financial conditions in Italy as well as weaker global growth. We think core consumer price inflation will pick up somewhat in 2019 from 1% as unemployment is likely to keep falling and wage growth has accelerated. Yet, it should still fall under the “below but close to 2%” objective. With the European Central Bank (ECB) ending net asset purchases, we expect one rate increase in the second half of 2019, although if the Fed pauses and the euro appreciates versus the U.S. dollar, the ECB may leave rates unchanged until 2020.
In the U.K., we expect real growth in the range of 1.25%–1.75% in 2019, based on our expectation that a chaotic no-deal Brexit will be avoided. Our below-consensus inflation forecast calls for inflation to come back to the 2% target over 2019 as import price pressures fade and weak wage growth keeps service sector inflation subdued. We see one or two rate hikes from the Bank of England over the next year.
Japan’s GDP growth is expected to be moderate at 0.75%–1.25% in 2019, supported by a tight labor market and a supportive fiscal stance. With inflation expectations low and improving labor productivity keeping unit wage costs in check despite wage growth, core inflation is likely to creep up only slightly to 0.5%‒1.0%, well below the 2% target. While we don’t expect the Bank of Japan (BOJ) to raise interest rates, we anticipate further tapering of bond purchases and further steepening of the yield curve as the BOJ tweaks its buying operations.
In China, we expect 2019 growth to slow to the middle of a 5.5%‒6.5% range that reflects large uncertainties caused by trade tensions with the U.S., domestic pressure to deleverage, and an economic policy with partially conflicting targets (growth and unemployment versus financial stability). We project a moderate rebound in CPI inflation to 2.0%‒3.0% on rising energy and food prices and expect the People’s Bank of China to cut reserve requirements further rather than cut rates. We also expect a fiscal expansion worth about 1.5% of GDP, focused mainly on tax cuts for corporates and households. Any further depreciation of the yuan against the dollar is likely to be moderate unless trade negotiations between the U.S. and China fail and tensions escalate.