In the World

Ending 2018 in a bout of volatility, U.S. stocks “caught down” to equity markets in the rest of the world and finished the year in negative territory. The S&P 500 plummeted 9.0% in the last month of the year as concerns about recession risk and the future path of interest rate hikes gripped investors − a stark contrast to the growth exuberance that characterized the start of 2018. December’s performance dragged the S&P 500 into the red for the year, marking the first negative calendar year for U.S. equities since 2008. The index finished down 4.4% for 2018, ‘catching down’ to its counterparts in other developed regions, MSCI EAFE Index, (down 13.8%) and in emerging markets, MSCI Emerging Markets Index, (down 14.6%). As equities sold off globally, the VIX index rose to eclipse the 30 mark last seen in February – highlighting the return to more normal levels of volatility in 2018. The weak risk asset performance plagued credit markets as well. Lower-credit-quality corporate debt underperformed higher-quality corporates in a departure from most of the year; even bank loans, one of the best-performing asset classes in 2018, J.P. Morgan Leveraged Loan Index, (up 1.1%), saw some weakness in December alongside significant outflows. By contrast, global government bond yields fell and yield curves flattened as global growth expectations dropped. For the first time in more than a decade, the U.S. yield curve partially inverted: The two-year yield rose above the five-year, though the more widely cited spread between the two-year and 10-year yields remained positive.

In a widely anticipated move, the Federal Reserve hiked rates for the fourth time in 2018 while reducing its expectations for rate increases in 2019 to two times from three. December’s quarter-point raise brought the policy rate to 2.25%−2.50% – just below the Fed’s range of estimates for neutral monetary policy – and the Fed trimmed its 2019 GDP projections from 2.5% to 2.3%. Although it reduced its guidance for hikes in 2019, the Fed’s bias to tighten further amid already tightening financial conditions partially contributed to the sell-off in equity markets. With the subsequent rally in U.S. Treasuries, market expectations for 2019 hikes have fallen dramatically since September, with less than one hike now priced into the markets. Despite concerns over slowing growth, the U.S. consumer remained a bright spot. Core retail sales beat expectations, and housing starts rose after two monthly declines, although they were still negative year over year, reflecting some softening in the U.S. housing market in 2018. In Europe, the European Central Bank (ECB) announced the end of its asset purchase program this year, as expected, and reiterated its intention to leave rates unchanged through the summer of 2019. The ECB also cut growth forecasts for both 2018 and 2019 by 0.1% to 1.9% and 1.7%, respectively. 

A government shutdown in the U.S., continued political fragility in Europe, and ongoing trade developments influenced investor appetite. The U.S. government partially shut down after President Donald Trump failed to secure funding for a border wall with Mexico. In the UK, ongoing Brexit negotiations showed little progress: While Prime Minister Theresa May survived a vote of no-confidence, she postponed Parliament’s vote on the withdrawal agreement over fear it would not pass. Investors’ concerns around Italy diminished after the government agreed to reduce its planned budget deficit to the European Union (EU)-compliant 2%, but France increased its planned budget deficit above the EU’s guideline. The shift was to accommodate the demands of “yellow vest” protestors, including a minimum-wage increase and tax concessions. The tone around U.S.-China trade appeared to improve at the start of the month when President Trump and Chinese President Xi Jinping reached a 90-day “truce” that forestalled tariffs; however, the arrest of Huawei’s CFO Meng Wanzhou in Canada at the request of the U.S. curbed some of that optimism. 

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Cash Is King

December’s equity market sell-off led global equity markets into the red, marking the first time that U.S., non-U.S. developed, and emerging market equities all ended the year in negative territory since 2008. In fact, very few assets managed to deliver positive returns in 2018; cash outperformed most major asset classes for the first time in more than two decades, supported by four Federal Reserve rate hikes, higher market volatility and a souring in investor appetite for risk. A rally late in the year helped global government bonds eke out positive returns, while credit-sensitive instruments were broadly negative. Commodities were also down, despite a generally positive setup for the sector heading into 2018, as global growth concerns and idiosyncratic, sector-specific issues arose later in the year. 

Catching Down

In the Markets

EQUITIES

Developed market stocks1 declined 7.6% on concerns over Federal Reserve policy, slowing global growth and ongoing trade tensions. Marking the worst monthly performance since 2009 and approaching bear-market territory, U.S. equities2 fell 9.0%; volatility surged, and investors fled risk assets amid fears of decelerating growth, China-U.S. trade tensions and rising interest rates. European3 equities declined 5.5% on Brexit concerns and social tensions in France, although weaker economic data were partially offset by a budget agreement between the EU and Italy. Japanese equities4 fell 10.3% as trade tensions and broader risk-off sentiment weighed on investors.

In emerging markets,5 stocks fell 2.7%, outperforming developed markets, and local currencies generally gained despite the significant risk-off sentiment across markets. In Brazil,6 stocks fell 1.8%, finishing the month on an upbeat tone ahead of the inauguration of President Jair Bolsonaro. Chinese7 equities fell 3.6% due to trade tensions and slowing domestic growth. In India,8 stocks declined only 0.3%, as the sharp drop in energy prices helped insulate local markets, while Russian9 equities fell 0.9% alongside declines in oil and the ruble.

DEVELOPED MARKET DEBT

Risk aversion and volatility marked the end of 2018, and developed market yields broadly fell in December. In the U.S., the 10-year Treasury yield ended the month 30 basis points (bps) lower at 2.68% – almost 60 bps lower than its 2018 high of 3.24% set less than two months earlier on November 8. The Fed raised its policy rate as expected for the fourth time this year, while also lowering its expectation for hikes in 2019. Even so, concerns about slowing growth contributed to the decline in rates. Meanwhile in the eurozone, the European Central Bank (ECB) reaffirmed its plan to end quantitative easing and hold interest rates steady until mid-2019. Yields ended lower in the region – German 10-year bund yields fell 7 bps to 0.24% and 10-year UK yields fell 9 bps to 1.28%. Japanese 10-year yields also reflected the broader trend and fell 9 bps to 0%. 

INFLATION-LINKED DEBT

Global inflation-linked bond (ILB) markets posted firm gains in aggregate for the month of December, with returns aided by a general decline in developed market interest rates and risk aversion. ILBs lagged their nominal counterparts in most regions, however, as oil prices continued to fall. In the U.S., TIPS posted positive absolute returns but sharply underperformed nominal Treasuries as inflation expectations slid with energy and equity markets. U.S. 10-year breakeven inflation ended the quarter at 1.71%, the lowest level since June 2017 and more than 0.4% lower than at the start of the quarter. U.K. linkers experienced strong gains over the month alongside nominal gilts as Brexit jitters continued to pressure yields lower. U.K. breakevens began the month higher due to the weaker currency before falling into month-end as the Bank of England predicted moderating inflation in 2019 due to energy base effects.

CREDIT

Global investment grade credit10 spreads widened 10 bps in December, and the sector returned 1.20%, underperforming like-duration global government bonds by -0.58%. Spreads were impacted by select downgrades in retail and food and beverage sectors, as well as concerns of slowing growth and the subsequent decline in equity markets and commodities. Mutual fund outflows also contributed to broader market weakness.

Global high yield bond spreads widened 85 bps in December.11 The sector returned -1.73% for the month, underperforming like-duration Treasuries by 3.12%. December mimicked most of the fourth quarter, with volatile markets and the underperformance of risk markets. Underperformance in high yield was likely driven by overall market sentiment, the declines in CCC credits and equities, and lower oil prices. In December, the higher quality BB segment returned -0.92% while the CCC segment returned -4.20%. 

EMERGING MARKET DEBT

Emerging market (EM) debt posted positive returns across its sub-sectors in December. Despite a modest spread widening, external debt returned 1.46%12 as underlying U.S. Treasury yields tightened significantly. Local debt also gave a robust performance of 1.31%,13 driven by lower index yields and stronger EM currencies against the U.S. dollar due to expectations of less tightening by the Fed going forward. Mexico was a notable outperformer in local debt as its conservative, new budget boosted market confidence that had been weakened in prior months by President AMLO.

MORTGAGE-BACKED SECURITIES

Agency MBS14 returned 1.81% and underperformed like-duration Treasuries by -0.15%. Spreads on mortgages started the month wider as rates moved higher. But with a risk-off tone in the markets, MBS were seen as a diversifier to corporate credit, outperforming investment grade credit by 19 bps per year of duration risk in December, bringing the year-to-date total outperformance to 21 bps. Lower coupons outperformed higher coupons; Ginnie Mae MBS outperformed Fannie Mae MBS, and 15-year MBS significantly underperformed 30-year MBS. Gross MBS issuance declined 11% from November, and prepayment speeds decreased 14%. Non-agency residential MBS underperformed like-duration Treasuries during December, while non-agency commercial MBS15 returned 1.5%, underperforming like-duration Treasuries by 58 bps.

MUNICIPAL BONDS

The Bloomberg Barclays Municipal Bond Index posted a return of 1.20% in December, bringing returns to 1.28% for 2018. Munis underperformed Treasuries across the curve. High yield munis (as represented by the Bloomberg Barclays High Yield Municipal Bond Index) ended 2018 strong and returned 0.86% in December, primarily driven by positive returns in the resource recovery and education sectors, bringing the year-to-date return to 4.76%. December’s supply of $21 billion was down 20% versus the previous month and 69% year over year. Gross issuance for 2018 totaled $338 billion compared with $439 billion in 2017. This 25% decrease in supply in 2018 was primarily due to the impact of U.S. tax reform. Muni fund flows were negative in December: Aggregate outflows totaled $2.94 billion for the month, which turned fund flows negative for the year.

CURRENCIES

The U.S. dollar ended the month 1.1% weaker against its G10 counterparts, despite the Fed raising its policy rate for the fourth time in 2018, as volatility in equity markets contributed to a decline in expectations for further tightening. The British pound finished the month roughly unchanged, despite weak economic data, as headlines indicated the possible delay of Brexit. The euro strengthened 1.3%, supported by Italy’s informal budget agreement with Brussels. The Japanese yen strengthened 3.5% as it benefitted from safe-haven flows stemming from weakness in equity markets and rising concern over U.S.-China relations.

Commodities

In energy, oil extended its decline to hit its lowest level in over a year. Despite signals from OPEC that it may extend or deepen its pledged output cuts, concerns over the health of the global economy and the pace of oil demand growth weighed on prices. Natural gas prices fell sharply, ceding nearly all of November’s gains, as forecasts for mild weather and a smaller-than-average stockpile drop eased concerns about winter supplies. The agricultural sector posted negative returns. Record stockpiles and trade concerns continued to weigh on soybean prices, while wheat fell on signs of ample global supplies. Corn prices rose amid solid export demand. Sugar declined as a slump in crude oil prices worsened the outlook for cane-based ethanol demand in Brazil. Coffee prices fell after the U.S. Department of Agriculture reported record production for the crop in 2018-2019. Base metals prices fell amid concerns over a slowdown in China’s manufacturing sector, while general risk-off sentiment added further pressure. Heightened volatility across financial markets brought out buyers for precious metals, with both gold and silver posting solid gains.

Catching Down

Outlook

Based on PIMCO’s cyclical outlook from December 2018.

PIMCO expects world GDP growth to slow somewhat but remain above-trend at 2.75%‒3.25% in 2019. With tighter global financial conditions, increased political and economic uncertainties, and U.S. fiscal stimulus starting to fade in 2019, we think the economic divergence of 2018 – the U.S. accelerating and other regions slowing – will give way to a more synchronized deceleration, with the U.S., the eurozone and China all seeing lower growth than this year. We expect inflation globally to fall to 1.75%−2.25% from about 2.3% in 2018 due to the recent plunge in oil prices and continued below-target inflation in the U.S., Europe and Japan.

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. We expect one or two more increases in the fed funds rate by year-end 2019, with a high chance of the Federal Reserve pausing or even ending the hiking cycle in the first half.

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.

FOOTNOTES:

1MSCI World Index, 2S&P 500 Index, 3MSCI Europe Index (MSDEE15N INDEX), 4Nikkei 225 Index (NKY Index), 5MSCI Emerging Markets Index Daily Net TR, 6IBOVESPA Index (IBOV Index), 7Shanghai Composite Index (SHCOMP Index), 8S&P BSE SENSEX Index (SENSEX Index), 9MICEX Index (INDEXCF Index), 10Barclays Global Aggregate Credit USD Hedged Index, 11BofA Merrill Lynch Developed Markets High Yield Index, Constrained, 12JP Morgan EMBI Global, 13JP Morgan GBI-EM Global Diversified, 14Barclays Fixed Rate MBS Index (Total Return, Unhedged), 15Barclays Investment Grade Non-Agency MBS Index

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Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk and liquidity risk. The value of most bonds and bond strategies is impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in foreign denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax; a strategy concentrating in a single or limited number of states is subject to greater risk of adverse economic conditions and regulatory changes. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation- Protected Securities (TIPS) are ILBs issued by the U.S. government. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax. Corporate debt securities are subject to the risk of the issuer’s inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to factors such as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be suitable for all investors. It is not possible to invest directly in an unmanaged index.


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