Highlights from last month
Volatility came roaring back into global markets in February. As the Winter Olympics officially kicked off in Pyeongchang, renewed volatility in U.S. equity markets grabbed investors’ attention and quickly spread across the globe. Concern about rising inflation in the U.S. came on the heels of a strong monthly employment report that showed steady wage gains creating the first tremors. A full-blown sell-off erupted the following week as global equity market weakness spread to credit and currency markets in short order. The CBOE Volatility Index (VIX), a measure of equity market volatility, had its single largest one-day rise in the index's historical data beginning in 1990, and some systematic strategies, including those focused on volatility, added technical selling pressure to the decline. U.S. Treasury bonds were not spared: Expectations for higher inflation and more Treasury supply, along with the prospect of more rate hikes by the Fed, drove interest rates higher across the curve. The U.S. dollar also marched higher, reversing the trend of previous months toward dollar weakness despite rising rates. When the dust settled, U.S. equity markets recorded their first monthly decline since 2016.
Growth remained solid globally, but signs of rising price pressures in the U.S. sparked some concern. The latest economic releases indicated robust growth in the developed economies at the end of 2017: The eurozone economy grew 2.5% last year, its fastest clip since 2007; Japan experienced its eighth consecutive quarter of expansion, its longest streak in nearly 30 years; and the U.S. grew at a 2.5% annualized pace, bringing 2017 growth to 2.3%. Business activity remained firm across regions, particularly in Japan where the Purchasing Managers’ Index (PMI) jumped to its highest level in nearly four years and job growth hit an 11-year high. Strong growth momentum helped foster inflation fears, especially after larger-than-expected gains in U.S. payrolls and hourly wages early in the month. A year-over-year rise of 1.8% in core inflation highlighted the growing pressure in the U.S., although the Fed’s preferred measure of inflation (core PCE) still remained firmly below its 2% target. Outside the U.S., inflationary pressures in the eurozone and Japan continued to show little to no sign of acceleration.
Political developments remained in focus around the world. The U.S. government shut down for the second time in 2018, though the funding gap lasted just hours before Congress passed a major two-year budget deal: The spending package included $300 billion in additional funds for defense and nondefense programs, $90 billion in disaster relief and a higher statutory debt limit. While the passage of the bill was viewed as a moment of rare bipartisanship, it was not without opposition from both Republican fiscal hawks and Democrats concerned over DACA (Deferred Action for Childhood Arrivals). Meanwhile, Jacob Zuma stepped down as president of South Africa on the eve of a no-confidence vote in parliament, paving the way for African National Congress head Cyril Ramaphosa to succeed him. Lastly, China’s Communist Party unexpectedly proposed amending the constitution to abolish presidential term limits, raising the likelihood of a longer term for President Xi Jinping. Global central banks were also in the news for notable appointments: Jerome Powell was sworn in as Fed chairman and delivered his first congressional testimony; Luis de Guindos, Spain’s economy minister, is all but set to follow Vítor Constâncio as vice president of the European Central Bank despite concern over the bank’s independence from politics; and Haruhiko Kuroda, in a break from tradition, was nominated for a second term as governor of the BOJ.
Despite generally strong fundamentals, developed market stocks1 fell 4.1% as concerns over inflationary pressures in the U.S. sent bond yields higher, risk assets lower and volatility to levels not seen since summer 2015. After rising for 15 consecutive months—their longest winning streak on record—stocks in the U.S.2 dropped 3.7%. European equities3 tumbled 3.9%, buffeted by the sell-off on Wall Street, and stocks in Japan4 lost 4.4% as the region was unable to shake the global risk-off sentiment.
Emerging market equities5 fell 4.6% despite relatively stable global market conditions and a strong technical backdrop. Chinese equities6 lost 6.4% in their worst month since January 2016, when weak manufacturing data and concerns over rising rates rekindled worries about the health of the economy. In India,7 the government announced a long-term capital gains tax on equities, which helped drive stocks down 4.9%. Brazil and Russia bucked the trend in global markets, however: Brazilian equities8 rose 0.5% after the central bank cut rates, and Russian equities9 gained 0.3% amid better-than-expected corporate profits.
DEVELOPED MARKET DEBT
In the U.S., yields continued to climb higher on optimism over the economic outlook and expectations for higher inflation. The U.S. 10-year Treasury yield ended the month 16 basis points (bps) higher at 2.86% despite a short-lived fall in rates in early February during the global equity sell-off. In the eurozone, German Bunds benefitted from the risk-off rally early in the month, but the move was reversed soon after. The 10-year bund ended 4 bps lower on the month at 0.66%. In the U.K., the yield curve flattened: Front-end rates moved higher following a hawkish tone at the Bank of England meeting, which increased expectations of a rate hike in May. The U.K. two-year government bond yield ended the month 11 bps higher at 0.78%, while the U.K. 10-year yield ended 1 bp lower at 1.50%.
Global inflation-linked bonds (ILBs) posted mixed returns across countries and generally performed in line with comparable nominal bonds in February. U.S. real yields moved higher across most maturities, as strong economic data continued to signal robust growth and reinforced expectations for rate hikes by the Federal Reserve. The U.S. breakeven inflation (BEI) curve flattened: Short-term expectations for inflation ended the month higher in response to a stronger-than-expected January inflation report and a sharp jump in wages. In the U.K., index-linked gilts closed the month in slightly positive territory; early in February, prices fell and yields rose in response to a more hawkish tone from the BoE, but those losses were later pared following the release of disappointing retail sales data. Real yields failed to keep pace with the rally in nominal gilts over the second half of the month, however, leaving breakeven inflation rates tighter despite a notable decline in the U.K. pound over the month.
Global investment grade credit10 spreads widened 8 bps in February, underperforming like-duration global government bonds by -0.44%. The sell-off in the equity markets, waning foreign demand due in part to rising currency-hedging costs, and interest-rate volatility all contributed to weakness in high quality credit.
Global high yield11 bonds declined by over 80 bps in February amid a meaningful sell-off in equities; a four-year high in 10-year Treasury yields; and significant outflows from high yield mutual funds. The month-over-month spike in global speculative grade yields outpaced the increase in government bond rates, and spreads were wider by 19 bps, ending the month at 336 bps.
EMERGING MARKET DEBT
Emerging market (EM) debt returns were broadly negative in February. Local debt performance was driven largely by the depreciation of EM currencies versus the U.S. dollar, as index yields remained relatively stable. External debt returns were driven by spread widening among corporate and sovereign issuers, as well as by a move higher in underlying U.S. Treasury yields. South Africa was a notable outperformer, particularly in local markets: Jacob Zuma resigned the presidency and his successor, Cyril Ramaphosa, carried out a reshuffling of the cabinet that was perceived to be market-friendly. Russian debt also outperformed; the country’s hard currency rating was upgraded to BBB- by S&P, giving it investment grade ratings from two out of the three major rating agencies.
Agency MBS12 returned -0.66% and underperformed like-duration Treasuries by 10 bps. Spreads widened when the Federal Reserve announced a harsh penalty for Wells Fargo, one of the largest buyers of agency MBS, which will prevent the bank from growing its portfolio. Lower coupon MBS outperformed higher coupons, while Ginnie Mae MBS performance was mixed; higher coupons outperformed conventional MBS, and lower coupons underperformed. Gross MBS issuance decreased 10% in February, and prepayment speeds fell 12%. Non-agency residential MBS outperformed like-duration Treasuries during the month, while non-agency commercial MBS13 returned -0.67%, underperforming like-duration Treasuries by 14 bps.
Although the Bloomberg Barclays Municipal Bond Index returned -0.30% in February, it outperformed Treasuries. Short maturities outperformed both intermediate and long maturities, and the muni yield curve steepened slightly over the month. While early in February municipal securities rallied, fears of rising rates became the focus later, and both U.S. Treasuries and AAA municipal yields ended higher for the month. Total supply was underwhelming at $16 billion, following weak issuance in January as well. The light supply was expected after the surge in muni issuance in December leading up to U.S. tax reform.
After a weak start to the year, the U.S. dollar bounced back from its three-year lows in January and posted a 1.7% gain against its G10 peers. Underpinning the move were the pullback in global equity markets and a more hawkish tone from new Fed Chairman Jerome Powell. Elevated market volatility also drove safe-haven assets higher, such as the Japanese yen, which ended the month up 2.5%. Political events pressured the British pound throughout the month as speculation increased surrounding a leadership challenge to Prime Minister Theresa May or another general election. On the European continent, the euro seesawed following comments from European Central Bank (ECB) President Mario Draghi on the potential for currency volatility to create headwinds for inflation. The Swedish krona fell 5%, the biggest drop among the G10, due to lower expectations for rate hikes from the Riksbank.
Commodities posted modestly negative returns. In the energy sector, which saw broad-based losses, natural gas was the notable underperformer, continuing January's sell-off due to warmer weather forecasts. Spurred by the risk-off sentiment in the markets early in the month, oil prices followed U.S. equities lower and faced additional pressure from higher-than-expected U.S. production forecasts. In the agricultural sector, wheat prices jumped in the last week of February on extended drought forecasts, and soybeans climbed through the month on warmer, drier weather in Argentina. In precious metals, gold initially dropped as real rates rose, but rallied mid-month after an upside surprise in the January inflation report. However, gold ultimately ended the month in negative territory, under pressure from a strong U.S. dollar and optimistic undertones in comments from new Fed Chairman Powell. Most base metals ended the month lower thanks to muted global demand and softer manufacturing data out of China.
Based on PIMCO’s cyclical outlook from December 2017.
PIMCO expects world GDP growth to remain above-trend at 3.0%‒3.5% in 2018, in a “Goldilocks” environment of synchronized global growth and low but gently rising inflation. Relatively easy financial conditions, reflecting buoyant risk assets and low interest rates, and fiscal stimulus in several advanced economies imply near-term tailwinds. However, 2017–2018 could mark the peak for economic growth in this cycle, and with many markets already reflecting an optimistic outlook, we see risks ahead: U.S. fiscal stimulus late in the cycle leaves less room for stimulus in the next recession; inflation may well overshoot expectations in 2018 due to fiscal stimulus, rises in commodity prices and easy financial conditions; and the reduction of accommodative monetary policy by global central banks could pressure economies and asset markets, which have become accustomed to low interest rates, possibly leading to bouts of market volatility.
In the U.S., we look for above-consensus growth of 2.25%–2.75% in 2018. Tax cuts and higher federal spending – due to hurricane-related disaster relief and a likely rise in discretionary spending limits under an expected government funding compromise – should boost growth. With unemployment likely to drop below 4%, we expect some upward pressure on wages and consumer prices, and core inflation to rise above 2% over the course of 2018. Under new leadership, the Federal Reserve is expected to continue tightening gradually; our baseline forecast calls for three rate hikes this year.
For the eurozone, we expect growth will be in a range of 2.0%‒2.5% this year, significantly above trend. The expansion is now broad-based across the region, with growth momentum strong and financial conditions favorable. Core inflation, though, is expected to remain very low, creeping only marginally above 1% this year due to low wage pressures and the appreciation of the euro in 2017. We expect the European Central Bank to end its bond purchases in September, but we do not foresee a rate increase until mid-2019.
In the U.K., we expect above-consensus growth in the range of 1.25%–1.75% in 2018. Our base case is that a deal for a transitional arrangement will be struck in the first half of this year, smoothing the U.K.’s separation from the European Union, and that growth will reaccelerate in the second half as business confidence and investment pick up. Inflation should fall back to the 2% target by year-end, with the effect of sterling’s depreciation in 2017 fading. The Bank of England will likely follow a very gradual path higher with a few hikes in 2018.
Japan’s GDP growth is expected to remain firm at 1.0%–1.5% in 2018, with risks tilted to the upside. Fiscal policy should remain supportive ahead of the planned value-added tax hike in 2019. With unemployment below 3% and job growth accelerating, we think inflation will move up gradually toward 1% over the year, but the 2% inflation target is likely to remain out of reach. We expect the Bank of Japan to aim to slow its balance sheet expansion and/or tweak its yield curve control policy so that the yield curve steepens this year.
In China, we expect a controlled deceleration in growth to 5.75%–6.75% this year. The authorities’ focus is likely to be on controlling financial excesses, particularly in the shadow banking system, and on some fiscal consolidation, chiefly by local governments. We expect inflation to accelerate to 2.5% on stronger core inflation and higher oil prices, inducing the People’s Bank of China to tighten policy by raising official interest rates, versus the consensus expectation of no hikes. We are broadly neutral on the yuan and expect exchange rate volatility to remain low.
In Brazil, Russia, India and Mexico, we expect growth to collectively rise to 4% in 2018, slightly above consensus, with modest upside risk from recoveries in Brazil and Russia. Emerging markets are catching up to the recovery in developed markets, with improving fundamentals and greater differentiation among countries. This recovery is likely to be shallower and slower than others, however; EM potential growth has fallen, and key political events are likely to keep investors cautious. We expect inflation to stabilize around 4%, also above consensus as most of the decline in EM inflation thus far appears cyclical rather than structural.