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.
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.
In the Markets
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
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%.
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
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.
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.
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.
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.
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.
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
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
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
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
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