In the World

The U.S.–China trade war escalated to new heights, weighing on risk-asset performance and sending global rates sharply lower. After little materialized from the Shanghai trade talks at the end of July, President Donald Trump announced tariffs of 10% on an additional $300 billion of Chinese goods. Shortly after, Chinese policymakers allowed the yuan to sink below 7 against the U.S. dollar for the first time since the global financial crisis, an apparent countermeasure to blunt the effect of the increased tariffs, which then prompted the U.S. Treasury to formally label China a “currency manipulator.” Tensions continued to build, with China adding more tariffs on U.S. goods. The trade developments, coupled with enduring global growth concerns, triggered a “risk-off” reaction across markets: Global stocks (MSCI World Index) fell 2%, credit spreads widened, inflation expectations dropped considerably, and 30-year sovereign bond yields from the U.S. to the U.K. to Germany fell by a startling 30–60 basis points (bps). In fact, the move in global yields led to a number of records: Germany issued negative-yielding 30-year bonds for the first time, while U.S. and U.K. 30-year yields likewise fell to all-time lows. In the U.S., the yield curve inverted between two- and 10-year Treasury yields for the first time since 2006.

Against a backdrop of slowing economic activity, central banks committed to easier policy stances. Evidence of a global manufacturing recession continued to mount in August: Flash purchasing managers’ indexes (PMI) showed slowing in U.S. manufacturing, while those in Germany, Japan, and 10 other countries in the G-20 were in contractionary territory. Data also showed signs of decelerating momentum in the U.S. labor market. Preliminary benchmark revisions from the Bureau of Labor Statistics suggested that the monthly pace of payroll gains was closer to 120,000 (versus the roughly 225,000 pace this time last year), just slightly above the level needed to keep the unemployment rate steady. Importantly, these slower payroll gains have coincided with fewer weekly labor hours – a trend that, if continued, could eventually hurt consumption (the largest driver of growth in the U.S. economy). Amid the heightened economic uncertainty, central bankers gathered in Jackson Hole for the annual Economic Policy Symposium to discuss the future path of monetary policy. Federal Reserve Chairman Jerome Powell’s remarks broke little ground, suggesting what the market already expected – a 25-bp rate cut in September – but stopping short of outlining further easing.  Meanwhile, expectations continued to build for an easing package from the European Central Bank (ECB) in September, and a number of other central banks cut their benchmark interest rates, including New Zealand, Mexico, India, and Thailand.

Outside of trade tensions, electoral developments in Europe and Argentina garnered attention. In the U.K., Queen Elizabeth II granted Prime Minister Boris Johnson’s request for a suspension of Parliament in September. The request was viewed as an attempt to limit Parliament’s ability to challenge a plan to remove the U.K. from the European Union with or without a deal on the 31 October deadline.  Elsewhere in Europe, the Italian government coalition between the far-right League Party and the anti-establishment Five Star Movement collapsed due to ideological differences, though a new coalition appeared to have formed between Five Star and the center-left Democratic Party under the leadership of Prime Minister Giuseppe Conte. That averted the need for snap elections that would have likely favored the League Party and investors responded favorably on expectations of less antagonism with Brussels. As a result, the Italian 10-year government bond yield fell below 1% for the first time in history. In emerging markets, there was a surprise outcome in the PASO (a key national primary) in Argentina – the lead-up to the presidential election in October – as current President Mauricio Macri lagged Peronist candidate Alberto Fernández by a much wider margin than anticipated. With Fernández now a clear favorite to win October’s presidential election, Argentine assets weakened considerably amid uncertainty over how a Fernández administration would handle the country’s debt obligations and Argentina’s critical financing program with the IMF.

 

Summer of Discontent

Rally or Recovery?
August’s escalating trade conflict spurred a “risk-off” market reaction – the S&P 500 fell 1.6%, U.S. credit spreads widened 11 basis points (bps), and the U.S. 10-year Treasury yield fell more than 50 bps – putting a small dent in what has been a notably positive year for risk assets. While the S&P 500 is still up more than 18% year-to-date, in the context of the 14% drawdown that began last September and continued through year-end 2018, it may be more accurate to think about 2019 as a risk-asset recovery than a risk-asset rally. Over the full period that includes the fourth-quarter drawdown, equities are about flat (up just 1.8%). What’s perhaps more concerning has been the unusually large move in interest rates over this time period. The U.S. 10-year yield has fallen nearly 160 bps, while at the same time, credit spreads have widened only 12 bps. This relatively modest widening in credit spreads is unusual, especially as growth outlooks have clearly worsened and central banks around the world have stepped in to provide support.

In the Markets

EQUITIES

Developed-market equities remained volatile in August, and stocks1 declined 2.0%, driven by escalating U.S.−China trade tensions and continued signs of slowing global growth. U.S. equities2 fell 1.6% as heightened trade tensions overpowered positive consumer data. European3 equities declined 1.4%, and Japanese equities4 fell 3.7% on the deteriorating outlook for global growth, increasing potential for a hard Brexit under new U.K. Prime Minister Boris Johnson, and trade uncertainties, even while the yen strengthened on “safe-haven” demand. Emerging market5 equities declined 4.9% overall in August, while performance across individual markets was mixed. In Brazil6, stocks modestly fell 0.7% amid contagion fears after an upset in the first leg of Argentinian national elections caused equities in Argentina7 to plummet 40.6% over the month. Chinese8 equities fell 1.5% on escalating trade tensions with the U.S. In India9, stocks fell 0.2% as a dispute with Pakistan resulted in the suspension of bilateral trade. Lastly, Russian10 equities were flat, returning 0.02%.

Equity markets

DEVELOPED MARKET DEBT

Developed-market yields fell sharply in August as investors sought refuge in government bonds amid escalating U.S.–China trade tensions. In the U.S., the 10-year Treasury yield dropped 52 basis points (bps) to 1.50%, contributing to an inversion of the yield curve between two and 10 years (10-year yields fell below two-year yields) for the first time since June 2007. Meanwhile, the 30-year yield reached an all-time low of 1.91%. Despite weakening fundamentals, the Bank of England kept its policy rate on hold as it looked ahead for more clarity around a Brexit outcome, with a no-deal scenario appearing increasingly likely. The 10-year gilt yield fell 13 bps to 0.48%, while the 10-year German bund yield fell 26 bps to –0.70% as the European Central Bank signaled a willingness to recommence quantitative easing. Rates in Japan also declined; the 10-year government bond moved 12 bps lower to –0.27%.

Developed market bond markets

INFLATION-LINKED DEBT

Global inflation-linked bonds (ILBs) posted positive absolute returns but underperformed their nominal counterparts in August. Global breakeven inflation (BEI) expectations finished the month materially weaker amid the general risk-off sentiment in the markets and a drop in oil prices. In the U.S., Treasury Inflation-Protected Securities (TIPS), despite positive absolute returns, underperformed nominal Treasuries; U.S. real yields continued to rally following the Fed’s July rate cut, but U.S. breakevens fell to multiyear lows during the month as market risk sentiment soured. Outside the U.S., U.K. inflation-linked gilts also underperformed, as U.K. breakevens dropped, with a pronounced move lower in longer-term expectations, which were more insulated from Brexit headlines.

Inflation-linked bond markets

CREDIT

Global investment grade credit11 spreads widened 10 bps in August, and the sector returned 2.37% for the month, underperforming like-duration global government bonds by –0.62%. Credit spreads widened due to increasing uncertainty around U.S.–China trade, as well as weaker economic data, and a significant move lower in rates globally. Industries that are more insulated from potential global trade disruptions outperformed the broader market, including telecoms, REITs, and banks.

Global high yield bond12 spreads widened 13 bps in August. The sector returned 0.52% for the month, underperforming like-duration Treasuries by –1.14%. High yield bond performance was mixed in August as the steady slide in rates offset weakness in equities stemming from the re-escalation of U.S.–China trade tensions and slowing global growth. With oil prices decreasing, the energy sector was under pressure. The higher quality BB segment returned 1.14% for the month, while the CCC segment returned –1.94%.

Credit markets

EMERGING MARKET DEBT

Emerging market (EM) debt performance was bifurcated along currency lines in August. External debt returned 0.55%,13 despite a 28-bp widening in spreads, as underlying U.S. Treasury yields fell by 52 bps.14 By contrast, local debt posted returns of –2.64%15 as EM currencies weakened significantly, offsetting a rally in local rates. EM investor sentiment generally worsened as U.S.–China trade tensions escalated with tit-for-tat tariffs. Contagion fears also arose in EM after the first leg of Argentina’s presidential elections; the less market-friendly candidate won by a much wider margin than expected, triggering a precipitous sell-off in Argentine assets.

Emerging market bond markets

MORTGAGE-BACKED SECURITIES

Agency MBS16 returned 0.89%, underperforming like-duration Treasuries by 63 bps. August was the 11th month of the Federal Reserve’s balance-sheet unwinding: The Fed sold $20 billion in MBS over the month and has cumulatively sold $300 billion. However, the pay-downs on the Fed’s holdings exceeded its $20 billion cap, and the Fed began to reinvest the additional $6 billion back into agency MBS. While the 52-bp drop in the U.S. 10-year Treasury rate accounted for some of the underperformance in agency MBS over the month, the supply from the Fed and summer seasonals also weighed on the market. Higher coupons outperformed lower coupons, GNMA outperformed conventional MBS, and GNMA 30-year MBS outperformed GNMA 15-year MBS; in addition, conventional 15-year MBS outperformed conventional 30-year MBS. Issuance in MBS was the highest in over four years, totaling $170 billion, a 29% increase from July. Prepayment speeds increased 29% in July (the most recent data available). Non-agency residential MBS spreads were flat during August, while non-agency commercial MBS17 returned 2.29%, underperforming like-duration Treasuries by 16 bps.

Mortgage-backed securities markets

MUNICIPAL BONDS

The Bloomberg Barclays Municipal Bond Index returned 1.58% in August, bringing the total return to 7.61% for the year. Munis underperformed the U.S. Treasury index over the month, causing MMD/UST ratios to increase across the curve. High yield munis outperformed investment grade munis over the month, returning 2.41% for August and bringing the year-to-date return to 9.91%. High yield performance was driven primarily by positive returns in the tobacco, special tax, and electric utility sectors. Total muni supply of $38 billion in August was up 34% versus the previous month and 13% year-over-year. Muni fund flows remained robust, marking 34 positive weeks straight: Investment inflows totaled $8 billion in July, which lifted year-to-date inflows to $64 billion, again the strongest recorded level for this point in the year.

U.S. municipal bond market

CURRENCIES

The U.S. dollar ended the month stronger (0.4% based on DXY) than its developed-market counterparts, as global trade tensions and falling oil prices generally weighed more heavily on other currencies. The euro weakened 0.8% versus the dollar on mixed economic data and escalating trade tensions between the U.S. and China and, in some respects, between the U.S. and E.U. Of note, the Norwegian krona softened 2.9% against the dollar due to both global trade tensions and the significant slide in oil prices. By contrast, the British pound was flat against the dollar; mixed Brexit headlines and a negative GDP report were offset by stronger-than-expected retail sales. The Japanese yen, a traditional “safe-haven” currency, was a strong outperformer due to the trade tensions, strengthening 2.4% against the dollar.

Currency markets

COMMODITIES

Commodity returns were negative in August. Oil declined sharply early in the month, with mounting concerns over slowing economic growth and trade tensions; however, prices were well-supported into month-end on declining U.S. inventories. Agricultural commodities were weaker, driven by an escalation in the trade dispute between the U.S. and China and a generally bearish WASDE (World Agricultural Supply and Demand Estimates) report: The U.S. Department of Agriculture forecast higher-than-anticipated corn plantings and production despite unfavorable weather conditions earlier in the season. Nickel prices continued to move higher on reports that Indonesia will bring forward its planned ban on ore exports, which drove gains for the overall base metals sector. Precious metals benefitted from lower real yields amid deteriorating sentiment on trade and slowing economic growth.

Oil market

Summer of Discontent

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), 7S&P 500 Merval Index (MERVAL Index),  8Shanghai Composite Index (SHCOMP Index), 9S&P BSE SENSEX Index (SENSEX Index), 10MICEX Index (IMOEX Index) 11Bloomberg Barclays Global Aggregate Credit USD Hedged Index, 12BofA Merrill Lynch Developed Markets High Yield Index, Constrained, 13JP Morgan EMBI Global, 14US Treasury 10 YR, 15JP Morgan GBI-EM Global Diversified, 16Bloomerg Barclays Fixed Rate MBS Index (Total Return, Unhedged), 17Bloomberg Barclays Investment Grade Non-Agency MBS Index

Outlook

Based on PIMCO’s cyclical outlook from March 2019. Note that a new outlook will be released in the next month.

In the U.S., we continue to expect growth to slow to 2%–2.5% in 2019 from nearly 3% last year. Factors contributing to the deceleration include fading fiscal stimulus, the lagged effect of tighter monetary policy over the past few years, and headwinds from the China/global slowdown. Headline inflation is likely to remain in the 1.5%−2% range this year, while core CPI is likely to accelerate somewhat as corporations pass on higher import tariff costs. With growth likely to continue slowing and higher downside risks from recent U.S. trade policies, the Fed has adopted a more dovish stance and looks likely to cut rates further in 2019.

For the eurozone, we expect growth to slow to a trend-like pace of 0.75%–1.25% in 2019 from close to 2% in 2018, as weak global trade exerts significant downward pressure on the economy and some countries experience a recession. An improvement in global trade conditions would contribute to a gradual reacceleration. Reflecting firmer wage growth, we expect a modest pickup in core inflation, which has been stuck at 1% for some time. Mirroring the dovish shift by many central banks, the European Central Bank (ECB) has also taken an accommodative tone with some potential for more easing policies in 2019. 

In the U.K., we expect real growth in the range of 1%–1.5% in 2019, modestly below trend, and we continue to think that a chaotic no-deal Brexit is relatively less likely than other scenarios. We see core CPI inflation stable at or close to the 2% target as import price pressures have faded and domestic price pressures remain subdued.

Japan’s GDP growth is expected to be modest at 0.5%–1% in 2019, broadly unchanged from 0.7% in 2018. Core CPI inflation is expected to dip into negative territory (due to temporary factors).

In China, we see growth slowing in 2019 to the middle of a 5.5%‒6.5% range from 6.6% in 2018, stabilizing somewhat in the second half of the year as fiscal and monetary stimulus find some traction. We expect fiscal stimulus of 1.5% to 2% of GDP. Inflation remains benign at 1.5%-2.5% in our forecast, and we may see additional stimulus if credit conditions deteriorate more.

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Disclosures

A “safe haven” is an investment that is expected to retain or increase in value during times of market turbulence. A “safe haven” currency is a currency perceived to be low risk due to the stability of the issuing government and the strength of the underlying economy. All investments contain risk and may lose value.

Past performance is not a guarantee or a reliable indicator of future results. 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 are 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 low interest rate environments increase this risk. 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 is exempt from federal income tax and 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.

The credit quality of a particular security or group of securities does not ensure the stability or safety of an overall portfolio. The quality ratings of individual issues/issuers are provided to indicate the credit-worthiness of such issues/issuer and generally range from AAA, Aaa, or AAA (highest) to D, C, or D (lowest) for S&P, Moody’s, and Fitch respectively.

This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2019, PIMCO.