Interest rates on hold, but not in reverse

Financial markets have surged since the start of the year after central banks appeared to put monetary policy tightening on hold. Our investment teams give their views on where monetary policy goes next and what that means for asset prices.

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Early in 2018, amid signs economies were enjoying their best synchronised growth spurt since the financial crisis, central banks began to shrink their balance sheets; removing the monetary policy punchbowl that had been nourishing financial markets for the best part of a decade.

Fast forward a year, and monetary tightening appears to be on hold; at least for the time being. The most abrupt about turn in the policy environment has been seen in the US.

On December 19 the Federal Reserve (Fed) largely turned a blind eye to heavy falls in the price of risk assets when it lifted rates for a fourth time in 2018, indicated there were two more hikes to come in 2019, and said it would press ahead with its plan to reduce its $4.1 trillion in bond holdings. Little more than a fortnight later, with its unexpectedly hawkish stance threatening to send equities and other risk assets into a tailspin, the central bank dramatically softened its stance.

Fed Chair Jerome Powell said on January 4 the central bank would not only be “patient” when it came to raising interest rates but that it "wouldn't hesitate" to shrink its balance sheet at a slower pace if it was causing problems in financial markets. 

Softer economic data is causing other central banks to re-appraise their policy stance too. Just two months since the European Central Bank (ECB) completed its 2.6 trillion-euro bond-buying scheme, the central bank is widely expected to backtrack on plans to hike rates in the second half of this year. With growth in the euro zone at a four-year low, the ECB has itself highlighted the downside risks to its forecasts.

The Fed’s dovish stance has been mirrored elsewhere, with central banks in China, Japan and Britain among those to have signalled growing concern over the economic outlook in recent weeks.

Financial markets were electrified by the shift in the Fed’s stance. Equities enjoyed their best month in over three years in January as the US bond market concluded the interest rate cycle had reached an inflection point and the next move in rates was more likely to be down than up. Other risk assets posted similarly big gains. Markets were lent further support by signs Washington and Beijing were making progress as they looked to end simmering trade tensions.

End of the cycle?

However, according to Michael Grady, Aviva Investors’ head of investment strategy and chief economist, investors who believe recent developments signal the end of the cycle of monetary tightening are likely to be disappointed.

Although financial conditions tightened appreciably during the final quarter of 2018 due to sharp falls in asset prices, January’s rally means most of that tightening has now been reversed. With the US economy still growing at a healthy clip – output is forecast to expand 2.5 per cent this year – Grady believes the Fed is likely to resume monetary tightening in the second half of the year.

“If risks assets continue to rally, financial conditions over the next month or two will be even looser than they were in the second half of last year. If we are right that growth is only slowing modestly, and we continue to see unemployment falling and wages and core inflation rising, we expect to see the Fed hiking rates once or twice in the second half of the year,” Grady says.

While James McAlevey, Aviva Investors’ global head of rates, concurs with that view, he says it is important to recognise there is now far more uncertainty over the outlook for US monetary policy than until recently.

Markets have been spoon-fed for the best part of a decade in terms of forward guidance. Suddenly what we’re seeing is akin to removing sugar from the sugar addict,

“Markets have been spoon-fed for the best part of a decade in terms of forward guidance. Suddenly what we’re seeing is akin to removing sugar from the sugar addict,” he says. “The distribution of outcomes has suddenly expanded massively, which could trigger much more volatility,” he argues.

While there may be a “short-term window of opportunity” to buy risk assets, McAlevey adds markets have been given no more than a temporary reprieve by the Fed. It is therefore premature for the US bond market to be signalling the end of the interest rate cycle.

“The market’s running with this idea that rates are on hold. But if growth is ok and inflation picks up, it is almost certain they continue to hike interest rates. They are likely to be back in the game sooner than people expect. You don’t want to be as long of risk as you are now when the Fed starts hiking again,” McAlevey says.

Limited upside in corporate bonds

That view is echoed by Colin Purdie, chief investment officer credit and Brent Finck, high-yield bond portfolio manager.

“We’re back in the goldilocks scenario that we have seen post the financial crisis. However, we don’t see this continuing,” says Purdie.

He says while it was the right decision to have increased the level of credit risk within their portfolios at the end of last year, his team is starting to reduce risk once again.

All the Fed’s done is move the timing of the next hike. At some point we’re going to be faced with the Fed wanting to hike again, or the economy is going to be slowing to a significant degree. Neither of those are great for credit,

“All the Fed’s done is move the timing of the next hike. At some point we’re going to be faced with the Fed wanting to hike again, or the economy is going to be slowing to a significant degree. Neither of those are great for credit,” Purdie explains.

According to Finck: “The ‘Fed put’ is back. It’s put a backstop behind the market, giving risk assets a strong bid. So long as policy stays on hold, markets are in a sweet spot.”

However, given the high-yield has already rebounded sharply in 2019, there looks to be limited further upside.

“The market has come a long way very fast, with spreads tightening by around 100 basis points already this year. If we saw them tighten by another 50 basis points or so, we would probably become a lot more conservative, looking at it as a time to de-risk,” Finck says.

He adds that an even bigger danger is the Fed starts to cut rates in response to the economy slowing faster than expected. In such an environment corporate profits would be expected to fall and defaults rise.

“The market is starting to price in the potential for that next year, and that’s an environment where we would become very defensive,” says Finck.

EMD surges, but for how long?

Nowhere has the shift in sentiment been more dramatic than in emerging market debt (EMD), which for most of last year was an asset class under intense pressure due to rising US interest rates, a strong dollar, and the escalating trade war between the US and China.

The improvement in sentiment has been reflected in a dramatic pick-up in investment inflows. Recent data from JP Morgan showed $10.2 billion flowed into EM bond funds in January, almost two thirds of that recorded in the whole of 2018.

According to Aaron Grehan, deputy head of emerging market debt at Aviva Investors, so long as the Fed stays on hold, EMD will continue to lure investors. The yield premium offered looks “compelling”, especially when considering that even if economic growth rates are likely to moderate across emerging economies, they are still likely to outstrip those recorded by developed nations.

Nonetheless, volatility is expected to remain relatively high, and with markets still vulnerable to periodic sell-offs, country selection will likely be a key driver of returns.

Delays in Europe

Turning to the policy outlook elsewhere, Geoffroy Lenoir, head of euro sovereign rates at Aviva Investors, says the weakness of recent surveys is leading European government bond markets to believe the ECB will not only refrain from tightening policy this year, but next year too.

“Fears the euro zone may be heading towards recession look unwarranted, at least for now. Nonetheless, with growth unquestionably softening, such an outcome cannot be ruled out,” he says.

Lenoir, who believes ten-year German government bond yields could be heading back towards zero - from around 0.75 per cent in February 2018 - argues the outcome of trade talks between the US and China, Brexit, and result of May’s European elections, especially in Italy, will determine bond markets’ fortunes.

Despite the downside risks to euro zone economies, he sees little value in core markets at current yields. His believes Spanish and Portuguese markets offer better value in relative terms, with both nations’ economies continuing to perform comparatively strongly.

Although he concedes there is a danger of a spill-over from any worsening of the political backdrop in Italy, political risk in Spain and Portugal is lower than in many other European countries.

Rates and Equities

As for other asset classes, Mikhail Zverev, Aviva Investors’ head of global equities, is more upbeat. He draws comfort both from valuations and recent company results.

The MSCI World index is trading on a price-to-earnings ratio of 14. That’s equivalent to a seven per cent earnings yield. This is attractive relative to history. You would need to see a sharp downturn in earnings before equities began to look expensive,

“The MSCI World index is trading on a price-to-earnings ratio of 14. That’s equivalent to a seven per cent earnings yield. This is attractive relative to history. You would need to see a sharp downturn in earnings before equities began to look expensive,” he says.

With the majority of firms continuing to grow profits at a healthy pace, beating market expectations, Zverev believes a collapse in earnings growth is unlikely, even if global economic growth cools.

“If that’s correct, we think shares should be able to withstand a modest further tightening in monetary policy, should central banks deem that necessary,” he says.

Alistair Way, head of emerging market equities, is somewhat more circumspect. While he is a little more confident of the prospects for his asset class than six months ago, thanks to the easing of US-China trade tensions, emerging equity markets look reasonably priced given the extent of the recent recovery.

“For emerging markets to generate strong returns from here we need to see a turn in the profit cycle, an end to downgrades and a return to decent levels of earnings growth. Re-rating is only going to take us so far,” Way says.

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