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Yields through the looking glass

Key points

  • For a euro-based investor, 70% of global fixed income is now negative-yielding – unprecedented for institutional investors
  • We continue to expect a narrowly-avoided US recession in the next 12 months thanks to the US Federal Reserve’s pre-emptive action, in absence of an external shock
  • Some risks remain contained despite regular flare-ups: US/China trade war, no-deal Brexit, Italy
  • Whilst it would be much appreciated, we are sceptical of a Northern European fiscal stimulus in the short run
  • We remain conservative in risk appetite, modestly underweight global equities, and looking for positive-yielding carry in credit and emerging debt

Down the deposit hole

In June 2014, the European Central Bank (ECB) first introduced a negative deposit interest rate on banks’ excess reserves. Two years later, the 10-year German Bund yield also dipped into negative territory for the first time in its history, partly because of the Brexit referendum scare. But the last couple of months have led us to a truly unchartered wonderland where about 70% of the global fixed income space is negative-yielding once hedged back to euros. Our computation includes all developed government bonds, investment grade and high yield corporate debt on both sides of the Atlantic, and emerging market debt in hard currencies. At the time of writing, the US market has still not witnessed its first negative-yielding bond – and the Federal Reserve (Fed) has been adamant it would prefer not to resort to a Fed Funds Rate below zero. However, with a circa 250 basis points hedging cost, euro-based investors must now consider facing interest rates starting with a minus sign as their new normal.

How did we get here? First, we continue a now 30-year global trend of decreasing interest rates. Ageing, the rise of income and net wealth inequalities – with the marginal saving rate increasing with income and wealth – and globalisation have all contributed to feed a global saving glut, boosting demand for debt. Second, the 2008-2009 global financial crisis left deep scars in households’ and corporates’ minds and behaviours. On balance the crisis elevated debt, reducing aggregate demand and strengthening the excess of savings over investments. Third, financial regulations were tightened in the wake of the crisis, from banks to insurers and other institutional investors. More recently these structural factors have been amplified by cyclical ones, namely markets’ fears of an economic downturn and additional monetary easing.

One shock away from tipping the cycle

In October 2018[1] when 10-year US Treasury (UST) yields were above 3%, we were “expect[ing] the debate over the implications of UST yield curve inversion to dominate 2019”. It effectively inverted in late March. Since then, we have regularly updated our probabilistic US recession model. The Fed’s pre-emptive monetary easing has been helping, whilst the US hawkish trade policy and threats were narrowing the gap to the historical threshold indicating a recession.

With 10-year UST yields below 2% since early August, we reviewed our model, but stick to our baseline outlook of avoiding recession in the next 12 months. We still believe that the Fed’s current predicament resembles both 1989 and 1998 - instances when the UST yield curve inverted, and the US central bank embarked on some easing in monetary policy. In 1989, an external shock – Iraq’s invasion of Kuwait, leading to a surge in oil prices – tipped the US into a recession the following year. In 1998, in the absence of a similarly significant shock, the Fed’s pre-emptive action was enough for the US economy to enjoy another three years of expansion and is one of the episodes where a mid-cycle policy adjustment helped avert a sharper slowdown.

We examined closely the drone attack on Saudi Aramco oil facilities, disrupting about 5% of the global oil output. This represented a similar – though smaller – magnitude as the Kuwaiti supply affected by Iraq’s invasion in 1990 of almost 7%. However, the price reaction so far has been smaller.

High potential for political or policy mistakes

The US/China trade conflict escalation has been another concern, for us – and for the bond market. Relief after the meeting between President Donald Trump and President Xi Jinping alongside the June G20 Summit in Osaka quickly turned sour as President Trump announced new tariffs on Chinese exports to the US in early August. Recent developments have eased some of this tension. Moreover, there is some speculation that the White House is becoming increasingly wary of the economic impact of further trade escalation on the US economy during the forthcoming election year. Meanwhile, China is walking a tightrope. After slowing to 6.2% year-on-year in the second quarter (Q2) – its slowest in 27 years – the Chinese economy demonstrated renewed signs of weakness, with August’s activity disappointing. Among other risks looms yet another Brexit deadline. The UK Parliament has voted against a no-deal exit and legal actions are underway. Still, preventing a ‘no deal by accident’ is no certainty.

A limited fiscal boost only

The Eurozone continues to walk its own tightrope. With the deleterious side-effects of negative interest rates in mind, September’s ECB meeting introduced a tiering system, exonerating about 40% of banks’ excess reserves from the new -0.5% deposit rate. Even with this mechanism in place – which offers only a partial compensation[2] – we believe the ECB has very thin margins for further rate cuts. As President Mario Draghi kept repeating in his penultimate press conference, “it is high time that fiscal [policy] takes charge”. Despite whispers of off-budget public investment spending, we remain sceptical of an imminent, meaningful fiscal stimulus in Germany. We worry that a spectre is haunting Europe – the spectre of “Growth in a Time of Debt”, the infamous 2010 research paper, flawed by serious errors, which led to dramatic procyclical fiscal tightening.

Asset allocation: Keep calm and carry on

September brought a welcome reversal to the deflationary summer pattern which pushed global yields lower, boosting long maturity debt exposures while undermining risk appetite in equities. In between, credit markets have found themselves once more in the sweet spot of a backdrop of modest growth and inflation but no recession. With an interim trade deal between the US and China a key potential catalyst, this fledgling reflationary cross-asset pattern may be sustained. Moreover, credit market conditions appear conducive to a further gradual rise in yields.

Sources:

[1] AXA IM Research’s Monthly Investment Strategy, “What yield curves are telling us about recession risks”, 19 October 2018

[2] Menut, A. and Tentori, A., “Q&A: The ECB and tiering”, AXA IM Research, 30 April 2019

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