In the World
Markets sustained their recovery from December’s sell-off. Global equities continued to retrace their drawdown from the fourth quarter last year: The MSCI World Index rose 3.0%, bringing year-to-date gains to a staggering 11.1%, though the index still remained 4% below its September high. Emerging market stocks underperformed those in developed markets, gaining just 0.2% in February;1 however, Chinese equities were a bright spot – up 13.8% – buoyed by U.S.-China trade talk progress.2 Credit spreads tightened across the board, with lower-credit-quality bonds outperforming higher quality, and the U.S. dollar strengthened against most of its developed-market counterparts. A notable exception was the British pound, which appreciated 1.2% to become the best-performing developed market currency year-to-date in anticipation that the Brexit deadline would be extended. The upbeat risk sentiment was bolstered by a more dovish stance from global central banks (see below), though developed market yields moved just barely higher as the shift in stance was in response to a softer growth outlook. Lastly, Brent crude oil resumed its rally from December lows, settling above $65 per barrel due to U.S. sanctions on Venezuela’s state-run oil company and OPEC production cuts.
Global central banks signaled more accommodative stances as recent economic data indicated decelerating growth. The eurozone continued to see softening growth metrics, most notably in manufacturing PMIs (purchasing managers’ indexes), which fell into contractionary territory for the first time since June 2013. Economic growth expanded in the region by a modest 0.2% last quarter, with notable laggards including Italy and Germany – the latter typically seen as a bulwark for European growth. The recent weakness, combined with a warning from the European Central Bank (ECB) that the slowdown “may be broader and longer-lasting than originally forecasted,” pushed out expectations for a rate hike well into 2020. Meanwhile, the Bank of England cut its growth and inflation forecasts (citing Brexit concerns), as did the Reserve Bank of Australia, which shifted from a tightening bias to a more symmetric policy stance. In the U.S, the Federal Reserve emphasized its “patient” approach and indicated the possible conclusion of balance-sheet normalization later this year amid mixed economic data: Stronger-than-expected GDP growth of 2.6% in Q4 and large payroll gains in January contrasted with softer-than-expected December retail sales.
Optimism over U.S.-China trade talks helped bolster market sentiment, while other geopolitical developments were more mixed. The ongoing trade conflict between the U.S. and China took a positive turn after President Donald Trump announced he would postpone a 1 March tariff increase as the two countries continued to make progress toward a deal. Beyond China, optimism on trade was more moderate. The Trump administration indicated it may impose tariffs on Japanese and European auto industries in the name of national security. In Britain, the threat of a no-deal Brexit seemed to recede: Prime Minister Theresa May announced a vote to take a no-deal exit off the table and extend the deadline if the two sides were unable to reach a new agreement by 12 March. Elsewhere in Europe, the European Commission warned of deterioration in Italy’s debt dynamics – along with those of Spain and Greece. Spain’s government was unable to pass a budget as Catalan parties withdrew their support, triggering snap elections in April. In Brazil, President Jair Bolsonaro put forward a much-anticipated, ambitious plan for reform of Brazil’s pension system, although it will need to pass through Congress for approval.
1 MSCI Emerging Markets Index
2 Shanghai Composite Index
In the Markets
Developed market stocks1 continued their recovery in February and rose 3.0%. U.S. equities2 climbed 3.2% as the outlook for China-U.S. trade talks continued to improve and Federal Reserve communication remained dovish. European3 equities rallied 4.2%; hints about additional stimulus measures from the European Central Bank (ECB) helped investors overlook an array of negative economic data, the ongoing Brexit drama and political setbacks in Italy. Japanese equities4 rose 3.0% on dovish comments from Bank of Japan about boosting stimulus measures, which supported risk assets and weakened the yen.
Emerging market5 equities rose 0.2% overall in February, but performance in individual markets varied significantly, and local currencies generally underperformed versus the U.S. dollar. In Brazil6, stocks fell following January’s strong performance as economic data was mixed and the Brazilian central bank kept rates on hold. In India8, stocks also fell 1.0%, weighed down by the continued recovery in energy prices, while Russian9 equities decreased 1.4% and the ruble weakened despite gains in oil prices. Chinese equities7, however, surged 13.8% when MSCI announced a significant increase in the weights of China A-shares in its global indexes; the outlook for trade talks and domestic stimulus measures also supported the rally in China’s equity markets.
DEVELOPED MARKET DEBT
Developed market yields ended the month higher even though global central banks signaled more accommodative policy stances. In the U.S., the Fed emphasized its “patient” approach and indicated the possible conclusion of balance-sheet normalization later this year. Though economic data were mixed, risk appetite was still robust (reflected in solid equity market gains and tighter credit spreads), and coupled with stronger-than-expected Q4 U.S. GDP growth (2.6%), contributed to higher yields. The U.S. 10-year Treasury ended the month nine basis points (bps) higher at 2.72%. Sovereign 10-year yields in Germany and the UK also rose by three and eight bps, respectively, boosted in part by some optimism over Brexit even as economic data were generally weaker and both the ECB and Bank of England (BoE) noted continued softening in growth. In Japan, the yield curve modestly flattened, with shorter-term yields unchanged and long-term yields edging lower – the Japanese 10-year yield fell three bps to 0.02%.
Global inflation-linked bond (ILB) markets posted mixed returns across countries in February. Breakeven inflation expectation (BEI) moves were also mixed, balancing the continued recovery in oil prices against slowing growth momentum in select regions and country-specific factors.10 In the U.S., returns for Treasury Inflation Protected Securities (TIPS) were flat overall, but they outperformed nominal Treasuries. The U.S. real yield curve steepened, with front-end rates moving slightly lower given a more dovish Fed outlook on rates and inflation. U.S. breakeven inflation continued to rebound, fueled by the upward move in oil prices and improving sentiment. Outside the U.S., U.K. breakevens notably underperformed as the British pound strengthened and investors focused on the mounting possibility of an extension to the March Brexit deadline.
Global investment grade credit spreads11 tightened nine bps in February, and the sector returned 0.14%, outperforming like-duration global government bonds by 0.62%.12 Credit markets enjoyed a reprieve from recent market volatility and benefitted from positive sentiment surrounding the U.S.-China trade talks, a better-than-expected GDP report, oil price stabilization and the expectation that central banks would be more accommodative.
Global high yield bond13 spreads tightened 47 bps in February, and the sector returned 1.78% for the month, outperforming like-duration Treasuries by 1.83%.14 The many catalysts behind the rally were the dovish pivot by global central banks, better-than-expected earnings, reflated equity markets, anticipation of a U.S.-China trade deal, and a reopening of capital markets. The rally in February continued the momentum in January and offset most of the decline in the last quarter of 2018. In February, the higher-quality BB segment returned 1.68%, while the CCC segment returned 2.01%.
EMERGING MARKET DEBT
Emerging market (EM) debt performance diverged by sub-sector in February. External debt posted positive returns of 0.62%15 as a 17-bps tightening in spreads was partially outweighed by a gradual steepening of the U.S. yield curve. Local debt turned in a poorer performance of ‒1.09%16, as strong U.S. economic data boosted the U.S. dollar against EM currencies. Perceived progress on U.S.-China trade talks, including the announcement that further U.S. tariffs would not be instituted on 1 March, buoyed risk sentiment, although the rally in EM assets so far this year left valuations less attractive than they were previously.
Agency MBS17 returned ‒0.09% and outperformed like-duration Treasuries by six bps. Broad-based demand from overseas investors, REITS and banks, coupled with low volatility during the month, supported the MBS sector, while excess supply from the Fed’s balance-sheet unwinding continued to weigh on performance. Higher coupons outperformed lower coupons; Ginnie Mae MBS outperformed Fannie Mae MBS, and 15-year MBS outperformed 30-year MBS. Gross MBS issuance declined 12% from January, and prepayment speeds decreased 7% in January (most recent data). Non-agency residential MBS spreads were flat during February, while non-agency commercial MBS18 returned 0.54%, outperforming like-duration Treasuries by 74 bps.19
The Bloomberg Barclays Municipal Bond Index posted a return of 0.54% in February, outperforming the U.S. Treasury Index and bringing the total return to 1.30% for the year. Furthermore, municipal/Treasury yield ratios richened four to six percentage points, led by performance at the short end of the yield curve. High yield munis also returned 0.54% in February, bringing the year-to-date return to 1.22%.20 February performance was primarily driven by positive returns in the water-and-sewer and resource-recovery sectors. February’s supply of $25 billion was up 1% from the previous month and up 39% year-over-year. Muni fund flows were positive: Aggregate inflows totaled $8.42 for the month and $12.41 billion so far in 2019, almost erasing the high outflows in December 2018.
The U.S. dollar ended the month 0.6% stronger against its G10 counterparts, despite continued dovish rhetoric from the Fed, as economic data remained strong relative to other G10 countries. The euro weakened 0.7% against the dollar when Q4 data indicated the eurozone had entered an industrial recession. The yen weakened 2.3% on dovish BOJ rhetoric and positive market sentiment on the China-U.S. trade talks. The Australian dollar was the worst-performing G10 currency, weakening 2.5% due to dovish comments from the Reserve Bank of Australia (RBA) governor and weak economic data, both domestic and Chinese. Meanwhile, the British pound benefitted from positive data surprises and a perceived lower probability of a no-deal Brexit, rising 1.2% against the dollar.
In energy, oil prices extended their gains on hopes for a U.S.-China trade deal, optimism around an improving supply backdrop and an increasingly dovish outlook for monetary policy. Ongoing trade negotiations between the two largest economies continued to fuel risk sentiment, easing concerns around oil demand. Although the U.S. Energy Information Administration (EIA) reported a continued rise in U.S. output, expectations for falling production elsewhere kept prices well supported: Saudi Arabia announced deeper-than-expected production cuts, while the U.S. imposed sanctions on Venezuela, targeting its crude oil exports. Petroleum products followed crude higher, with gasoline leading the way after a larger-than-expected inventory draw and strong seasonal demand at the end of the month. Natural gas prices were unchanged over the month. The agricultural sector posted negative returns. Wheat prices fell sharply amid ample global supplies and strong export competition. Spillover pressure from wheat and favorable growing conditions across Argentina weighed on corn prices. Despite a downward revision to domestic and global stocks, soybeans were weaker over the month. Coffee declined as rainfall in Brazil’s main producing regions boosted the crop outlook. Base metals moved higher on more accommodative signals from global central banks and growing expectations for a U.S.-China trade deal; expectations for economic stimulus in China further contributed to the rally. Precious metals declined, though platinum rallied alongside palladium as both metals benefitted from increased industrial demand.
Based on PIMCO’s cyclical outlook from December 2018. Our updated outlook based on our cyclical forum in March will be available in the next Monthly Market Update.
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 months, reflecting base effects and the recent plunge in oil prices, while core CPI of about 2% is expected to trend sideways. While another opportunistic hike is possible, we expect the current level of the fed funds rate is at or near the terminal level of this hiking cycle.
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 avoided. 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 buying operations.
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 escalate.