Recent weak economic data has raised market concerns that economic gloom might be spreading beyond the manufacturing sector. Worries that the drag on economic activity from the global protectionist push could start to slow consumer spending and economic growth more broadly have been weighing on risk assets. We believe building portfolio resilience is crucial in this environment of elevated macro uncertainty, as we write in our latest Fixed income strategy.
Relatively muted cross-asset volatility suggests markets are not fully pricing in heightened geopolitical risks that threaten to weaken economic activity. Yet central banks’ dovish pivot is buying investors time to add ballast to portfolios, with government bonds playing an important role – even at today’s low yield levels.
We see the Federal Reserve cutting rates further, but not by as much as what markets are pricing in. And it’s far from certain that the Fed will try to respond to the trade war fallout with meaningfully looser monetary policy. Supply chain disruptions could deliver a hit to productive capacity that fosters mildly higher inflation even as growth slows. This complicates the case for further policy easing. Elsewhere, the European Central Bank materially exceeded market expectations on stimulus, launching open-ended asset purchases, cutting rates and strengthening its forward guidance. We expect this broad package will have a combined impact that should be greater than the sum of its parts.
The role of government bonds
We see government bonds as crucial diversifiers that can help offset the impact of equity selloffs in today’s environment of rising macro uncertainty and easy monetary policy. We prefer U.S. Treasuries for this role due to their negative correlation with equity returns. See the charts below. European bonds may be less effective shock absorbers as euro area rates approach a lower bound.
Yet we also note that the cost of this diversification is higher, and the risk/reward tradeoff is different on a near-term horizon. On a tactical basis we prefer euro area bonds over U.S. Treasuries. A relatively steep yield curve brightens euro area sovereign bonds’ appeal even at low or negative yields. We still see markets pricing in too much U.S. easing, while the ECB exceeded market expectations, as we note above. And U.S. dollar-based investors can potentially pick up an immediate yield boost after hedging euro-denominated exposures back into their home currency.
We see the protectionist push as a key driver of global markets and economy going forward. Recent geopolitical volatility underscores this message from our midyear outlook. We see some possibility of a U.S.-China truce, but a comprehensive trade deal appears unlikely and geopolitical uncertainty from protectionist policies is likely to persist. We believe building portfolios that can withstand short-term turbulence is critical against this backdrop, as detailed in the Q4 update to our Global investment outlook.
Another key theme in our outlook: We see central bank easing helping stretch the length of this economic cycle. This underpins our positive view on credit and other income generating assets in the near term. Read more on our tactical bond market views in our Fixed income strategy.