In the world
The political landscape continued to surprise. British Prime Minister Theresa May’s snap election backfired when her party lost its majority in parliament in June, throwing the government into a state of uncertainty and undermining her negotiating position heading into Brexit talks. Emmanuel Macron, on the other hand, fared better in France’s parliamentary elections, unexpectedly securing a majority that should help him push through much-needed labor law reforms. The Saudi royal family even saw a shakeup as King Salman named his 31-year-old son, Mohammed bin Salman, next in line to the throne at the expense of his nephew. This shift, however, was largely expected as the new crown prince was already responsible for oil policy, defense and the economy, including the recent decision to cut ties with neighboring Qatar over the country’s friendly relationship with Iran. Paralysis continued to grip Washington: The healthcare bill was pulled (again) from the floor in the Senate as Majority Leader Mitch McConnell struggled to wrangle enough votes before the July recess. The Trump-Russia probe also cast a pall over the administration, and FBI director James Comey’s testimony before the Senate Intelligence Committee dominated the news circuit. Lastly, in the latest blow to the country’s political stability, Brazilian President Michel Temer was charged with corruption and will proceed to trial if two-thirds of the lower house approve.
A host of central banks, including the Fed, ECB, BOE and BOC, showed signs of reducing monetary accommodation that has been heavily prescribed since the financial crisis. With economic growth on sound footing, Federal Reserve officials raised the policy rate above 1% – the third increase in six months – and officially provided some details on how the Fed will shrink its $4.5 trillion balance sheet; the Fed plans to gradually end reinvestments from maturing Treasuries and mortgage-backed securities starting sometime this year. While front-end Treasury yields drifted higher, this was quickly overshadowed by rate moves in Europe, where markets took ECB President Draghi’s comments on a strengthening recovery as hints that the ECB may soon trim its bond-buying program. The comments came amid sturdier eurozone manufacturing and multiyear highs in business and consumer confidence. In the UK, year-over-year inflation of 2.9% prompted BOE governor Mark Carney and three voting members to suggest rate hikes may soon be appropriate; the pound jumped and rates moved sharply higher.
The hawkish shift in tone from central banks drove interest rates higher and yield curves flatter, while oil prices slumped into a bear market. Though the 10-year U.S. Treasury yield touched 2.10% during the month – the lowest level since November 2016 – the shift in tone from key central bankers sparked a late-month sell-off in bonds that quickly spread across the globe. While front-end yields rose across developed markets (DM), a tepid near-term outlook for inflation kept a lid on longer-dated rates. Oil prices tumbled as lingering fears of oversupply underscored skepticism of the OPEC deal to stabilize prices and the U.S. dollar slipped for the fourth month in a row against a basket of DM currencies. Despite rising DM rates and falling commodity prices, emerging markets (EM) were broadly stable, and both local currency debt and equities gained on the month. Chinese markets were in the spotlight as global index provider MSCI elected to include local A-class shares in its benchmark emerging market equity indices for the first time, a milestone symbolizing the integration of China’s equities with the global markets.
The Fed raised interest rates for the third time since December 2016 and announced plans to start unwinding its balance sheet later this year. Yet, financial conditions have actually eased since the start of the year, owing in part to lower Treasury yields, higher equity prices and a weaker U.S. dollar. While that may seem counterintuitive, the Fed’s current hiking cycle has more to do with getting away from the dreaded zero-bound than it does with a traditional “tightening” of conditions to slow an overheating economy. Thus, the Fed is taking the opportunity to gain room to maneuver without upsetting solid (if lackluster) growth.
In the markets
Emerging Markets’ Resilience
Driven by export linkages, emerging market (EM) bonds and commodity prices – particularly crude oil – have historically exhibited a high correlation with one another. However, returns have decoupled quite dramatically thus far in 2017: EM local bonds have gained 10% while Brent crude oil prices are nearly $9 per barrel (or about 16%) lower. The breakdown in the traditional relationship between EM and oil prices has a few potential explanations. First, oil price softness has been driven by a supply overhang while global demand has remained robust. Second, the drop in oil prices has coincided with a weaker U.S. dollar and stronger local currencies, attracting capital flows into EM. Last, EM fundamentals appear encouraging and diminished inflationary pressures are allowing EM central banks to ease policies and stimulate growth.
Developed market stocks1 returned 0.4% as the technology sector’s momentum subsided and value outperformed growth for the first time this year. In the U.S.,2 investors took the Federal Reserve’s rate hike in stride, and equities returned 0.6%. In Europe,3 markets interpreted comments by European Central Bank (ECB) President Mario Draghi as hawkish, causing stocks to fall 2.5%. Japanese equities4 rose 2.1% on
a weaker yen and relatively strong growth fundamentals.
In emerging markets,5 stocks benefitted from relatively stable global market conditions and a strong technical backdrop, returning 1.0%. In Brazil,6 stocks rose 0.3% even as President Michel Temer was formally charged for his alleged involvement in an ongoing graft scandal, which potentially threatened future reform in the country. Chinese equities7 returned 3.0% after MSCI announced the inclusion of mainland A-shares in the MSCI Emerging Markets Index. Indian equities8 fell 0.3% as markets assessed the potential impact of the country’s new goods and services tax, scheduled to be introduced in July, while Russian stocks9 rose 0.2%.
DEVELOPED MARKET DEBT
The 10-year U.S. Treasury yield touched 2.10% during the month – the lowest level since November 2016 – as most developed market (DM) rates rallied early in the month amid more political surprises, including the outcome of the U.K. snap election. However, an apparent hawkish shift in tone from central banks late in the month sparked a global bond sell-off, and DM rates ended the month higher. In the U.S., the Fed raised rates for the fourth time in this cycle and announced detailed plans to reduce its balance sheet by tapering reinvestments. A shift in tone was also apparent from the ECB and the Bank of England (BOE) after both Mario Draghi and Mark Carney indicated that reducing policy accommodation may be warranted soon. As a result, 10-year bunds and 10-year gilts increased 23 basis points (bps) and 16 bps, respectively, over the month.
Global inflation-linked bonds (ILBs) posted losses across most countries in June, while inflation expectations were mixed across markets. U.S. Treasury Inflation-Protected Securities (TIPS) continued to experience weakness, significantly underperforming nominal Treasuries. U.S. breakeven inflation rates continued their downward trajectory as the Consumer Price Index (CPI) came in below expectations for the third consecutive month. Real rates climbed higher in the U.S., with the yield curve flattening, when the Fed hiked rates and said it viewed recent weakness in economic data as temporary. In the U.K., index-linked gilts posted sharp losses alongside nominal gilts, with Bank of England members apparently divided on the appropriate path of future rate hikes. U.K. inflation expectations ended the month higher across most maturities, as inflation readings surprised to the upside and offset lackluster demand from pension funds.
Global investment grade credit10 spreads tightened 5 bps, outperforming like-duration global government bonds by +0.45% in spite of weakness in commodity markets, with oil touching lows not seen since last August. Strong market technicals continued to drive spread compression in global investment grade credit, especially continued investor demand for stable yield above government bonds.
Global high yield11 returns decelerated from their strong year-to-date pace, amid volatility in oil and rates. Nevertheless, global high yield was slightly in positive territory, up 0.2% for the month, as spreads inched lower to 360 bps. The highest-quality high yield bonds led the charge in June, even though they tend to be more sensitive to government rates, which rose over the month.
EMERGING MARKET DEBT
Following a strong performance streak, emerging markets (EM) debt cooled off somewhat in June and exhibited greater dispersion in returns. Modest spread widening and higher underlying U.S. Treasury yields drove negative performance in external debt, while falling index yields drove positive performance in local currency debt. Mexican local debt was a notable outperformer: Yields fell following the incumbent PRI’s victory in the state of Mexico governor’s race, quieting discussion of a populist political wave. Elsewhere, South African external and local debt underperformed meaningfully following a proposal to change the independent central bank’s mandate to include a focus on growth. Despite the relative slowdown in performance, investment flows into the asset class remained robust.
Agency MBS12 returned -0.40% and underperformed like-duration Treasuries by 20 bps. The announcement of the terms of the Fed’s balance sheet unwind, a pick-up in refinancing and seasonal housing turnover all contributed to the underperformance. Overall, conventional MBS outperformed Ginnie Mae MBS, 30-year MBS marginally outperformed 15-year MBS and lower-coupon conventional MBS outperformed higher-coupon conventional MBS. Gross issuance increased 11% from May, while prepayment speeds increased 18%, which was slightly faster than expected. Non-agency MBS prices rose moderately, and spreads relative to swap rates tightened. Non-agency commercial MBS13 returned -0.34% and outperformed like-duration Treasuries by 5 bps.
Municipals pulled back in June after strong performance over the first five months of the year. The Bloomberg Barclays Municipal Bond Index returned -0.36%, bringing its year-to-date return to 3.57%. June's weakness was driven by higher interest rates, a pick-up in supply and credit-related news ahead of state budget deadlines. June's $39 billion in issuance was the highest monthly total this year, although it was 19% lower than a year ago. Lawmakers across the country grappled with difficult budget decisions: Most states start their fiscal calendars on 1 July. Weak tax collections, federal policy uncertainty and slower growth in energy-producing states have all made legislative compromise more challenging this year. Eleven states ended the month without a finalized budget in place. Illinois, entering its third consecutive year without a budget, was punished by the rating agencies in June; the state's debt is now rated the lowest investment grade.
Hawkish rhetoric from central bankers in the U.S. and Europe drove most DM currency movements in June. Statements from officials at the Bank of Canada pointed to a positive economic outlook
and a reassessment of easy policy, which pushed the Canadian dollar to be the strongest performer among the G-10. Both the euro and the pound ended the month on a high against the U.S. dollar as ECB and BOE presidents also shared hawkish sentiments on monetary policy. The rally in the British pound was preceded by a 2% decline following the surprising electoral defeat for the Conservative Party majority in snap elections. In EM, the Argentine peso fell significantly after index provider MSCI announced that the country’s equities would not be added to its flagship EM index.
Broad commodities posted losses in June. Continued weakness in energy prices offset gains in industrial metals and agriculture. Crude oil continued its downward trajectory, pressured by resilient U.S. production as well as higher Libyan and Nigerian output – which are slowing OPEC’s efforts to rebalance the market. Within agriculture, wheat gained notably as harvest reports suggested poorer quality in U.S. winter crops. In industrial metals, constructive data from China broadly supported prices. Gold fell over the month as a relatively hawkish June Fed statement pushed U.S. real yields higher.
PIMCO expects the eight-year-old global economic expansion will continue to strengthen and broaden for the remainder of 2017, driving global GDP growth to 2.75%–3.25% from 2.6% in 2016 and boosting CPI inflation to 2.0%–2.5%. Our outlook reflects several positive factors: generally supportive fiscal policies (or expectations of them) in most developed market economies, easier financial conditions since the start of the year, positive animal spirits as indicated by consumer and business confidence data, and a rebound in global trade.
In the U.S., we see growth above-trend at 2%‒2.5% in 2017 as business investment recovers, particularly in the energy sector, and consumer spending is supported by a further decline in unemployment, high consumer confidence and expectations of personal income tax cuts in 2018. We forecast core inflation to hover sideways this year at 1.75%–2.25%, owing to some softer trends of late. With policy normalization underway, we expect the Fed to embark on reducing its balance sheet by gradually tapering its reinvestments in a predictable and transparent manner.
For the eurozone, we expect growth will be in a range of 1.75%‒2.25% in 2017, revised higher from our forecast in March to reflect the stronger momentum this year. While political uncertainty remains ahead of elections in Germany and potentially Italy, the likelihood of disruptive populist outcomes has diminished. In addition, both fiscal and monetary policy are expansionary, and the recovery in global trade growth supports exports and investment. We anticipate core inflation remaining well short of the European Central Bank’s (ECB) “below but close to 2%” objective, but the solid growth momentum will likely allow the ECB to taper and eventually end its purchases from early next year.
In the U.K., we expect growth to be in the range of 1.5%–2.0% despite Brexit, reflecting robust momentum, higher government spending and a positive contribution from net trade on the back of the 15% drop in the pound in 2016. We forecast CPI inflation to exceed the Bank of England’s 2% target but expect the bank to leave policy rates unchanged this year.
Japan’s strong private demand and export growth should support GDP growth of 1.0%‒1.5% in 2017 while inflation remains significantly below the 2% target. The Bank of Japan is likely to keep targeting the overnight rate at –0.1% and the 10-year bond yield at 0% and thus continue its standing invitation to the government to engage in additional fiscal expansion, which we expect to happen later this year.
China’s public sector credit bubble and private sector capital outflows will likely remain under control, and we expect growth in a 6.25%‒6.75% range in 2017 as policymakers prioritize financial stability over economic stimulus ahead of the 19th National Party Congress in the fourth quarter. Any trade war with the U.S. will likely involve words rather than action, and we expect the yuan to depreciate gradually against the U.S. dollar.
In emerging markets, we expect moderate growth in Brazil and Russia in 2017 as they emerge from recession. With inflation dropping, both countries’ central banks have room to cut rates further. We expect Mexico’s growth to be 2.25%-2.75%, with the potential for Banxico to adopt an easier policy stance if inflationary pressures abate.
The Great Unwind
On 14 June, the Fed released the much-anticipated details for “normalizing” its $4.5-trillion balance sheet. Later this year, the Fed plans to start reducing its holdings of Treasuries and mortgage-backed securities (MBS) in a “gradual and predictable manner” with preannounced caps, or limits, on the dollar amounts it will allow to run off each month; the Fed does not intend to sell any assets but rather reinvest less and less of the maturing proceeds. Initially, the caps will be set at $6 billion and $4 billion per month for Treasuries and MBS, respectively, increasing every three months until they reach $30 billion and $20 billion. These caps will remain in place to ensure a measured decline to its estimated optimal balance sheet size of around $3 trillion.
While the Fed’s balance-sheet expansion helped lower Treasury and MBS yields, shrinking the balance sheet may have a milder reverse effect: The Fed’s transparent approach is designed to avoid disrupting the bond markets. In addition, relatively attractive MBS valuations – as well as favorable technicals, including higher demand from foreign investors and banks – may help mitigate any volatility that occurs.