In the World
An unanticipated escalation in global trade tensions precipitated a sell-off across risk assets. After the latest round of trade talks with China hit an impasse, President Trump announced an increase in tariffs from 10% to 25% on $200 billion in Chinese goods; he also signed an executive order barring U.S. companies from conducting business with the controversial Chinese telecommunications company Huawei, among others. China retaliated by hiking tariffs on $60 billion in U.S. goods and threatening to tax rare earth metals, a move that could stunt U.S. technology growth. The global trade war then opened on a new front after the U.S. administration surprised markets by announcing it would impose a 5% tariff on all Mexican imports – set to rise by 5% each month, up to 25% – unless Mexico helped stem the flow of illegal immigration into the U.S. Risk assets globally reversed course as developed market equities1 fell 5.8%, marking their first negative month this year, while emerging market (EM) equities2 fell 7.3% on the month as dollar strength exacerbated the trade concerns. Not surprisingly, the Chinese yuan and Mexican peso were the worst-performing EM currencies against the U.S. dollar in the month. Credit markets weren’t immune to the pullback in risk appetite either: Spreads broadly widened, with high yield spreads3 75 basis points (bps) wider. As risk assets sold off, bond yields fell sharply across the yield curve, leaving U.S. 10-year yields 38 bps lower at 2.12%, their lowest level since 2017. The front end of the yield curve also inverted for the second time this year as the spread between three-month and 10-year yields turned negative.
Signs of decelerating global growth also weighed on market sentiment. Manufacturing metrics in particular dipped lower across regions as purchasing managers’ indexes (PMIs) in Japan, Europe, and China fell below 50 (the level separating contractionary activity from expansionary), while the U.S. index – though still above 50 – fell over two points to its lowest level in nearly a decade. Other economic data in China also pointed to weakness despite recent stimulus measures, highlighted by slowing retail sales and a larger-than-expected decline in industrial production. With global inflation pressures still subdued, central banks remained supportive: New Zealand’s central bank became the latest developed economy to ease policy, cutting rates to a record low of 1.5%, in light of unexpected weakness in inflation. Even Federal Reserve members suggested that rates could be lowered if data were to show persistently below-target inflation or materially weaker global conditions.
Outside of trade, May featured a number of election-related headlines. In the U.K., Prime Minister Theresa May announced that she would step down after political pressure arising from her failure to pass a Brexit deal. Meanwhile, a number of incumbents will remain in office: Australian Prime Minister Scott Morrison secured a third term for his center-right government in a surprise victory, and India’s Prime Minister Narendra Modi handily won his re-election. The European Parliament elections revealed few surprises, with populist and eurosceptic parties picking up support broadly in line with predictions, though remaining well below 50% and thus limited in their power. The Brexit Party in the U.K. finished first, with 31% of the vote; Deputy Prime Minister Matteo Salvini’s League Party solidified its power in Italy, while its coalition partner, the Five-Star Movement, saw its popularity wane; and Marine Le Pen’s National Rally Party finished ahead of President Emmanuel Macron’s pro-EU party in France. In the U.S., the Trump administration delayed tougher sanctions on Iran’s petrochemical sector in hopes of easing growing tensions between the two countries after the U.S. accused Iran of attacking Saudi Arabian oil tankers.
1 MSCI World Index
2 MSCI EM Index
3 Bloomberg Barclays US High Yield 3% Issuer Cap Index
In the Markets
Escalating U.S.-China tensions in May stalled the recovery in developed market equities. Stocks1 declined 5.8% and cyclical sectors underperformed defensive shares. U.S. equities2 fell 6.4% as mixed economic data also weighed on investors. European equities3 declined 4.9%, and Japanese equities4 fell 7.4% on the deteriorating outlook for global growth and trade, even as the yen strengthened on “safe-haven” demand.
Emerging market equities5 declined 7.3% overall in May, but performance across individual markets varied significantly. Chinese equities7 fell 5.6% as sluggish economic data and escalating trade tensions led to a sharp increase in volatility. By contrast, Indian stocks8 increased 1.9% in conjunction with the sweeping victory of Prime Minister Narendra Modi and his party, the National Democratic Alliance, in the general election. Despite a drop in oil prices, Russian equities9 also rallied 4.7% after a dividend hike announcement from Gazprom spurred global investor interest in discounted local market stocks. And finally, in Brazil, stocks6 rose 0.7% thanks to positive developments regarding pension reform and improving public sentiment toward the government.
DEVELOPED MARKET DEBT
Developed market bond yields broadly fell, and yield curves generally flattened in May as escalating trade tensions and weaker fundamental data weighed on risk sentiment. The U.S. 10-year Treasury yield fell 38 basis points (bps) to 2.12%, and the yield curve inverted more noticeably, with the 10-year yield dropping further below the three-month rate: The yield spread reached its widest negative level since 2007. In the U.K., another round of Brexit developments contributed to the decline in yields; the 10-year U.K. gilt yield fell 30 bps to 0.89%. Similarly, the 10-year German Bund fell 22 bps to a new low of -0.20% and the 10-year rate in Japan dropped 5 bps to -0.09%. On the monetary policy front, the Reserve Bank of New Zealand became the latest central bank to cut policy rates alongside slower growth and below-target inflation.
Generally perceived as a safe haven, global inflation-linked bonds (ILB) posted positive absolute returns across most countries in May when global trade concerns re-emerged. Linkers underperformed their nominal bond counterparts, however, as risk-off sentiment and a plunge in oil prices put pressure on inflation expectations. U.S. TIPS absolute returns were strong, and the real yield curve bull-flattened on the expectation of Federal Reserve rate cuts amid weakening global growth and increased market uncertainty. Breakeven inflation (BEI) rates10 in the U.S. dipped sharply lower in concert with the energy markets; weaker inflation readings and the Fed’s assessment that the weakness was “transitory” put further pressure on expectations. U.K. linkers rallied sharply in May and, breaking from the global trend of weaker inflation expectations, breakevens surged when cross-party Brexit negotiations stalled and European Parliament elections highlighted a divided population.
Global investment grade credit11 spreads widened 15 bps in May as global trade tensions escalated. The sector returned 1.14%, underperforming like-duration global government bonds by 1%. Trade-dependent industries, such as gaming, automotive, and metals and mining, led the underperformance. Energy sectors also declined alongside an 11% drop in crude oil prices. Industries insulated from potential global trade disruptions outperformed the broader market, led by healthcare and REITs.
High yield bonds came under strong pressure in May from falling equity and oil prices, signs of deteriorating growth, and intensifying trade tensions. Global high yield bond12 spreads widened 80 bps. The sector returned
-1.19% for the month, underperforming like-duration Treasuries by 2.47%. The higher-quality BB segment returned -0.64% while the CCC segment returned -2.83%.
EMERGING MARKET DEBT
Emerging market (EM) debt finished the month modestly positive in both subsectors, displaying resilience in a generally volatile month. External debt returned 0.57%13 as a substantial 28-bp widening in spreads was outweighed by a 37-bp move lower in the underlying U.S. Treasury yields.14 Local debt15 posted a return of 0.30%, while a rally in local rates cushioned generally weaker EM currencies versus the U.S. dollar. Despite the relatively strong performance in EM debt, the escalation of trade tensions and resurgence of growth concerns represented a negative turn in the global backdrop that could weigh on EM risk sentiment overall.
Agency MBS16 returned 1.29%, underperforming like-duration Treasuries by 40 bps. May was the eighth month with the Fed unwound at $20B, and the Fed has cumulatively sold $240 billion of MBS. MBS lagged their Treasury counterparts in May, but performance was mixed across the coupon stack. Lower coupons materially outperformed higher coupons; Ginnie Mae MBS underperformed Fannie Mae MBS, and 15-year MBS underperformed conventional 30-year MBS. Gross MBS issuance increased 20% to $115 billion, and prepayment speeds increased 24% in April (most recent data). Non-agency residential MBS spreads were flat during May, while non-agency commercial MBS17 returned 2.1%, outperforming like-duration Treasuries by 5 bps.
The Bloomberg Barclays Municipal Bond Index returned 1.38% in May, bringing total returns to 4.71% for the year. Munis underperformed the U.S. Treasury index over the month, however, and MMD/UST ratios cheapened across the curve. High yield munis continued to demonstrate strong performance, returning 1.62% for May and outperforming the investment grade muni index. This brought year-to-date returns to 6.11%. High yield performance was driven primarily by positive returns in the tobacco and resource recovery sectors. Total supply of $28 billion in May was 7% higher versus the previous month but down 19% year over year. Muni fund flows remained strong, marking 21 straight weeks of inflows. Investment inflows totaled $7.9 billion in May and $37.3 billion for 2019, still the strongest recorded start to a year.
The U.S. dollar ended the month modestly stronger (0.3% based on DXY) than developed market counterparts, driven by Fed rhetoric, escalating global trade concerns, and weakness in eurozone fundamentals. The euro was 0.4% weaker versus the dollar as political fragmentation in the European Union elections also weighed on the currency. Despite surprisingly positive economic data, the British pound weakened 3.1% against the dollar due to increasing uncertainty around Brexit following Prime Minister Theresa May’s resignation. The Japanese yen, a traditional “safe-haven” currency, benefited from global trade tensions and strengthened 2.9% against the dollar. Turning to emerging markets, the Chinese yuan was 2.5% weaker versus the dollar on higher trade tensions with the U.S. and lower-than-expected manufacturing PMI reports.
Commodities delivered negative returns in May. Despite signs of tightness in the physical market, oil prices fell the most since November 2018 as mounting trade tensions and a continued slowdown in the Chinese economy cast doubt on the outlook for global growth and related demand for oil. In its latest oil market report, the International Energy Agency (IEA) reduced its demand growth forecast for 2019 by 90,000 b/d to 1.3 million b/d, while data from the U.S. Energy Information Administration (EIA) pointed to bloated domestic inventories. Natural gas prices continued to decline amid bearish fundamentals: Strong production and milder weather contributed to higher-than-usual injections at storage facilities. Row crop prices including corn, wheat and, to a lesser extent, soybeans moved sharply higher over the month as exceptionally wet spring weather across the U.S. Midwest significantly delayed planting and spurred concerns over crop quality. According to the May 28 USDA Crop Progress Report, corn planting was just 58% complete compared with the five-year average of 90%. Concerns over the outlook for the global economy also weighed on base metals, while gold benefitted from a flight to quality.
Based on PIMCO’s cyclical outlook from March 2019.
In the U.S., we continue to expect growth to slow to 2%–2.5% in 2019 from nearly 3% last year. Factors contributing to the deceleration include fading fiscal stimulus, the lagged effect of tighter monetary policy over the past few years, and headwinds from the China/global slowdown. We estimate that China’s easing will not filter through to U.S. growth until late 2019 or early 2020. Headline inflation looks set to drop to 1.5%−2% this year, while core CPI moves sideways. With growth slowing and inflation remaining below target, the Fed is likely to keep rates unchanged in 2019.
For the eurozone, we expect growth to slow to a trend-like pace of 0.75%–1.25% in 2019 from close to 2% in 2018, as weak global trade exerts significant downward pressure on the economy and Italy slipped into recession. An improvement in global trade conditions through this year should contribute to a gradual reacceleration. Reflecting firmer wage growth, we expect a moderate pickup in core inflation, which has been stuck at 1% for some time. In line with the European Central Bank’s (ECB) forward guidance, we expect policy rates to remain unchanged this year.
In the U.K., we expect real growth in the range of 1%–1.5% in 2019, modestly below trend, and we continue to think that a chaotic no-deal Brexit is a low-probability event. We see core CPI inflation stable at or close to the 2% target as import price pressures have faded and domestic price pressures remain subdued. In the event of a soft Brexit by midyear, a rate hike by the Bank of England in the second half of the year would appear likely.
Japan’s GDP growth is expected to be modest at 0.5%–1% in 2019, broadly unchanged from 0.7% in 2018. With core CPI inflation expected to dip into negative territory (due to temporary factors) around the middle of the year, we expect the Bank of Japan to keep its targets for short rates and the 10-year yield unchanged this year.
In China, we see growth slowing in 2019 to the middle of a 5.5%‒6.5% range from 6.6% in 2018, but stabilizing in the second half of the year as fiscal and monetary stimulus find some traction and a likely trade deal between the U.S. and China supports confidence. We expect fiscal stimulus of 1.5% to 2% of GDP. Inflation remains benign at 1.5%-2.5% in our forecast, and we look for another rate cut by the People’s Bank of China in addition to more reductions in banks’ reserve requirement ratios. Yuan stability is well anchored with a patient Fed and the understanding that this needs to be a component of the China-U.S. trade deal.