In the World

While the bulls ran in Spain, central bank “doves” – headlined by the U.S. Federal Reserve and its highly anticipated rate cut – took the spotlight in July. For the first time since the financial crisis, the Fed cut its policy rate by 25 basis points (ending a three-year hiking cycle that began in December 2015) and announced an earlier-than-expected end to its balance sheet unwind. Although the Fed was aiming to help keep the longest economic expansion in U.S. history on track, Chairman Jerome Powell’s press conference took markets by surprise as he shied away from providing specific guidance on further easing and indicated a “mid-cycle adjustment to policy” rather than the start of a protracted easing cycle. While the European Central Bank (ECB) left its policy rate unchanged, President Mario Draghi sent a clear signal of intent to ease further, stating the ECB was “determined to act” to spur inflation and help combat a worsening economic outlook. Elsewhere, the Bank of Japan (BOJ) left rates unchanged, but indicated potential for future support; the Reserve Bank of Australia (RBA) cut rates by 25 bps for the second time this year; and a host of emerging market countries, including South Africa, Malaysia, Turkey, and Russia, all cut rates.

In odd timing for the Fed, U.S. economic data showed some resiliency. Although exports declined and business investment contracted, U.S. Q2 real gross domestic product (GDP) growth was still better than expected at an annualized 2.1%. Albeit slower than the first quarter’s 3.1% pace, the Q2 figure was led by robust growth in consumer spending. Retail sales were also stronger than anticipated, core inflation firmed, and U.S. job growth handily beat expectations. In contrast to better trends in U.S. economic data, fundamentals in the eurozone continued to weaken: GDP growth slowed to 0.2% for the second quarter, inflation dropped to 1.1% year-over-year (its lowest this year), and flash manufacturing purchasing managers’ indexes (PMIs) fell deeper into contractionary territory. Meanwhile, political developments in Europe featured turnover in key posts: Germany’s former defense minister Ursula Von der Leyen became the new president-elect of the European Commission, Christine Lagarde resigned as the head of the IMF to replace Mario Draghi as president of the ECB in September, and Boris Johnson became the new Prime Minister of Great Britain. In Washington, the House passed a budget deal that extended the debt ceiling until after the 2020 elections and increased federal spending in 2020 by about $50 billion.

Market performance was more mixed in July. In the U.S., Chairman Powell’s less accommodative-than-expected rhetoric helped send equities lower, the U.S. dollar stronger, and yields at the front-end of the curve higher (despite the 25-bps rate cut). Still, the S&P 500 managed to end the month 1.4% higher. Year-to-date gains crossed over 20%, and the index reached fresh all-time highs, due in part to a strong start to the Q2 earnings season (though many companies guided toward weaker Q3 results given trade tensions and slowing global growth). Outside the U.S., equity gains across developed markets were more modest as stimulus efforts from central banks were dampened by economic data that affirmed slowing growth momentum while emerging market equities fell 1.2% alongside a strengthening U.S. dollar. In Germany, the 10-year bund yield slid 11 bps to -0.44% (an all-time low) as expectations built for a September easing package from the ECB. In response to newly-elected Prime Minister Boris Johnson’s pledge to remove the UK from the EU on October 31 with or without a deal, the pound fell 4.2% to a two-year low. Lastly, Bent crude oil prices fell 2.1% as concerns about demand growth outweighed the impact of flaring tensions with Iran in the Gulf and inventory draws in the U.S.

 

Long but shallow: Putting the recent Fed hiking cycle in context
The Federal Reserve lowered its target policy rate for the first time in over a decade, ending one of the longest hiking cycles in the past 30 years. While the cumulative increase in the federal funds rate of 225 basis points (bps) was relatively in line with most recent tightening cycles, it took three years to get there. One of the reasons for the longer and shallower cycle may be that the Fed’s objectives were different: This cycle was about getting away from the zero-bound – to remove emergency accommodation and have room to cut rates in future economic downturns – as opposed to tightening conditions to slow some type of overheating. The fact that there is less room to reduce rates than in past cycles may also help explain why the Fed focused on the cut as “insurance” to stave off the possibility of returning to zero in the near future; it is also likely the reason the FOMC members were divided, based on their forecasts in June, between leaving the target rate unchanged and cutting it 50 bps by the end of 2019.

In the Markets

EQUITIES

Developed market stocks1 gained a modest 0.5% in July, primarily led by U.S. markets. U.S. equities2 climbed 1.4% to reach new all-time highs, thanks to the Federal Reserve’s pivot to easing policy and a (temporarily) improving outlook for U.S.-China trade negotiations. European3 equities increased 0.3% and Japanese equities4 rose 1.2% as ongoing stimulus efforts from global central banks were dampened by global developments, Brexit fears, and global growth concerns.

Emerging market5 equities fell 1.2% in July largely due to trade concerns and a strengthening U.S. dollar. In Brazil6, stocks rose 0.8% as positive progress for social security reforms and a rate cut from the central bank supported local equities. Chinese7 equities declined 0.7% after hopes early in the month that trade talks with the U.S. would resume quickly faded and macro data were mixed. In India8, stocks dropped 4.6% due to an increased tax on foreign investors and supply uncertainties for local equity market issuers caused by the Union Budget (India’s national budget) announcement on 5 July. Lastly, Russian9 equities rose 1.7% despite a modest drop in the ruble and Brent crude prices.

Equity markets

DEVELOPED MARKET DEBT

Developed market yield moves were mixed in July. In the U.S., short-term yields in particular moved higher alongside strong economic data releases (including labor, GDP, and inflation metrics) and more-hawkish-than-expected forward guidance from the Fed (including a shorter timeline for the balance-sheet unwind) despite a widely-expected 25-bps rate cut. The two-year Treasury yield ended the month 12 bps higher, while the 10-year rose 1 bps to 2.01%. Meanwhile, the ECB, BOJ, and Bank of England (BOE) continued to signal easier policy ahead amid a softening global economic outlook. Ten-year German bunds yields fell 11 bps and ended the month at an all-time low of –0.44%, while the 10-year yield in Japan was little changed (1 bp higher to –0.15%). In the UK, new PM leadership heightened Brexit concerns and 10-year gilt yields fell 22 bps to 0.61%.

Developed market bond markets

INFLATION-LINKED DEBT

Global inflation-linked bonds (ILBs) posted positive absolute returns across most countries and outperformed their nominal counterparts in July as global real rates continued to drop and breakeven inflation (BEI) expectations rebounded from recent weakness. In the U.S., Treasury Inflation Protected Securities (TIPS) delivered positive absolute returns as real yields continued to rally on mounting expectations for a July Fed rate cut. The FOMC followed through on the widely expected 25-bps rate cut at month-end, the first easing of rates in 11 years. U.S. BEI moved higher, supported by positive sentiment from a dovish Fed, firmer-than-expected inflation prints, and a pause in trade tensions. Outside the U.S., U.K. breakevens richened as the British pound dropped sharply on increased speculation of a no-deal Brexit after the election of Boris Johnson as prime minister.

Inflation-linked bond markets

CREDIT

Global investment grade credit spreads tightened eight bps in July, and the sector returned 0.90% for the month, outperforming like-duration global government bonds by 0.63%. Spreads tightened across nearly all industries alongside a continuation of accommodative central bank policies. Credit markets remained supported by positive technicals: Lower supply, paired with low global government bond yields, drove demand for relatively high income-producing assets.

Global high yield bond11 spreads tightened 10 bps in July. The sector returned 0.63% for the month, outperforming like-duration Treasuries by 0.63%. Higher-quality bonds continued to outperform against a backdrop of slower growth and falling rates – with the energy sector lagging amid commodity price volatility. In July, the higher-quality BB segment returned 0.76% while the CCC segment returned –0.06%.

Credit markets

EMERGING MARKET DEBT

Both local and external emerging market (EM) debt posted positive returns for the month. External debt returned 1.15%12, aided by a 29-bp tightening in spreads, which overcame a slight move upward of two bps in the underlying U.S. Treasury yields.13 Local debt posted similar returns of 0.93%14 as local rates continued to rally – following developed-market yields generally lower – which offset generally weaker EM currencies due to U.S. dollar strength. Both subsectors benefitted from dovish signals from the ECB, BOJ, and BOE, although this was constrained by strong U.S. economic data, which reshaped expectations for further Fed cuts. Additionally, although the U.S.-China trade truce held, mixed headlines on trade negotiations weighed on EM investor sentiment.

Emerging market bond markets

MORTGAGE-BACKED SECURITIES

Agency MBS15 returned 0.40%, outperforming like-duration Treasuries by 43 bps. July was the tenth month of the Fed’s balance-sheet unwinding; the Fed sold $20 billion in MBS over the month and has cumulatively sold $280 billion. Rates remained range-bound and incrementally higher in the month of July which was enough for the mortgage basis to outperform. Higher coupons outperformed lower coupons within the 30-year Uniform MBS (UMBS) stack; Ginnie Mae MBS outperformed Fannie Mae MBS, and 15-year MBS outperformed conventional 30-year MBS. Gross MBS issuance increased 11% to $132 billion, and prepayment speeds increased 3% in June (the most recent data available). Non-agency residential MBS spreads were flat during July, while non-agency commercial MBS16 returned 0.78%, underperforming like-duration Treasuries by 1 bp.

Mortgage-backed securities markets

MUNICIPAL BONDS

The Bloomberg Barclays Municipal Bond Index returned 0.81% for the month, bringing the total return to 5.94% for the year through July. Munis outperformed the U.S. Treasury index over the month, while MMD/UST ratios decreased across the curve. High yield munis underperformed investment grade munis, returning 0.63% for July. This brought the year-to-date return to 7.33%. High yield performance was driven primarily by positive returns in the tobacco and leasing sectors. Total muni supply of $30 billion in July was down 13% versus the previous month, but up 13% year-over-year. Muni fund flows remained robust, marking 30 straight weeks of inflows: Investment inflows totaled $9.1 billion in July, which brought year-to-date inflows to $52.9 billion, still the strongest recorded start to a year.

U.S. municipal bond market

CURRENCIES

The U.S. dollar ended the month substantially stronger (2.5% based on DXY) than its developed-market counterparts on a resurgence of strong U.S. economic data, which reduced market expectations for Fed cuts. Dollar strength in combination with a litany of weaker data elsewhere – including German factory orders – and dovish rhetoric from the ECB weakened the euro by 2.6% versus the dollar. Similarly, the British pound weakened 4.2% against the dollar due to dollar strength and increased fears of a no-deal Brexit following comments from the new UK prime minister Johnson. The Japanese yen, a traditional “safe-haven” currency, was somewhat inoculated against dollar strength by geopolitical tensions in the Persian Gulf and weakened only 0.9% against the dollar. Turning to emerging markets, the Chinese yuan was 2.1% weaker versus the dollar as mixed trade-related headlines weighed on the currency.

Currency markets

Commodities

Commodity returns were negative in July. Oil prices ended up relatively unchanged: The effects of ongoing geopolitical tensions and declining U.S. stockpiles balanced the demand concerns arising from indications of slowing global growth. After initially rising in anticipation of hot weather and hurricane-related supply disruptions, natural gas prices fell to a three-year low amid forecasts for moderating temperatures. Agricultural commodities were weaker over the month as rains brought needed moisture to U.S. crops, easing concerns about hot, dry weather and heat damage to plants. Coffee prices had their biggest drop in more than two years following the realization that an outbreak of frost in Brazil left the country’s crop largely unscathed. Despite slowing growth in China and elsewhere, base metals posted gains on renewed concern of a ban on nickel ore exports in Indonesia. Precious metals also moved higher, driven by lower real yields in the U.S.

Oil market

Appendix Table

FOOTNOTES:
1MSCI World Index, 2S&P 500 Index, 3MSCI Europe Index (MSDEE15N INDEX), 4Nikkei 225 Index (NKY Index), 5MSCI Emerging Markets Index Daily Net TR, 6IBOVESPA Index (IBOV Index), 7Shanghai Composite Index (SHCOMP Index), 8S&P BSE SENSEX Index (SENSEX Index), 9MICEX Index (INDEXCF Index), 10Breakeven Inflation: Market-based measure of expected inflation derived from the difference between the yield of a nominal bond and an inflation-linked bond of the same maturity, 11Bloomberg Barclays Global Aggregate Credit USD Hedged Index, 12BofA Merrill Lynch Developed Markets High Yield Index, Constrained, 13JP Morgan EMBI Global, 14US Treasury 10 YR, 15JP Morgan GBI-EM Global Diversified, 16Bloomerg Barclays Fixed Rate MBS Index (Total Return, Unhedged), 17Bloomberg Barclays Investment Grade Non-Agency MBS Index

Outlook

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. Headline inflation is likely to remain in the 1.5%−2% range this year, while core CPI moves sideways. With growth likely to continue slowing through the year and inflation remaining below target, the Fed has adopted a more dovish stance and looks likely to cut rates by 50 basis points (bps) by year-end 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 some countries experience a recession. An improvement in global trade conditions would contribute to a gradual reacceleration. Reflecting firmer wage growth, we expect a modest pickup in core inflation, which has been stuck at 1% for some time. Mirroring the dovish shift by many central banks, the European Central Bank (ECB) has also taken an accommodative tone with some potential for more easing policies in 2019.

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 lower-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.

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), 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, stabilizing somewhat in the second half of the year as fiscal and monetary stimulus find some traction. . We expect fiscal stimulus of 1.5% to 2% of GDP. Inflation remains benign at 1.5%-2.5% in our forecast, and we may see additional stimulus if credit conditions deteriorate more. 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.

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A “safe haven” is an investment that is expected to retain or increase in value during times of market turbulence. All investments contain risk and may lose value.

Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in foreign denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. Income from municipal bonds is exempt from federal income tax and may be subject to state and local taxes and at times the alternative minimum tax; a strategy concentrating in a single or limited number of states is subject to greater risk of adverse economic conditions and regulatory changes. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation- Protected Securities (TIPS) are ILBs issued by the U.S. government. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax. Corporate debt securities are subject to the risk of the issuer’s inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to factors such as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be suitable for all investors. It is not possible to invest directly in an unmanaged index.

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