No Need To Panic—Keep Calm and Carry On

Fixed Income Views: the US economy to be continuing to hold up relatively well and partly compensating for a mixed outlook in the rest of the globe.

Franklin Templeton Fixed Income

In this issue

Our expectation continues to be that the global economic outlook will prove more resilient than widely predicted by many market participants. While the trade and political environment is significantly more volatile than during past periods, the US economy continues to hold up relatively well and should partly compensate for a mixed outlook in the rest of the global economy.

The period following the Federal Open Market Committee’s (FOMC’s) decision to cut rates in July—its first policy rate cut in a decade—can be described as nothing short of what US Federal Reserve (Fed) Chair Jerome Powell called “eventful.” We’ve seen global manufacturing data contract, intensification of protests in Hong Kong, a drone attack on Saudi Arabian oil fields, the initiation of an impeachment probe in the United States, and a Turkish military offensive in Syria, as well as a further ratcheting up of the US-China trade dispute (although a recent agreement to suspend another round of tariffs in exchange for Beijing’s commitment to buy more American farm products has alleviated some pressures). Volatility has risen, putting markets on edge.

Abundant liquidity in the market fueled by unconventional monetary policy continues to be a source of financial market distortions, particularly for risk asset valuations, and keeps pushing investors toward riskier, less liquid assets. At current levels, we remain cautious overall in many regions and sectors. From a fixed income perspective, we currently recommend keeping assets at the ready in highly liquid portions of the market to take advantage of periods of volatility to invest in fundamentally sound sectors at more attractive valuations.

Franklin Templeton Fixed Income macroeconomic views

Yield curve inversions: much ado about nothing?

The recent inversion of the US Treasury yield curve has had the financial press in a bit of a frenzy. With global growth weakening, geopolitical tensions on the rise, continued uncertainty around trade and inversions of the US yield curve, many are asking: Is a US recession imminent?

We see a glaring contradiction in the fact that so many market participants and commentators emphasize the heightened level of economic uncertainty, and at the same time seem to consider flat or inverted yield curves as foolproof predictors of a recession. We believe this is completely misguided—the yield curve today is telling us very little about what lies ahead for the real economy. Market fears of an imminent recession are overblown, in our opinion, and investors need to look closer at the nature of the yield curve inversion.

Inversions are seen by many as a harbinger of an economic recession because the yield curve spread has flattened and then inverted preceding the past seven recessions. A closer look, however, suggests that this time may be different. We looked back at the time periods the US10Y–US3M1(10y–3m) spread first inverted before each of the prior two recessions and then examined how the slope of the yield curve changed in the four quarters prior to that first inversion. The yield curve inversions prior to the 2001 and 2008 recessions were driven by a rise in short-term rates, as seen in Exhibit 1.

NATURE OF THE YIELD CURVE INVERSION IS DIFFERENT THIS TIMEExhibit 1: Change in yields across the US Treasury curve—Trailing 4 quarter change prior to past three yield curve inversions

Exhibit 1: Change in yields across the US Treasury curve—Trailing 4 quarter change prior to past three yield curve inversions

Source: Franklin Templeton Capital Market Insights Group, Bloomberg, Macrobond.

This time instead—the 10y–3m first inverted in May 2019—a sharp fall in longer dated rates has caused the inversion. Yes, shorter dated rates have risen, but only marginally; the inversion has been driven by the falling yields for Treasuries across all other maturities—in sharp contrast to what we’ve seen previously.

Given that financial conditions are relatively calm compared with prior episodes and domestic macroeconomic fundamentals remain strong, we believe that the current compression in yields is largely a symptom of the more globalized bond market and unconventional monetary policy in other developed markets—namely, that of the European Central Bank (ECB) and Bank of Japan (BOJ). Both banks’ negative interest-rate policies have depressed their longer dated government bond yields, making comparable US Treasuries that much more attractive—especially as the US dollar has strengthened. Overall, the US bond market is no longer driven exclusively by US business cycles and Fed policies. Fixed income markets worldwide are still being distorted by the major role that central bank policy continues to play.

Furthermore, relative to other major developed economies, the US economy is fundamentally stronger, thus offering a positive economic growth-rate differential as well.

Don’t worry about a US recession—yet

There is little to no evidence of an imminent recession in US economic data. Despite the uncertainty brought on by persistent trade tensions and a contentious political environment, the US economy, particularly the consumer, remains robust. Consumer spending powers roughly two-thirds of US economic output, and strong labor markets have ensured that consumers continue to provide the primary impetus for growth. The third quarter yet again saw consumers contributing the most to headline GDP growth. Even though consumer spending has moderated from a 4.6% annual rate in Q2 to 2.9% in the third, this was still well above the trend growth seen in consumer spending over the past decade.2 The consumer is still king.

The University of Michigan’s consumer sentiment and consumer expectations indexes saw a mild decline in August but rebounded in September and October. Although The Conference Board’s measure of consumer confidence saw a mild decline in October, it has remained at a historically high level. Employee wages and salaries averaged roughly 4.7% growth in 2017, 5% in 2018 and a solid 5.2% during the first three quarters of 2019. Given that core personal consumption expenditures (PCE) year-over-year growth has held steady between 1.5% and 2% over the past 2–3 years, inflation-adjusted wage growth has also been increasing healthily. Similarly, the personal savings rate stood at 8.3% in the third quarter of 2019—much higher than during the previous two recessions, as shown in Exhibit 2. Consumers, who’ve thus far been the primary drivers of the US growth, remain in good financial health.

October’s jobs report confirmed a still-robust labor market, with employers adding 128,000 jobs. This figure was likely weighed down by a now-settled strike against General Motors, which led to thousands of workers being temporarily counted as unemployed. Moreover, job growth estimates for August and September were revised up by a combined 95,000, suggesting a healthier labor market than previously thought. The unemployment rate at 3.6% remains at a 50-year low. Payroll gains thus far this year have averaged 167,000 workers per month, lower than in 2018 but well above the 100,000 needed to keep the unemployment rate stable.3

HEALTH OF THE US CONSUMERExhibit 2: Savings rate, wage growth and core PCE (January 1990–September 2019)

Exhibit 2: Savings rate, wage growth and core PCE  (January 1990–September 2019)

Source: US Bureau of Economic Analysis (BEA).

But it’s not all clear skies either

The ongoing escalations in trade tensions, however, have led to a slump in US manufacturing. The Institute for Supply Management’s purchasing managers’ index (PMI) showed the manufacturing sector remained in contractionary territory (below the 50 watermark) in October for the third successive month. The manufacturing employment index has also cooled off significantly. This is also mirrored in the manufacturing employment data, where job gains have sharply leveled off since mid-2018, even as the broader labor market has remained tight.

Regional surveys4 from the Fed show that expectations around future capital expenditure have also receded, reflecting trade uncertainty and slower global demand. The National Federation of Independent Business’s survey on small businesses shows that actual capital expenditure has gradually declined, while expectations of future expenditure have seen a sharp drop through much of 2018 and 2019. As a result, production of manufacturing machinery has slowed, which in turn is reflected in non-residential fixed investment—particularly, business equipment.

The US economy saw similar (if not worse) levels of business pessimism in 2015–2016 as manufacturing activity fell and business investment declined. Much of this was in response to a sharp drop in oil prices, which in turn led to a drying up of investment related to the energy sector. Although consumer sentiment also took a hit, strong consumer spending—which grew at roughly 2.7% during that period5—still helped the US economy avoid an outright recession.

We believe strong household consumption will once again help the US economy avoid a recession, but should trade tensions persist or even intensify, they will take an increasing toll on business confidence and investment. In this regard, an additional cautionary note is that domestic policy uncertainty is likely set to increase as the 2020 presidential campaign gathers steam, given the very stark differences in the policy positions of the two major parties.

Eurozone outlook is clouded with political uncertainty

Our outlook for the eurozone remains subdued, and we expect a further deceleration in growth by year-end, due partly to uncertainty stemming from trade tensions and Brexit. The main source of weakness remains the manufacturing sector. This is seen in the July–September PMI in Exhibit 3, where services held up better. However, business expectations continued to be weak in September (with the index at 91.3) signaling that the weakness in industry is starting to spill over.

We believe Germany has entered technical recession and continues to face downside risks to growth from weakening global demand (see Exhibit 4). Special attention will have to be given to Germany’s automotive sector, which has already taken a big hit, particularly if the United States imposes tariffs on European Union cars. Germany alone exports 58.3% of all European cars to the United States.6 The weakness in German data has made a fiscal stimulus package more likely, but the government remains on the sidelines, and we believe any stimulus is likely to be limited in size. Ultimately, we expect European authorities to soften their approach on fiscal slippage and incentivize fiscal easing in Europe via the issuance of Green bonds. This option would spare the German government a loss in popularity from changing its schwarze Null, or zero budget deficit policy, and prevent peripheral countries like Italy and Spain from re-entering the European Commission’s Excessive Deficit Procedure. However, the details and timing of any alternative fiscal stimulus plan still need to be ironed out and may face some challenges given the lack of a shared European fiscal framework.

EUROZONE OUTLOOK IS SUBDUEDExhibit 3: PMI indicates weakening conditions in eurozone (October 2016–September 2019)

Exhibit 3: PMI indicates weakening conditions in eurozone (October 2016–September 2019)

Source: Markit Economics, (IHS Markit Eurozone Manufacturing PMI, Eurozone Services PMI, IHS Markit/BME Germany Manufacturing PMI, IHS Markit Germany Services PMI).

GERMANY’S CONFIDENCE INDICATORS HAVE DECLINED TO RECORD LOWSExhibit 4: Business climate, situation, and expectations (seasonally adjusted, 3-month moving average) December 2015–September 2019

Exhibit 4: Business climate, situation, and expectations (seasonally adjusted, 3-month moving average) December 2015–September 2019

Source: ifo Institute Business Climate Survey.

Italy suffered another bout of political volatility during the summer. The newly formed Five Star Movement-Democratic Party (M5S-PD) government is likely to adopt a more cooperative stance with European authorities, which will support market sentiment. Nonetheless, we expect economic activity to stagnate this year, and downside risks remain elevated. Italy’s medium-term fiscal outlook remains challenging, undermined by a combination of a high debt, weak growth and low productivity. Public debt at end-2019 is projected at 134% of gross domestic product (GDP),7 and we see further increases ahead given the lack of room for significant budget savings. For now, low interest rates are helping preserve debt sustainability, but longer term, we fear concerns could return if nominal GDP growth continues to disappoint.

Conversely, the fiscal and growth outlook remains positive in Spain, and we expect the current political impasse to be short-lived. Under a no-policy-change scenario, we still envisage some fiscal consolidation, with the deficit expected at 2.3% in 2019 (from 2.5% in 2018) and public debt falling below 97% of GDP (from a peak of 100.4% of GDP in 2014).8 On the growth front, domestic demand remains robust and supported by strong, but moderating, business sentiment.

Asia paints a mixed picture

Japan’s economy surprised to the upside in the second quarter despite expectations that its economy was particularly vulnerable to the ongoing weak trade environment. Household and capital expenditure increases offset declining exports, and labor markets continue to be exceptionally strong, with the unemployment rate unexpectedly rising to 2.4% in September but still up only slightly from the 27-year low of 2.2% it hit in July and August.9 The sustainability of Japan’s economic rebound remains uncertain. The decline in export activity, sharp deterioration in the health of the manufacturing sector, and economic sensitivity to a number of industries most in focus during trade discussions make the growth trajectory tenuous at best. Japan’s recent consumption tax hike on goods and services, from 8% to 10% on October 1, could also have a chilling impact on consumer spending.10

The BOJ continues to anchor 10-year Japanese government bonds at 0% in a fight to boost persistently low inflation.11 To maintain that yield target, the BOJ has a standing bid in the market and recently bolstered its forward guidance to reinforce the message that it stands ready to take measures for further monetary easing if economic conditions warrant.

China’s 6.0% headline growth rate in the third quarter was the lowest quarterly reading since records began in March 1992,12 and risks are growing that it could moderate further in the year ahead due to headwinds created by a slowing global economy and the ongoing trade dispute with the United States. The policy response has pivoted from prioritizing stability of the credit- to-GDP ratio and deleveraging to one that is more supportive of growth and channeling liquidity to weaker parts of the economy, specifically the small-medium-enterprises (SMEs) sector that has been impacted from the pull-back in shadow banking. While leverage issues and ongoing social unrest pose potential risks to the outlook, we believe that China’s economy will be better able to absorb trade disruptions than the market fears.

Since the onset of elevated US-China trade tensions, overall Chinese export activity has remained relatively stable, and while exports to the United States have declined, this has been largely offset by increased export activity with alternate trade partners such as the European Union and ASEAN economic community (see Exhibit 5).

It is important to note that China’s growth is now less dependent on trade than it was a decade ago and the economy has been re-balancing with domestic consumption as the key underlying driver. Asian economies such as South Korea, Singapore, Malaysia, the Philippines and Vietnam are closely connected to China’s global supply chains, and many more rely on China as a market for exports. However, China’s trade issues with the United States do not necessarily spell disaster for its Asian neighbors. In fact, the imposition of tariffs seems to have accelerated a process that was already underway—the relocation of lower value-added manufacturing from China to Southeast and East Asia.

CHINA OFFSETTING LOWER US EXPORTS WITH STRONGER EXPORTS ELSEWHEREExhibit 5: Total China exports by region (December 2004–June 2019)

Exhibit 5: Total China exports by region (December 2004–June 2019)

Source: General Administration of Customs, China Customs, 2019

Emerging market policymakers taking matters into their own hands

The weakening global growth outlook, ongoing trade tensions and idiosyncratic spillovers have continued to create volatility in emerging markets and impacted economic conditions across many economies. While growth forecasts have been revised lower over the past few quarters, the International Monetary Fund (IMF) continues to expect GDP growth of 3.9% in 2019 and 4.6% in 2020 for emerging markets.13 We believe growth across emerging markets will continue to disappoint, with most large emerging economies growing below economists’ estimates of long-term potential and below policymakers’ aspirations. This is in part driven by continued uncertainty about Chinese and US relations, but also by weaker developed market growth. In addition, China’s more restrained approach to stimulus than in past cycles has reduced positive spillovers to aggregate emerging markets growth, especially in emerging Asia.

To fight this slowdown, emerging market policymakers are taking matters into their own hands. The dovish pivot by the Fed and continued accommodative stance by most developed economy central banks have provided greater scope for emerging market central banks to ease monetary policies, as well as support local currencies versus the US dollar. Monetary easing has been joined by fiscal support in many countries.

We believe underlying long-term financial fundamentals remain strong for much of the emerging markets universe, underpinned by stronger sovereign balance sheets and greater fiscal discipline. Capital inflows and high liquidity levels among investors, along with the fact that many upcoming maturities have already been refinanced, provide additional technical support. In our view, risk of contagion from economies under pressure, such as Turkey and Argentina, is lower than it had been in 2018, and we do not believe it is a high-risk concern at this stage of the cycle.

ENDNOTES

  1. The yield curve spread between the 10-year and three-month curves. When the number goes negative, that‘s an inversion.

  2. Source: US household spending, Bureau of Economic Analysis, Q3 2019.

  3. Source: Employment data, Bureau of Labor Statistics, October 2019.

  4. Source: Regional Federal Reserve (Dallas, Kansas, NY, Philadelphia) Manufacturing/Business Outlook Surveys, September 2019.

  5. Source: US household spending, Bureau of Economic Analysis, Q4 2016.

  6. Source: Eurostat, as of 2018.

  7. Source: Italy public debt-to-GDP projection, OECD Economic Survey estimate, April 2019.

  8. Source: European Commission, Spring forecast, May 2019.

  9. Source: Japan unemployment data, Internal Affairs and Communications Ministry, September 2019.

  10. Source: Japan consumption tax, Ministry of Finance, Japan, 2019.

  11. Source: BOJ 10-year rate anchor, Bank of Japan.

  12. Source: China GDP, National Bureau of Statistics of China.

  13. Source: Emerging markets’ growth, IMF, October 2019.

    Indexes are unmanaged and one cannot directly invest in an index. They do not include fees, expenses or sales charges. There is no assurance that any estimate, forecast or projection will be realized. Past performance is not an indicator or a guarantee of future results.

Fixed Income Views: Franklin Templeton Fixed Income conducts a periodic team-wide investment forum, driven by independent macroeconomic, fundamental sector, and quantitative research, to explore and collaborate on economic and investment outlook. These Fixed Income Views reflect the outcome of this investment forum. An evaluation of macroeconomic conditions and developments across the world’s regional economies serves as the backdrop of our investment process, with an eye toward identifying potential changes in fiscal and monetary policies, market risk premiums and relative valuations that drive portfolio positioning. From a bottom-up perspective, we provide readers with condensed high-level summaries of our sector views.

Contributors

Franklin Templeton Fixed Income teams




Editorial Review

Sonal Desai, Ph.D. Chief Investment Officer,
Portfolio Manager

David Yuen, CFA, FRM Director of Quantitative Strategy,
Portfolio Manager

John Beck Director of Fixed Income, London

David Zahn, CFA, FRM Head of European Fixed Income,
Portfolio Manager

About Franklin Templeton Fixed Income

Franklin Templeton has been among the first to actively invest in many sectors of the fixed income markets as they have evolved—covering corporate credit, mortgage-based securities, assetbacked securities and municipal bonds since the 1970s, international fixed income since the 1980s and bank loans since the early 2000s. Over 170 investment professionals globally support the portfolio managers, who oversee more than US$169 billion in assets under management. Being part of an established investment group at Franklin Templeton gives the portfolio managers access to experts across different areas of the fixed income market, helping them to diversify opportunities and risks across multiple sectors.

Our global reach through Franklin Templeton Investments provides access to additional research, trading, and risk management resources. Portfolio managers have opportunities to exchange insights with other investment groups, and collaborate with an independent risk team that regularly examines risk analytics to help identify and address areas of excessive risk exposure within our portfolios.