What’s Next for the Global Economy and Central Banks?
Joseph Graham: Welcome to the 2019 Midyear Outlook. My name is Joe Graham. I'm an investment strategist at Lord Abbett. Today, I'm joined by a number of our leading investment professionals. We'll be talking about markets, what's happened over the last few quarters, where the opportunities are today. So now I'll turn it over-- to these-- individuals to introduce themselves.
ID: Kewjin Yuoh
Partner & Portfolio Manager
Kewjin Yuoh: Hi, this is Kewjin Yuoh, partner and portfolio manager of taxable fixed income.
ID: Thomas O’Halloran, J.D., CFA
Partner & Portfolio Manager
Tom O’Halloran: This is Tom O'Halloran. I'm a partner of Lord Abbett and a portfolio manager of the growth strategies.
ID: Dan Solender, CFA
Partner & Director of Tax-Free Fixed income
Daniel Solender: Hello, I'm Dan Solender, partner and director of the tax-free fixed income group.
ID: Leah Traub, Ph.D.
Partner & Portfolio Manager
Leah Traub: Hi, I'm Leah Traub, partner and portfolio manager in taxable fixed income.
ID: Giulio Martini
Partner, Director of Strategic Asset Allocation
Giulio Martini: I'm Giulio Martini, partner and director of strategic asset allocation.
Graham: The start of the year has been pretty tremendous for risk assets, which has been a surprise to a lot of market participants who expected the volatility of the fourth quarter to continue. So let's start with Giulio. Why do you think this reversal has happened from Q4 to year to date?
Martini: Well, Joe, with the benefit of-- 2020 hindsight, of course, I think what happened is that investors started to get really concerned, around about September or so of 2018, that the Fed might have overdone it and raised interest rates by too much.
And the market started to react negatively to the prospect of even more rate increases. And simultaneously, what had been kind of a garden-variety trade dispute between the United States and China was threatening to escalate into a major strategic conflict that went beyond just trade.
And what happened is that very late in the year and in early January, both those problems kind of resolved themselves favorably. The Fed signaled that it was going to end rate increases at the end of the year and would likely hold rates steady for most of 2019, so the threat of excessively tight monetary policy was removed. And secondly, the U.S. and China sat down and started to negotiate on trade issues.
VISUAL: Update: Register for our June 13 webinar to get our latest views on trade and other key investment issues.
Graham: So the point about the Fed; the market has really accepted the Fed's 180-degree turn from where they were back in September. Kew, do you buy that? Do you think that the Fed's next move will be a cut, rather than a hike, as the market's kind of implying now?
Yuoh: I'll repeat something Giulio said, in terms of hindsight being 20/20. I think what the Fed has done is very interesting, because as Giulio alluded to, there was this fear in September that they had gone too far, in terms of raising rates.
And what we saw in September was their removing that word--a very precious word to the markets--in terms of "accommodative" out of their statement. And it was after that in fourth quarter where things started to melt, with everything that was going on globally.
And they did do a 180-degree significant pivot with a pause in December and their statement in January. And I would've said back then that their credibility was significantly damaged from that pivot, because it was just a too drastic stance [change] on how they viewed the market and what was a threat to the markets.
But in hindsight, again, the data had turned softer, right? You could look at a lot of indicators and they'd come back down to levels fundamentally for the domestic economy that we had seen at the end of 2016, before these rate hikes started to happen.
Financial conditions were tighter, and so inflation, which we'll probably get to later, was not a problem. And so all of those things combined--hindsight being 20/20, you could make a case that the Fed was appropriate in what they did. I think their credibility comes into question because they've just never changed stances in such a compact period of time, especially recent Feds. So what are they saying now? The markets are pricing in a two-thirds probability of a rate cut by the end of this year, but I think they've gotten to the point where it'll be data-dependent, which we always like to think is the main driver of the Fed.
VISUAL: Inflation and other critical topics are covered in the second video in our Midyear Outlook series.
But personally, given where things stand right now, given their pause, given how much financial conditions have eased, and where their data could potentially kind of plateau here or rebound, especially with global conditions, our base case would be that there would not be a rate cut this year.
Graham: How do currency markets respond to that now that the increases are taken away now?
Traub: So, so building on what Giulio and Kew have already talked about, I think a lot of people thought going into 2019 that as the Fed was reducing their projections of hikes and the market had fully priced out any possibility of a hike by the end of 2019, so at the end of 2018, they'd totally priced out any possibility of a hike.
The market consensus was that the dollar would weaken. And it did for a few weeks there--we had about a 2.5% decline in the broad dollar index towards the end of last year and into January. But the dollar has rallied all the way back since then; [the weakness] has not continued. A lot of people were confused about that.
Graham: I see.
Traub: There was this feeling in the market of, "Why isn't the dollar weakening more?" And really what it is -- it's not just the Fed who moved more dovish. All of the central banks have moved more dovish. The Bank of Canada was hiking. They're in a wait-and-see mode, just like the Fed.
The ECB--European Central Bank--they were on pace to maybe hike in the fourth quarter of this year, and the market was pricing in one hike in Q4 for the ECB in 2019. Now that's totally gone. The ECB actually went even easier, right? They put a new lending program in place. They are completely backing away.
You're seeing that throughout the developed markets, and most emerging markets too have now also gone easier. China has been cutting rates. India went from hiking last year to cutting. A lot of EM central banks, especially in Asia, are now thinking about cutting, because they don't have to keep up with the Fed anymore.
Yuoh: So Leah, I thought that was interesting what you said about keeping up with the Fed. So when you talk about other economies and their accommodative stance or lowering of rates, are they doing that in reaction to their own economy? Or are they just doing that because that's what the Fed's doing? And how do they think about that?
Traub: It's probably a combination of both, to be honest. But their economies have been slowing, just like we saw a slowdown in China last year. That's kind of a slowdown in global trade, partially because of the trade tensions that Giulio had alluded to. We're seeing slowdowns in some of these other Asian-- especially emerging market Asian--economies, such as South Korea, Indonesia, Taiwan.
You're seeing some slowdown there. So as in last year when the Fed was hiking and projected to still be hiking, they would be hesitant to cut rates or to not even consider hikes, because they would be worried about their currencies weakening too much, maybe causing some issues—financial stability issues—within their own countries.
But now that the Fed is on hold and other global central banks are also on hold, they don't have that pressure anymore, and they're now free to talk about the possibility of cutting, right? Both South Korea and Malaysia, they're considering cuts coming up in the next few months. South Korea just hiked last fall, right? So now they're considering cuts, because they're very affected by the trade situation and the slowdown that they're seeing in China.
Yuoh: You know, we keep talking about kind of where we are in the business cycle, and that's a temporal notion, right? And we always also talk about in a conservative way what's going to end this, and Giulio eloquently talks about the “murder” that happens.
Martini: Well, we're in a very long business expansion. It's about to be 10 years. And so there's a natural tendency to think, "Well, it has to end. It's been going on for so long that it's going to die of old age."
But business expansions don't die of old age. They are either murdered or they commit suicide. When they're murdered, they're murdered because they develop an inflation problem, and the Fed eventually tightens monetary policy enough to force the economy into a downturn to correct the excesses that led to the inflation.
And when they commit suicide, it's usually because a financial bubble develops that's so significant and so large that when an event comes along that starts to pop that bubble, it spills over to the economy more generally by reducing spending among households and among businesses, violently enough to create a recession.
But even though there may be pockets of the market where valuation is generous, it's hard to identify something that is a financial bubble, in the sense that it's an asset price that's just completely detached from the underlying fundamentals. I certainly don't see one.
ECB refers to the European Central Bank.
Fed refers to the U.S. Federal Reserve.
Risk asset describes any financial security or instrument that is not a risk-free asset (i.e. a high-quality government bond). Risk assets generally encompass equities, commodities, property, and all areas of fixed income apart from high-quality sovereign bonds.
Yield is the annual interest received from a bond and is typically expressed as a percentage of the bond’s market price. Spread is the difference in yield between two different investments.
Yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares the three-month, two-year, five-year and 30-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.
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