Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
Equities are treading on thin ice
Peter Garnry
Chief Investment Strategist
Summary: As we released our Q3 Outlook a couple of months ago the world was slowing down fast and the probability of a recession was rising. Nevertheless, investors were buying the Powell Put elevating equities to new highs. Hope and confidence were in abundance. We zoomed out and wrote our Q3 Outlook around the theme of global supply chain shock, economic slowdown, US-China decoupling, higher input costs from green policies and inequality driving a wage war. Overall our stance going into Q3 was underweight equities vs bonds.
Equities have terrible risk-reward
Comparing global equities (hedged into EUR) against global government bonds (hedged into EUR) equities are 5.6%-pts behind as the escalating trade war is finally making investors to adjust their views of the world. The global economy continues to slow down with OECD’s leading indicators showing the worst economy since 2009 and economic activity close to recession levels. South Korea, which is one of the most tuned economies to growth, is still sending distressing signals which is a good proxy that China is still slowing down. Given the events we are observing we put the probability of Germany already in a recession at around 80% and the world seems to be following.
Based on leading indicators we maintain our view that investors should be underweight equities vs bonds and that exposure within equities should be in defensive and high-quality stocks. We main a more positive on US equities and investors should consider leaning into more pro-cyclical equity markets to have exposure when the macro cycle turns. But overall equities do not have an attractive risk-reward ratio relative to bonds for the rest of the year.
Lower interest rates have held up valuations but if a recession hits lower profits should begin to offset the expansion in the equity risk premium from lower rates. Equities are indeed treading on thin ice for the rest of the year.
50 bps cut coming?
The Fed is not moving fast enough on rates as the central bank’s models are looking at variables that are most likely not driving the dynamics for next recession. In our view the US-China trade war is the key dynamic to understand all the things that are happening. But the Fed’s problem is that it wants to be objective and model-driven, but the US-China trade war is highly dynamic and not something that can be modeled.
The Fed should most likely cut by 50 bps at the September FOMC meeting, but market consensus is pricing in 25 bps and another 25 bps at the October FOMC meeting. But this could change quickly if market conditions worsen due to Trump rhetoric.
Germany needs to reset
The developed country that has benefited the most from globalization since the early 1980s is Germany, but the export-driven economic machine is sputtering in this new era of reconfiguration of the global supply chain.
Germany’s intense focus on a balanced fiscal budget has led to low domestic surplus in the corporate sector forcing German industry to seek growth elsewhere. As a result of Germany’s policy choice, the economy has evolved into an export machine tuned for globalization. The surplus from exports have been recycled into capital markets and not domestic consumption and investment. This has led to an infrastructure deficit and outrageously depleted Internet access infrastructure for a highly developed country; Germany is ranked 27th on Internet speed. Not the ideal starting point for a digital economy.
In our view Germany should take advantage of low interest rates and increase deficit spending massively to upgrade its infrastructure but also create a domestic surplus in its corporate sector to offset the loss from weak export markets. Given the trajectory of the US-China trade war, Germany should not bet on globalization to take Germany back to trend growth. It should take matters in its own hands stimulate growth. For Europe it would be a game changer.
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