After a weak finish to 2018, the strong performance of risk assets has characterised much of 2019 so far, with equities and high-yield bonds the top performers.
Both asset classes benefitted from market optimism around the return to central bank dovishness and trade tensions between the US and China easing substantially. But, the fundamental backdrop has remained in place, namely the growing global divergence between strong market performance and the muted performance of economic fundamentals.
It is becoming increasingly evident that we are in a late cycle environment. Growth is average, and while still positive it is beginning to roll over. Even the US, whose growth has powered ahead of the rest of the world, is beginning to show some signs of slowing.
The outlook on Europe is concerning, with internal growth slowing and Italy firmly in recession, but perhaps even more concerning for Europe is the growth outlook for China following a poor showing in 2018.
Chinese data is improving, however, and stimulus is showing tentative signs of coming through, but the data is notoriously opaque and we are not yet ready to call the historically small stimulus package a success yet.
With the data still lagging markets despite the best efforts of policy makers, the important question remains: where to for markets from here? If the growth outlook improves, will risk assets continue to rally? We believe that this story is already priced in. What if the growth outlook deteriorates meaningfully? Then we are likely to see a substantial sell off. As a result, we prefer to remain defensive. But what does this mean in practice?
When risk assets come under pressure, there is usually a ‘flight to quality’, and so-called safe havens such as gold and US Treasury Securities attract investors. Unlike the precious metal, US Treasury Securities are a yielding asset, which makes them more attractive for income funds, but like any other asset they are still subject to supply and demand dynamics.
In the case of US Treasury Securities, this is influenced heavily on the supply side by the issuance calendar – driven by the spending requirements of the US Treasury Department (tax cuts do have to be funded from somewhere) – and on the demand side by investors, including the US Federal Reserve.
In both cases, investors were rightly concerned in late 2018. With the Fed announcing the winding down of its quantitative easing program, and record levels of issuance from the US Treasury to fund the growing deficit, there were worries of a supply glut combined with the world’s largest source of demand drying up. Intuitively, one would assume this would cause a spike in yields and losses for holders of US Treasury Securities.
Despite this backdrop, US Treasury Securities showed their strength as a safe haven asset, with yields ending 2018 close to where they began as equity markets erased their year-to-date gains in the final quarter of the year.
