Fixed Income Outlook  |  Q2 2018

Growth remains steady amid higher rates, market swings

Fixed Income Team

Growth remains steady amid higher rates, market swings

  • The U.S. economy is poised to remain solid in 2018.
  • The risk of a trade war between the U.S. and China 
is now elevated.
  • Eurozone growth is easing to a more reasonable pace.

Global growth prospects are expected to remain solid in 2018. The U.S. economy is poised to pick up some speed this year given indicators for consumer spending, corporate capital expenditure, and fiscal spending. The likelihood of a recession remains low. During the past few months, economic data, both in the United States and overseas, has been stronger than most market observers were expecting several months ago, especially given the fact that interest rates have risen. Despite this strength, we think it is unlikely that the global economy will overheat at this stage of the business cycle and spark a sustained rise in inflation.

In terms of fixed-income markets, this year is turning out to be more challenging than 2017. In recent months, the risk of a global trade war, the trajectory of U.S. interest rates, and geopolitical tensions have caused a series of market ups and downs. Still, we see a stabilizing dynamic at work in the markets. With bond yields trending higher, on days when market-moving economic data is released, bond investors react and the yield curve adjusts, helping to dampen the impact on risk-sensitive assets. Bond yields will continue to drift higher over the course of 2018, we believe, as rate normalization continues. Global central bankers continue to move along the path of gradual tightening, with the U.S. Federal Reserve at the forefront, normalizing interest rates and gradually reducing the size of its balance sheet. We expect the Fed to continue increasing interest rates throughout 2018.

A key challenge in coming months will be the Trump administration's return to its campaign promise of "America First" trade policies. Despite this backdrop, we believe there is still an environment that fosters risk-taking overall.

U.S. economy to benefit from spending

The underlying story in the economy has not changed. The labor market is one of the best indicators of economic health, and it began 2018 on a strong note as Americans saw wage gains accelerate and hiring improve. In February, President Trump signed into law a far-reaching budget deal that will boost spending by hundreds of billions of dollars. Output is likely to accelerate for the rest of 2018 as the fiscal stimulus kicks in. The Tax Cuts and Jobs Act of 2017, which became law in December, is also likely to create some upward momentum, boost corporate earnings, and prolong the eight-year U.S. economic expansion.

The U.S. dollar weakened against most other major developed market currencies during the quarter, partly on concerns about U.S. trade policy with China and the risk of a global trade war. Also weighing on the dollar was the global economic upswing that has encouraged central bankers in Europe and Asia to take the first steps toward normalizing monetary policy after years of monetary stimulus. Still, the volatility of asset prices, to some extent, is taking a bit more of a back seat now to the real economic story, where growth continues to look stable and steady. But of course, how the trade conflict with China develops will have an important influence, and there are clear downside risks to the outlook.

The risk of a trade war

It is fair to say that trade protectionism and the risk of a trade war rose during the first quarter. President Trump in March proposed tariffs on an estimated $50 billion in imports from China, weeks after slapping tariffs on aluminum and steel and washing machines. The tariffs follow an investigation of the administration into the theft of intellectual property from U.S companies. In April, China, the world's second-largest economy, retaliated by imposing tariffs on U.S. imports worth around $3 billion. China launched a World Trade Organization complaint against the U.S. action, and while it could be withdrawn, this machinery is now in motion. However, it should be remembered that the tariffs on both sides remain proposals until they are scheduled to go into effect in June, allowing time for negotiations.

At the same time, the U.S. administration is still in the midst of renegotiating the North American Free Trade (NAFTA) agreement. Canada and Mexico were exempted from the imported steel and aluminum tariffs, provided they make concessions in a new NAFTA deal. If the U.S. administration withdraws from NAFTA or imposes another spate of anti-China trade measures, there will be downside risks to the U.S. economy. Despite Trump's firmly held beliefs, tariffs will not close the U.S. trade deficit, absent higher savings (in the public or private sectors) or lower investment.

Europe's dance with rates

The eurozone economy had it best year in a decade in 2017, growing at a 2.5% annual rate, and the jobless rate fell to its lowest level since 2008. However, more recently growth is easing to a more reasonable pace. The eurozone grew by 0.6% in the final three months of 2017, slower than the previous quarter.

The European Central Bank (ECB), which has been providing stimulus to the region through negative interest rates and massive sovereign bond purchases, is adjusting to the economy's stronger pace. The central bank said it would continue purchasing government bonds through at least September 2018, but in reduced monthly amounts. This decision may signal a policy shift by the ECB that will eventually lead to more rapid tapering of its bond-purchase program. Markets expect QE will end in December 2018, and the ECB may raise the deposit rate in the second quarter of 2019. If everything goes as planned, the best we can expect is that the policy rate will move toward zero at the end of 2019.

In the United Kingdom, the economy appears stable, even as the country is in the midst of Brexit negotiations. We also expect a hike by the Bank of England in May. Europe is seeing more inflation than expected, and this is not priced in to rates currently. This could produce some volatility in euro-based sovereigns and corporate bonds. We expect rate normalization to continue, though monetary policy on the whole remains mostly accommodative.

China: President Xi and the economy

President Xi Jinping's supporters have succeeded in their attempt to lift the constitutional provision on the length of time a president can serve. The expansion of the two-term limit, which was in place for nearly two decades, was ratified by the National People's Congress in March 2018. This is a departure from the economic and political reforms of Deng Xiaoping, who had emphasized separating the Party from the everyday machinery of the government. Xi and his supporters claim they want to strengthen the Communist Party's leadership. This could create risks for the economy over the long term because this type of authoritarian government leads to capital being misallocated, creating bad assets on the books of the financial system.

China's macroeconomic data has deteriorated a little. However, it's hard to interpret the data flow in January and February because of the changes in the timing of the Lunar New Year. The government has set a GDP growth target of around 6.5%, the same as in 2017. China also trimmed its fiscal deficit target for 2018. While, it's not clear whether the growth and deficit targets are achievable, it is clear that keeping the growth target the same as last year means the government is not interested in risking slower growth by advancing economic reforms more rapidly.

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