CANADIAN FIXED INCOME MARKET COMMENTARY

The world in 2019

Dec 7, 2018

Aubrey Basdeo shares this month's Canadian Fixed Income outlook.

 


We are on the brink of finishing 2018 with global bonds and equities ending in the red – a rare case. For bond investors, the critical question is: what’s next?

It could be more of the same. Our base case is a continuing state of “uneasy equilibrium,” where positive fundamentals, in the form of solid economic and corporate earnings growth, square off against rising macroeconomic uncertainty. Overall, the expectation is still that the environment for risk assets will be positive, but only mildly so: the economic cycle is getting long in the tooth and financial vulnerabilities are growing.

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Key to those vulnerabilities are rising economic uncertainty, driven largely by trade disputes, and tightening financial conditions, driven by monetary policy that’s slouching towards neutral. For 2019, global growth looks poised to slow along with corporate earnings growth, as the U.S. economy hits late-cycle. In our view, there doesn’t seem much chance of a U.S. recession in 2019, but… there are those financial vulnerabilities to worry about. While still well below pre-crisis levels, they are rising. Asset valuations look reasonable given the still-low interest rate environment, and American households are healthy (unlike in the mid-2000s). Corporate debt levels seem manageable, but there are pockets where the leverage looks excessive. In private markets, meanwhile, valuations are high.

None of those augur recession, yet fear of recession might be a bigger factor, and could hit risk assets while supporting bonds. Vulnerabilities that have built over the past decade could shorten the cycle – or aggravate a downturn, should one occur – especially as financial conditions tighten. In the U.S., which has been leading developed economies in rate normalization, financial conditions are still not restrictive, though we believe the policy rate is approaching neutral. That has heightened uncertainty over the U.S. Federal Reserve in 2019.

Elsewhere, Eurozone monetary policy looks like it will stay accommodative at least through next year; inflation is stuck below target as a sustained growth cycle seems to be eluding Europe once again. The potential for fragmentation in the European Union isn’t helping. While we see a Brexit transition deal by the deadline in March 2019, the path will not be smooth. Italy could be a larger concern, as it heads for a long standoff with the European Commission; Italy bond spreads seem poised to expand even more.

Meanwhile, there is some support for cautious optimism on Emerging Markets. Valuations are cheaper. China is in stimulus mode. Country-specific risks might have peaked – for instance, in Turkey and Argentina. If there’s a pause at the U.S. Federal Reserve, or if trade tensions ease, Emerging Markets would be immediate beneficiaries. Yet on trade, we see little chance of any substantive U.S.-China agreement having much effect in 2019, in part because the underlying conflict – a struggle for technological dominance – is pushing the two nations into a long economic cold war. If the disputes hold, then companies will likely reorient supply chains; Mexico and Southeast Asia will be the likely beneficiaries. A significant yuan depreciation seems unlikely, but China will probably react by renewing its fiscal stimulus programs, supporting growth and political stability – another tailwind for Emerging Markets.

While China tries to stabilize, the United States has fallen into an unaccustomed role – as a key source of geopolitical instability. Beyond a protectionist trade agenda, its confrontational leadership – which will likely only intensify given the newly divided Congress – suggests an already-ugly divide in American politics will only get uglier. Policy gridlock looks to be the base case. We foresee “turbulent stasis.”

For investors, that means (another) choppy year in 2019. How to respond? In general, cash and cash-like instruments might come in handy in the event of selloffs, while investors are getting paid more handsomely for shortduration debt. On the other hand, if there are more equity swoons, long bonds will provide a buffer.

We will explore the ramifications for Canadian fixed income investors more thoroughly in our next commentary, but for now, consider this: In an uncertain environment, resilience is key. That doesn’t mean just reducing risk. It also means maintaining an agile stance, responding to opportunities – and threats – as they arise.

And they surely will.

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Aubrey Basdeo
Head of Canadian Fixed Income, BlackRock
Aubrey Basdeo, Managing Director, is a member of the Strategy Team within BlackRock's Global Fixed Income group. He leads the product strategy effort in Canada ...