How Low Can Rates Go? Total Return Market Outlook
The fixed income market benefited in the third quarter as both global growth fears and the trade dispute continued to drive uncertainty in financial markets. With Europe remaining in an economic rut and China showing signs of slowing from the protracted trade conflict, investors sought the safety of U.S. Treasuries, pushing up prices and reducing yields. The effect was most pronounced at the long end, with 30-year Treasury yields down 41.9 basis points (bps) and 2-year yields down only 13.3 bps. Much of this move took place in concert with European yields as they were driven further into negative territory in anticipation of a dovish September European Central Bank (ECB) meeting. Yet as flows continued to move into risk-free assets, credit remained stable as spreads were unchanged during the quarter, thus resulting in the continuing rally across investment grade fixed income.
Overall the domestic economy has been resilient this year despite the ongoing trade war, but the manufacturing sector has been hit hardest and is beginning to show signs of weakness. The Institute for Supply Management (ISM) and Purchasing Managers Index (PMI) manufacturing surveys are both hovering around 50 (anything less than 50 is signaling contraction), which is keeping the markets on edge. In the latest September release, the ISM survey posted 47.8, which surprised markets and suggests an increased possibility of a recession. The September PMI survey was a little stronger, remaining above 50 at 51.1.
Away from manufacturing, consumer-driven indicators suggest a more stable environment, as low unemployment and wage growth have supported retail sales and other consumer services. Indicators such as the Citi Economic Surprise Index, which measures data surprises relative to market expectations, rose from -68.30 to +43.00 during the quarter (positive numbers suggest positive surprises, and vice-versa). The move from negative to positive was definitely a good sign, but the index backslid a little to +23.20 in October due to the weaker manufacturing survey data.
Our portfolio remains defensive as the trade war endures and could potentially bring the economy to the brink of recession, but we believe such an outcome will be contained as it is in the best interest of both parties to come to a resolution prior to a complete meltdown.
During the quarter, several defensive central banks around the world cut rates in an effort to stimulate their respective economies. Accordingly, the Federal Reserve (the Fed) cut 25 bps during the quarter as inflation remained under control with trade uncertainty muddling the economic outlook. The market continues to price-in another 25 bps cut before the end of the year, which seems reasonable based on the Fed’s recent actions. The quarter was also marked by the Fed resolving funding pressures in the overnight repurchasing (repo) market by initiating a temporary open market operation. The Fed acknowledged the cause of the dislocation was a technical issue as the reserve cushion was reduced and resulted in the overnight rate being set as high as 10% from rates hovering around 2%. Such a move in the repo rate was alarming for market participants but posed little risk to the financial system. The Fed’s initial reluctance to carry out temporary operations (which were common pre-crisis of 2008) could have been driven by concerns of the action being misperceived as additional quantitative easing, which could have created more of a confidence issue in the Fed than an actual problem.