Potential hazards litter the horizon, including Federal Reserve policy meetings on July 30-31 and September 17-18 and Britain’s next date to leave the European Union on October 31. Mario Draghi’s eight-year term as European Central Bank chief ends the same day; his successor may oversee the reintroduction of quantitative easing before year-end.
But investors’ addiction to central bank largesse has many believing that the end of a decade-long bull run – and the longest economic expansion on record – will be postponed.
“It’s almost like bad news becomes good news,” said Jim Leaviss, a fixed income fund manager at M&G, predicting that weak economic data would spur central banks into launching a new round of monetary easing, as they have already signalled.
Markets’ dependency on central bank stimulus has created a disconnect in asset pricing that has dominated 2019.
While government bond yields in Germany and the United States have plummeted – which many investors say is a clear sign of nervousness about the outlook – equity markets have soared back towards record levels.
“One of the key themes we’ve focused on is that there is misplaced macro pessimism,” said Joseph Little, chief strategist at HSBC Global Asset Management.
“So if you get anything reasonably constructive in terms of economic news, politics, corporate profits, or the news is not as bad as the market discounts, then there is scope for a number of risky assets to perform well in the second half of the year.”
While equities are retesting 2019 highs, investors have entered the second half of the year in a cautious mood as data points to slowing growth momentum across the world.
Demand for government debt is predicted to remain high – Goldman Sachs said their downside risk scenario for the 10-year German Bund, the go-to safe-haven European government bond, is to yield around -0.5 per cent. It hit a record -0.34 per cent low last week.
The pressure is on Fed chief Jerome Powell.Credit:Cate Dingley
Gold too recently surged to a six-year high as investors sought hedges against a weakening dollar and falling US interest rate expectations.
But investors are hardly panicking. Yields on junk-rated company debt, usually shunned during troubled times, are near their lowest in over a year, down some 2 percentage points since January.
In a world where an estimated $US13 trillion ($18.7 trillion) of fixed income assets carry sub-0 per cent yields, money managers are likely to continue diversifying into lower-rated – riskier – securities.
What’s more, rock-bottom volatility – swings in prices – favours seeking “carry”, a strategy where investors sell lower-yield assets to buy higher-yielding securities.
“The question (for credit investors) is are we going to see a significant increase in (company) default risks?” said Eric Brard, head of fixed income at Amundi Asset Management.
“We are in a period of slowing growth but we don’t expect a recession,” he told Reuters, noting yield premiums on investment-grade corporate debt were still 40 to 50 basis points away from their tightest levels over underlying benchmarks.
Put to the test
The disconnect between buoyant equities and nervous bonds may be explainable if fixed income investors are simply adjusting to lower “neutral” policy rates in the world’s big economies, rather than anticipating a major downturn.
Barclays analysts believe just that, meaning the “stock market move is more consistent with the bond rally”.
Others are less sure. Colin Harte, head of research for BNP Paribas Asset Management’s multi-asset solutions team, predicts investor faith in central banks will be tested later this year.
He believes markets’ current disposition is sustainable only if “Goldilocks” conditions, of economic growth without much inflation, remain in place.
The risk is that markets are underplaying the trade war impact and not yet pricing in how a broader retrenchment from the “high point” of globalisation will impact the world economy.
“If that is the case, monetary policy won’t work,” he said. “Markets may be quite disappointed.”