August has been a very challenging month so far for risk markets, while in traditional risk off, UST treasuries have seen sharp declines in yield back to the lows last seen in October 2016. We can’t help but think that this sharp adjustment will become more ingrained in August, following 6 months of relatively benign markets.
While markets were facing a globally coordinated slowdown in economic activity with the headwind of rising rates last year, the response was a sharp Q4 sell off as participants viewed this as a policy error being made. This reversed sharply in Q1 2019 as the Fed did a 180 degree pivot and many other central banks also moved into easing mode; a response which has almost single handedly worked to make this current economic cycle the longest in US history. In the absence of external shocks this approach could well result in a soft landing and further records for the current cycle. A simple reading through the Fed’s beige book report in July, coupled with a precautionary rate cut would suggest that the Fed was on track to achieve this most difficult goal.
However, monetary policy tools are simply not enough to deal with the event risks that have been hanging over markets in the last year, and from time to time these are flaring up causing markets to retrace their optimism.
Starting in Europe, there is the increasing likelihood that there will be a hard Brexit on October 31st. We would put the chances as high as 50 percent, although we probably won’t know the final answer until the last minute. Markets are focussed mainly on what this might mean for the UK economy but it’s inevitable that Germany and the Eurozone would also dip into recession. We think inventory build ups probably mean that it’s not in 2019, but Q1 2020 when it could become ugly, no matter how much easing the central banks try to mitigate it with.
This political debacle however is overshadowed by the trade battle between the US and China, which has the possibility of pulling the world’s largest economy into recession. This battle is no longer just posturing as it has already spilled into the real economy via the actions of the corporates that have been affected. Both sides seem serious in the determination of their own policies, but then equally determined when they are at the negotiating table together. As we all know, dealing with political risks in financial markets is one of the most difficult circumstances and this one, like Brexit, feels quite binary.
So we have a tug of war between a global slowdown that can probably be cured by monetary and fiscal policies, and event risks that could go wrong for markets and cause the next downturn. Right now the event risks are in the chair and have the upper hand.
All of this uncertainty means portfolios need to be well balanced and nimble as the outcomes can change quite literally on a tweet. We believe that for pure fixed income investors this means a heavy allocation to pure rates products alongside yield generating credit assets, coupled with a lot of liquidity.