Global debt outlook: A more stable second half could stem the tide of slower growth

The Global Debt team expects a mix of moderate growth and falling inflation to have a positive impact on asset prices

The second quarter was a continuation of the first in both the economic data (as growth continued to slow) as well as the market reaction to that data. Looking ahead, the Global Debt team expects global growth momentum to keep tapering in the third quarter, but at a slower rate since we expect greater stability in the second half of the year.

What did we see in the second quarter?

Global growth, as we expected, continued to slow, and policymakers responded by moving toward easier monetary conditions in almost every major global economy.  With the easier stances in developed economies, emerging market central banks, led by Chile and India, joined in the trend of easing tight monetary conditions. 

The market reaction in the quarter was as anticipated. Those sectors that had been hurt by tighter monetary conditions in 2018 benefitted the most in this environment.  Emerging market assets performed the best in the quarter with an EM local currency bond index returning 5.6%, an EM US dollar bond index returning just over 4%, and a broad US dollar index falling by nearly 1%.1

Below, we take a deeper look at each region, and expand upon our second-half outlook.

Developed markets

The US economy has been slowing down, but from quite high levels. In our view, it’s moving toward its potential level of just below 2%. Part of the slowdown is due to the waning fiscal stimulus of last year, but uncertainty about trade and the slowdown in the world economy are also factors. Business surveys on balance suggest weakening confidence and business investment has slowed down this year. We expect consumption to remain resilient, thanks to the solid job market, wage gains, low household borrowing, and strong confidence. Inflation is below target and will likely remain so until 2020, in our view. The Federal Reserve has strongly signaled that it may cut interest rates, and we expect a total cut of 50 basis points in 2019.

The eurozone’s economic weakness has continued because of its exposure to global trade. Weakness started mainly in manufacturing and trade, while more domestically oriented sectors proved resilient. On the domestic side, consumer confidence has declined from the cyclical highs but nevertheless has remained at strong levels. Credit is available and the labor market has continued to improve. As in the US, there is domestic resilience but there is more need for policy support given the eurozone’s more fragile recovery and higher exposure to the global economy. We believe the European Central Bank is ready to act, and we expect to see some modest stimulus in the fall, which could be signaled in the summer.

Japan also suffered from trade tensions. Economic growth surprised in the first quarter, but its composition was not encouraging and recent surveys suggest ongoing loss of momentum. With external risks increasing, firms have been reluctant to increase wage growth. However, the labor market is extremely tight in Japan, jobs are plentiful, and workers are hard to find. In response, companies have been investing in machinery and software to address labor shortages. The tight labor market and investment demand in domestically oriented sectors could provide a cushion against downside risks.

China and Asian emerging markets

As we expected, the first quarter was mired in further data weaknesses for Asian emerging markets (EM), despite some stabilization in China. We see this as a manifestation of global trade blues as global exports and industrial production fell sharply. In addition, Asia is also feeling the headwinds from a slowing technology cycle. In China, front-loading of exports before tariffs took effect and the domestic policy easing were behind the stabilizing growth numbers in the first quarter. However, forward-looking indicators point to the potential for further weakness ahead for the region as global demand weakens.

The stabilization we had expected in the second half of 2019 was rooted in our expectation for a trade deal between China and the US. Despite the recent truce at the G-20 meeting, the higher tariff rates as well as continued uncertainty about a deal pose further downside risks to China’s and Asian emerging markets’ growth in the second half, notwithstanding the ongoing stimulus in China. We see this uncertainty a key driver for weak global investment, which in turn negatively affects Asian exports. On the positive side, we expect further easing from China, should second-quarter data surprise significantly.

We believe that this global backdrop, benign demand-led inflation pressures and widening output gaps may allow room for more interest rate cuts in several countries, such as India, Indonesia, Korea, Malaysia, Philippines, Russia, and South Africa.

Latin America

The EM economies of Latin America have underperformed growth expectations, and we are therefore cutting our 2019 and 2020 growth forecasts across the board. The disappointing slowdown has broadened from the region’s larger economies, which we expect to see traction later, to the smaller economies. We have not materially changed our inflation outlook, as output gaps are even wider and inflation risks are lower. We expect easier global monetary conditions to curb exchange rate pressures and allow all regional central banks to add stimulus.

Colombia’s lagged economic recovery soldiers on while Argentina has been the larger exception in the region with negative growth and double-digit inflation. Yet these two economies are still improving from last year. We believe the bar is now too high for the Argentinian economy not to contract this year, but we are hopeful for a background of macro-stabilization, which we think will succeed with the potential reelection of Mauricio Macri in the October presidential election.

Mexico’s growth was hurt by the US slowdown and uncertainties over domestic policy. In our opinion, while the Mexican economy benefits from a good starting point with low debt levels, its economic fundamentals are deteriorating with President López Obrador (AMLO) and his heterodox policy mix. Within this context, we are constructive because we see inflation convergence with central bank easing, high real rates, and fiscal prudence. We do not see Mexican sovereign debt ratings going to below investment grade, while the national oil company may be downgraded again and removed from investment grade mandates.

In Brazil, we are more optimistic with the approval of the strong pension reform, and we expect the central bank to drive expansionary conditions. Economic activity has faltered on global and local shocks that allowed a large negative output gap, with domestic uncertainties failing to support a more benign environment. We think traction will come, with higher growth more likely to materialize next year. All in, decreasing global interest rates allow for more accommodative monetary policy, which would support EM assets. The primary risk to emerging markets is a full-blown trade war, instead of a protracted conflict-resolution solution, leading to recession. However, we see this as unlikely.

Outlook

We still see global growth momentum slowing in the third quarter, but at a slower rate since we expect greater stability in the second half of the year. We think EM growth will improve marginally in the second half, but at a lower level than we originally expected in the first quarter. The slowdowns in trade and related investments have been the primary drivers of the decline in global growth. The domestic drivers of growth have been stable, in almost every region, despite signs of weakness evident in declining inflation expectations. 

The US economy has been slowing down, but from high levels, towards its potential of just below 2%. Declining fiscal stimulus of last year, along with uncertainty about trade and lower global growth, are also contributing factors. Lower growth in the eurozone continues from weakness in manufacturing and trade, while domestic sectors have been more resilient. Consumer confidence has declined from the cyclical highs but remains at strong levels.

While the delta of change to growth is still negative, we think there will be some stability in the second half and an improvement in global growth in 2020. Our 2019 growth forecast is 2.8% for the countries in our investible universe, and this is a bit below consensus. However, our 2020 growth forecast is 3.1% with the increase coming mainly from outside the US. While global growth is weaker, it is still very much with the global sweet spot of being at potential or slightly below providing support for risk assets. The impact of both monetary and fiscal policy is expected to be positive for assets.   

We expect that monetary policy globally will continue to become more supportive, especially as the Federal Reserve has moved toward an easing bias.  Similarly, The European Central Bank has already announced that further monetary policy stimulus is quite likely, and we are waiting to see which form it takes.

In this environment, there is room for emerging market central banks to provide monetary stimulus. EM central banks from India to Chile have eased, and we expect other central banks to follow. Real policy rates in emerging market countries remain high with room to fall. The high real rates also highlight the fact that inflation remains very muted globally, and we see little near-term risk of it accelerating in a meaningful manner.

We expect the mix of moderate growth with falling inflation to have a positive impact on asset prices. While we will monitor global conditions closely, we do not expect a recession. The positive policy environment that began in the first quarter should continue for our investment horizon.

Portfolio implications

Due to the shift in economics and the policy environment, the Global Debt team has kept a stable outlook for our portfolio positioning.  We continue to believe the US dollar will slowly decline, possibly accelerating in the second half of 2019 into 2020 as the global growth differential to the US may widen. We maintain our view that the medium-term trend for the dollar is lower, continuing the decline that started in 2015, and was only interrupted in 2018 because of the large fiscal stimulus in the US. EM currencies will likely benefit from carry while developed market currencies could benefit from valuations.  

In our portfolios, we favor carry from EM currencies. We increased our exposures to the Brazilian real, Indian rupee, Indonesian Rupiah, and South African rand. We also like the Norwegian krone. We continue to favor emerging market interest rates over developed market interest rates. Real yields in emerging markets remain close to highs when compared to a combination of developed market yields. Given the strong performance in credit in the first half of the year, we are reducing our credit exposure in both emerging markets and Europe. We look to redeploy that capital into emerging market interest rates.

1. Source: Bloomberg, L.P. The EM local currency bond index is defined by the J.P. Morgan Government Bond Index – Emerging Markets Global Diversified, which consists of regularly traded, liquid fixed-rate, domestic currency government bonds to which international investors can gain exposure. The EM US dollar bond index is defined by the J.P. Morgan Emerging Markets Bond Index Global Diversified, which is a composite index representing an unleveraged investment in emerging market bonds that is broadly based across the spectrum of emerging market bonds and includes reinvestment of income (to represent real assets). The broad US dollar index is represented by the Bloomberg Dollar Spot Index, which tracks the performance of a basket of 10 leading global currencies versus the US dollar. It has a dynamically updated composition and represents a diverse set of currencies that are important from trade and liquidity perspectives. An investment cannot be made directly into an index. Past performance  does not guarantee future results.

Important information
Blog header image: Thaï Ch. Hamelin – ChokdiDesign / Unsplash.com

Carry is defined as the profit investors gain from selling a certain currency with a relatively low interest rate and using the funds to purchase a different currency yielding a higher interest rate.

Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa.

An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.

The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

The performance of an investment concentrated in issuers of a certain region or country is expected to be closely tied to conditions within that region and to be more volatile than more geographically diversified investments.

The opinions referenced above are as of July 19, 2019. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial advisor/financial consultant before making any investment decisions. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

Hemant Baijal is Head of Multi-Sector Portfolio Management – Global Debt at Invesco. He leads the Global Debt team and also serves as a Senior Portfolio Manager.

Mr. Baijal joined Invesco when the firm combined with OppenheimerFunds in 2019. He joined OppenheimerFunds in 2011 and led the Global Debt team, in addition to being the lead portfolio manager on a number of strategies including International Bond, Global Strategic Income, Emerging Market Local Debt, and Global Unconstrained Bond. Before joining OppenheimerFunds, Mr. Baijal co-founded Six Seasons Global Asset Management, where he served as partner and portfolio manager with a focus on fixed income macro strategies. Before his role at Six Seasons, he was a partner and portfolio manager at Aravali Partners, LLC., and Havell Capital Management, LLC., where he focused on fixed income macro and relative value strategies. Earlier in his career, Mr. Baijal was a senior portfolio manager for international, global, and multi-sector fixed income portfolios at Neuberger Berman. He has also held positions at Banca Di Roma, First Boston Corporation, and Merrill Lynch and Co.

Mr. Baijal earned a BA degree from the University of Delhi and an MBA from Columbia University.

Claudia Castro is a Director of Fixed Income Research for the Invesco Fixed Income team.

Ms. Castro joined Invesco when the firm combined with OppenheimerFunds in 2019. She joined OppenheimerFunds in 2004 and has covered emerging markets since 2000. Ms. Castro started her career in the global securities industry at Morgan Stanley, serving in the global economics group. She held academic and research positions at various institutions, including the Belgium University of Louvain, the Central Bank of Spain, the International Monetary Fund, and the World Bank. Over the course of her tenures as an economist, political scientist, and financial market practitioner, she has covered a range of advanced, emerging, and frontier markets, focusing on political risk, policymaking, and capital markets. Earlier in her training career, she worked on various economic projects in Brazil, Switzerland, and Italy, at Companhia Vale do Rio Doce, Esso Brasil SA, International Trade Centre Unctad/GATT, and Pirelli Coordinamento Pneumatici.

Ms. Castro earned a PhD from Columbia University in economics, and her main area of research was international finance. In addition to her PhD and master’s degrees in economics from Columbia University, she earned a master’s degree in political science from the University of Pennsylvania, and a BA degree in economics from Universidade do Estado do Rio de Janeiro, Brazil.

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