Ever since China allowed a meaningful devaluation of the Renminbi on the 11th August last year, risk markets have faltered and volatility has picked up. Concerns around China are justified. China is critical to the world as they made up over 50% of annual nominal Global GDP growth between 2014 and 2015, based on IMF data, and although a structurally slowing China was already on most people’s radar, this action brought it forward to the cold light of day.
Unfortunately the world’s current problems are not confined to China. Weakness is spreading across the major economies, as confirmed by our proprietary G10 composite leading indicator, which has fallen from an above trend pace of growth and is now tracking at trend like. Q4 GDP data for the US was revised up last week but still only came out at a lacklustre 1% annualised growth rate. While in Japan, 1% GDP growth would seem like a dream as their economy fell -0.4% in the fourth quarter and had not grown in real terms since 2013. And over in Europe, although the economic data is holding up ok, inflation expectations remain challenged. CPI has just fallen back into negative territory, concerns around migration are increasing and the possibility of “Brexit” and the knock on effects that the UK leaving would have for the European Union’s long term sustainability are creating uncertainty.
However, with all the negative noise that is occurring in the world it is important not to get too caught up in the downward spiral of despair. The US consumer (still the most important part of the economy) remains in robust health, jobs are being created on a monthly basis, low oil has pushed down gasoline prices and there are tentative signs that wage growth is rising. And although we are only two thirds through the quarter, everyone’s current favourite GDP monitor, the Atlanta Fed’s GDPNow real GDP forecast, has Q1 2016 currently tracking at 2.1%. Additionally, Central Banks will continue to be supportive. The Federal Reserve hiked rates back in December but given how this year has started the market is currently not pricing another full hike until summer 2017, and the Fed is expected to corroborate at least some of that reduction in hike expectations at the next meeting. While the ECB is expected to ease policy at next week’s meeting, the Japanese have just ventured into the world of negative interest rate policy, the Bank of England (like the Fed) is expected to be on hold for longer than previously thought and the PBoC has just cut their reserve ratio requirement (RRR) and is expected to do more as the year progresses.
Although these are uncertain times, what this all creates is a positive environment for fixed income assets. Admittedly, after such a strong start to the year, it is likely we see some consolidation in core government bonds, yet yields are not going materially higher anytime soon; growth, although not negative, is anaemic; inflation expectations continue to fall and major central banks are on hold or easing further. However, over the last 18 months significant value has been created in credit markets, both high yield and investment grade, where spreads have doubled and are now pricing in a recessionary environment (see High Yield: What’s in the Price – for Real). If this current global environment of low growth and low inflation continues, then looking forward it is likely that investors could be very pleasantly surprised by the returns achieved from their fixed income allocations.