Outlook 2019: Markets – adapting to quantitative tightening

05 Dec 2018

Quantitative tightening – central bank policy normalisation – gradual in the US, perhaps steeper by the ECB, will doubtless be an important component of investors’ asset allocation thoughts as we move into 2019, for a variety of reasons.

Whereabouts are we in the credit cycle?

Simply looking at measures of the credit cycle, for example, ratings upgrade- downgrade ratios or default rates, the environment still appears fairly benign. In the US, the ratio is improving, and not showing the signs of deterioration that are often seen ahead of a recession. In Europe, the balance is quite positive (see exhibit 1).


Exhibit 1: Investment-grade credit upgrade-downgrade ratio, 2000-2018 (six-month moving average)


Source: Bank of America Merrill Lynch, BNP Paribas Asset Management, as at 31/10/2018


For high-yield credit in the US, excluding commodities, the rate of issuer defaults has been declining from the surge that began in 2016. In Europe, the rate remains low (see exhibit 2).


Exhibit 2: Changes in default rates of US and European high-yield debt, 1998- 2018 (trailing 12-months)


Source: Bank of America Merrill Lynch, BNP Paribas Asset Management, as at 31/10/ 2018. *Excludes commodities.


We are nonetheless in the later stage of the US economic cycle and it should be just a matter of time before worries about growth drive investors to favour government bonds over corporate debt. We are worried about a lack of discipline among corporate debt issuers. The stimulus from the tax cuts should eventually fade, while the US Federal Reserve will still be raising rates to forestall an increase in inflation and will still be reducing the size of its balance sheet. It is then that the build-up in corporate leverage over the last few years will likely become a problem for company treasurers. The asset class has seen significantly lower fund inflows compared to 2017 as investors began to anticipate rising interest rates.

In contrast, the eurozone economy may not have shown the same vigour as that of the US, but as far as credit is concerned, it has the virtue of the tortoise versus the hare. The Bloomberg Barclays eurozone credit index outperformed the euro government bond index as at 31 October 2018. By contrast, in the US, only high- yield (slightly) bettered government bonds.

Europe, however, faces the prospect of a much steeper normalisation of monetary policy in 2019 as quantitative easing ends (including the ECB’s Corporate Sector Purchase Programme (CSPP)) and the ECB may begin to raise interest rates. While this normalisation has already progressed reasonably far in the US (Treasury yields are well above the levels seen in the QE-era from 2010), yields of Bunds are still quite depressed (see exhibit 3).


Exhibit 3: Variations in the yields of selected benchmark 10-year government bonds, 2010-2018 (in %)


Source: FactSet, BNP Paribas Asset Management, as at 27/11/ 2018


Emerging  markets  had  a  difficult  2018.  How  do  you  assess  their prospects for 2019?

The key surprise in 2018 was the focus placed by President Donald Trump on trade. The fear of protectionism and trade wars contributed to a sharp rise in the US dollar and equally sharp falls in emerging market (particularly Chinese) equities.

Trade and the US dollar aside, however, the macroeconomic outlook for EM remains broadly positive. The prospects for 2019, then, depend on how the trade environment evolves.

Whenever President Trump ‘tweeted’ about trade, or announced higher tariffs on US imports, the US dollar generally strengthened. This explains much of why the dollar rose in 2018 after having declined from 2016 (see exhibit 4).


Exhibit 4: Changes in US dollar against emerging market currency index and US interest rates, 2000-2018


Source: JPMorgan, FactSet, BNP Paribas Asset Management, as at 27/11 2018


We had expected the dollar to continue its depreciation in 2018, despite rising US rates, because we believed the currency was overvalued. It was the surprise increase in the dollar’s value, combined with rising US rates, that put so much stress on emerging market assets in 2018.

We expect the Fed to continue raising interest rates through 2019, so pressures on emerging markets will only increase. Whether they will be able to withstand the pressure will depend on whether the dollar reverses course. If the trade tensions diminish (without entirely vanishing), we believe the prospects for a fall in the dollar are good, clearing the way for a rebound in emerging market equities and (local currency) fixed income markets.

There has nonetheless clearly been a negative impact on growth in emerging markets from the rising USD-interest rate combination. While purchasing manager indices (PMIs) for most markets have remained in positive territory (readings above 50 indicate expansion, those below 50 point to contraction), the trend over the last six months for many countries has been downwards.

This deceleration stems from emerging market central banks needing to either increase domestic interest rates or refrain from lowering them to defend their currencies. Inevitably, higher interest rates slow growth. If the US dollar pressure recedes, interest rates in emerging markets should stabilise or decline, as inflation remains contained in most countries.

How likely is it that trade tensions will lessen? It is worth separating the Trump administration’s concerns into three areas: divergent tariff levels, national security, and intellectual property. The first issue applies to most US trading partners, while the latter two are specific to China.

As for tariffs are concerned, there has already been progress made with South Korea, Europe, Canada, Mexico and Japan to adjust or reduce levies. While the changes in the actual levels have in the end often not been large, the important thing for the markets is that the prospect of a global trade war resulting from the imposition of retaliatory tariffs by the US trading partners has fallen.

We are cautiously optimistic that a similar arrangement will be made with China (eventually) as it is so clearly in the interest of both countries to keep trade flowing.

National security considerations, leading to restrictions on Chinese mergers and acquisitions in the US, and the concerns of both the US and the European Union about the forced transfer of intellectual property to the Chinese partners of foreign companies operating in China will remain.

However, marginally less M&A activity is not going to materially damage equity markets in either country, and any reduction in intellectual property transfers will be to the benefit of those companies retaining that asset.

While the US now has a more assertive stance vis-à-vis China than was the case under the Obama administration, this does not preclude continued economic growth in both countries and further equity market appreciation.