Moving to a risk-off environment: Will market sentiment become reality?

June 19, 2019

Anne Mathias

Anne Mathias
Senior Strategist
Global Rates
and FX Strategist

As both sides in the China-U.S. trade dispute speed toward the edge of the cliff, and new trade tensions appear (and disappear) with rapid frequency, we are seeing markets being driven more by sentiment and less by fundamentals. As active investors, we must ask ourselves, What is the reality? The U.S. economy is slowing, but not stalling. The trillion-dollar question for investors is, Will volatility and enough negative sentiment make worries become reality? Vanguard's Investment Strategy Group team doesn't see the threat of an imminent recession, and with a Federal Reserve that seems willing to keep rates low, we may get a pass. Tight financial conditions are one of the keys that could turn sentiment into reality. But we haven't yet seen a large move in financial conditions or volatility, and lower yields are offsetting the price decline in equities.

At the moment, the market is anticipating one or more rate cuts this year. But, with the federal funds rate at 2.5%, there isn't a lot of room to maneuver for looser conditions (not nearly as much as in the 1990s).

It's not that it's "different this time," but it is different from last time. We see the current cycle being more akin to the late 1990s cycle, when no single sector of the economy was massively overlevered and the Fed was able to move rates up and down in fairly small increments over a number of years without inducing a recession.

In this environment, with sentiment seemingly driving market moves, we think it's critical to keep an eye on economic fundamentals and remain active in terms of balancing risk and opportunity, but not succumb to sentiment and become reactive. We like balancing our neutral credit position in our active funds with a U.S. Treasury allocation structured in a way that should reward investors if the Fed cuts rates or if the economy surprises to the upside once the trade tensions clear.

Market and economic trends

Much of the market headwinds are political and can be resolved quickly if the parties become willing. This is very different from the major market-structure and household overleverage issues that drove the financial crisis of 2008.

Market technicals are also becoming concerning. Lower yields are prompting increases in mortgage prepayments, which reduce the duration of mortgage-backed portfolios (MBS). This drives MBS holders to try to cover the duration reduction, increasing the demand for U.S. Treasuries and driving down yields further.

Overall, we continue to like curve steepeners in rates—we haven't yet thrown in the towel on the U.S. or European economies. We also like strategies that have some element of positive carry—which is tough in an environment where the yield curve is so inverted at the short end. We do like shorter-dated break-even inflation because we see a combination of a dovish Fed, higher import costs, and a likely stabilization or even increase in oil prices as issues driving inflation expectations higher as the trade clouds clear.

Credit markets

As we assess the risks of tariffs on the credit markets, we prefer the more defensive sectors: media/telecom, health care, and pharmaceuticals. Alternatively, we are more cautious on consumer discretionary, retail, and autos. We believe that the technology, agriculture, and chemical sectors will remain volatile as trade talks continue, with the second-order impact felt most by the energy and retail sectors.

European economy—Brexit

Because U.K. Prime Minister Theresa May was unable to broker a Brexit deal, resulting in her voluntary resignation, polls point to the next leader of the Conservatives and, therefore, the new prime minister as being a hard Brexiter. This has significantly increased uncertainty. In fact, the market is pricing in the probability of a hard Brexit, causing the British pound to fall sharply.

U.S. economy

Despite strong headline first-quarter economic growth, the softer underlying activity has continued into the second quarter. Consumption growth appears to have stabilized at just under 3.0%, but investment has remained weak and modestly below our expectations. Weak housing data continue to be a drag on the economy and a concern for us given their strong association with downturns.

Emerging markets

If trade wars escalate, they are likely to damage emerging markets (EM) in general via the real economy channel as well as the sentiment channel/risk-off. A stronger U.S. dollar (USD), which may be the first stage of such an escalation, makes EM foreign exchange very difficult and may affect some of the EM rates markets, which have been trading quite well this year.

The reaction of China is critical, of course, and any large slowdown in EM is generally considered negative. How the renminbi gets managed is paramount, especially if the onshore Chinese yuan (CNY) is allowed to go through the 7.0 level. This would be very bad for sentiment, for Asian currencies first off, and then for EM countries/currencies that have large, external funding needs, such as Turkey and South Africa.

Foreign exchange

While the USD has had an impressive run since the lows of 2018, our current research has the USD as being only slightly overvalued.

Even with the bout of risk-off in April, foreign exchange volatility is still at relatively low levels. Given that the USD is the highest carry currency in the G-10, unless the Fed becomes more dovish (which will be tough to do since two cuts are already priced into the forward curve), we will continue to remain in a strong dollar environment.

Because European growth is more reliant on trade (and, consequently, global growth), we will need to see a decisive rebound in global growth to push the euro higher.

Historically, the USD has been a safe haven currency. However, the USD has been a carry currency. This means that any increase in market volatility may cast the USD as not as strong across the board. As a result, the Swiss franc and Japanese yen are better risk-off hedges.

Overall, it looks as if CNY will continue to fluctuate between 6.5 and 7.0 since the central bank seems willing to tolerate more two-way volatilities based on market forces. Nonetheless, the People's Bank of China is still trying to lean into the wind and strengthen the macroprudential management. Thus, a sharp depreciation is unlikely in our view.

Read The Fed must play the hand it's been dealt for Vanguard's perspective on where monetary policy may be headed.


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Anne N. Mathias is a senior strategist in Vanguard Fixed Income Group, with a focus on global macro rates and foreign currency. She is responsible for analyzing interest rates, currency valuations, economic developments, and political risks for Vanguard's portfolio managers and investment staff.

Before joining Vanguard in 2017, Anne was the senior macro strategist for Guggenheim Partners Investment Management in Los Angeles. She also spent an earlier part of her career on the sell side, producing her own research and managing U.S.-based research teams for MF Global, Charles Schwab, and others. In these roles, she led the Washington Research Group team, which provided political, economic, and industry research for investors and was consistently ranked among the top three in the Institutional Investor "All-America Research Team" poll. Anne was a private equity investor with the Global Environment Fund and spent five years with Deloitte & Touche as a senior consultant specializing in emerging markets privatization and enterprise restructuring.

Anne earned a B.A. from the University of Maryland and an M.S. in international affairs from Georgetown University's School of Foreign Service. She is a CFA® charterholder and a member of the CFA Society of Los Angeles and the CFA Institute.


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