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

June 17, 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.

Market and economic trends

With sentiment seemingly driving market moves, we think it's critical to:

  • Keep an eye on economic fundamentals while balancing risks and opportunities.
  • Not succumb to market sentiment and become reactive.
  • Balance our neutral credit position with a Treasury allocation that can be rewarded if the Federal Reserve cuts rates.
  • Be prepared if the economy surprises on the upside once trade tensions clear.

We believe that:

  • Reactive sentiment changes have not yet hurt underlying fundamentals irrevocably.
  • Market headwinds are mainly political and can shift quickly.
  • Lower yields prompting an increase in mortgage prepayments—and thus reducing the duration of mortgage-backed portfolios—will increase demand for U.S. Treasuries and further drive down yields.
  • Curve steepeners in rates and strategies that include an element of positive carry (a challenge in an inverted yield curve environment) are good policy.
  • Shorter-dated break-even inflation, because of a dovish Fed, higher import costs, and likely stabilization or even increase in oil prices, is driving inflation expectations higher.

Credit markets

As we assess the impact of tariffs on credit markets, we:

  • Prefer more defensive sectors, such as media/telecom, health care, and pharmaceuticals.
  • Are more cautious on consumer discretionary, retail, and autos.
  • Believe that the technology, agriculture, and chemical sectors will remain volatile as trade talks continue.

European economy—Brexit

  • Because U.K. Prime Minister Theresa May was unable to broker a Brexit deal, resulting in her voluntary resignation, the polls point to the next Prime Minister being a hard Brexiter.
  • The market is pricing in the probability of a hard Brexit, causing the British pound to fall sharply.
  • The European Union's future economic growth will be highly dependent on Chinese/global economic growth, and those risks are more to the downside.

U.S. economy

  • Despite strong first-quarter economic growth, 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 growing concern given their strong association with downturns.

Emerging markets

  • Escalating trade wars could prove damaging to emerging markets (EM) 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.
  • China's response is critical, 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, in particular for Asian currencies and EM countries/currencies that have large, external funding needs, such as Turkey and South Africa.

Foreign exchange

  • Despite the USD's recent impressive runs, 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, 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.
  • Usually a safe haven currency, the USD has recently been a carry currency. Any increase in market volatility may cast the USD as not as strong across the board. As a result, the Swiss franc and the Japanese yen are better risk-off hedges.
  • It looks like the CNY will continue to fluctuate between the 6.5 and 7.0 levels since the central bank seems willing to tolerate more two-way volatilities based on market forces. Nonetheless, the People's Bank of China is trying to lean into the wind and strengthen macro-prudential management, thus making a sharp depreciation unlikely.

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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