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Perspective from Franklin Templeton Fixed Income Group
US Fundamentals Solid Despite Global Financial Market Turbulence
The start of 2016 brought turbulence to financial markets, amid a sharp deterioration in sentiment among investors about the prospects for the global economy and the effectiveness of central bank policies. US economic data showed some signs of related headwinds, but on the whole fundamentals remained supportive of US growth. As expected, the fourth quarter of 2015 saw a slowdown, as US gross domestic product (GDP) expanded at an annualized rate of only 0.7%, hurt by a drop in exports that underlined the adverse effects of the strong US dollar and slower growth around the world on US companies. Though consumer spending—a key driver of growth for the economy—failed to maintain the heady pace seen in the third quarter, it still posted a relatively healthy annual rise of 2.2% in the final three months of the year.
Investment was another weak spot in the GDP data, mainly due to big reductions in spending by energy and mining companies that had been forced to adjust to the collapse in global commodity prices. Evidence of more wide-ranging weakness among US manufacturers came from the Institute for Supply Management’s (ISM’s) manufacturing purchasing managers’ index (PMI), with January marking its fourth sub-50 reading in a row. The one positive aspect of the report was a pickup in new orders, though notably this improvement was seen only in domestic orders. Another negative was the US Federal Reserve’s (Fed’s) quarterly survey of the banking sector’s corporate lending conditions, which indicated a second consecutive tightening of standards over the fourth quarter.
With commodity-related companies and manufacturers under pressure, speculation grew about whether previously robust parts of the US economy—particularly the labor market and the services sector—would start to be affected. Therefore, a resilient payrolls report for January was welcomed, even though the addition of 151,000 jobs was weaker than consensus expectations. The increase in payrolls was still enough to pull the unemployment rate down to 4.9%, the lowest level since 2008, while wage growth was a notable bright spot, coming in at a much higher-than-expected annual rise of 2.5% in hourly earnings. However, markets were disappointed by a surprisingly large fall in the ISM’s non-manufacturing PMI for January, which, though still indicating service sector expansion, pointed to a slowdown in activity, employment and new orders.
Inflation readings remained subdued. The headline Consumer Price Index for December slipped 0.1% month-on-month (m/m), and the equivalent core number (ex food and energy) rose by a similar amount. Both measures accelerated a little on an annual basis compared with November, at 0.7% and 2.1% respectively. Over the same period, the Fed’s preferred measure of inflation, personal consumer expenditures (PCE), painted a similar picture, with December’s headline PCE price index at -0.1% m/m and the equivalent core number unchanged, and annual gains of 0.6% and 1.4%, respectively.
The turmoil in global markets increased the focus on future moves by the Fed, following its decision to increase policy rates in December. At that meeting, the Fed had estimated that policy rates could rise by another 100 basis points by the end of 2016, but a steady flow of weak global data and heightened market volatility meant that the far slower pace forecasted by the consensus in the market increasingly appeared a more likely scenario. Commenting on developments since December, Fed Chair Janet Yellen argued that continued hiring and wage gains should support the US economy, but she also acknowledged that further market turbulence could damage US growth. She also refused to rule out further tightening, emphasizing that the Fed’s decisions would remain dependent on the interpretation of forthcoming data about the economic outlook and that any potential changes would be gradual.
The pricing of US asset classes shifted abruptly as risk aversion among investors increased significantly. Treasury yields moved closer to their lowest levels since the global financial crisis, partly in response to falling sovereign yields in other parts of the world, while the US yield curve flattened significantly—the difference between two- and 10-year Treasury yields narrowed to its smallest spread in eight years. Riskier US assets joined a global selloff, and banking stocks came under particular pressure on concerns that a period of lower-to-negative interest rates and a flatter yield curve could hurt banks’ profitability. As expectations for additional US rate rises dwindled, the US dollar fell to its lowest point on a trade-weighted basis since October 2015, unwinding all of its gains in the run-up to December’s rate increase.
We believe that although the United States is far from immune to weakness overseas, financial markets may have exaggerated the potential downside from these risks, as fundamentals continue to signal a relatively strong US economy. Uncertainty about global growth could see market volatility persist, and risks clearly remain—for example, a significant weakening in the US labor market or a major global adjustment, such as a Chinese “hard landing”—but in the absence of such developments, it seems more likely that the Fed will conclude that a delay rather than a change in the direction of its monetary policy is the appropriate way forward.
Global Economy Is Slowing, but Growth Still Acceptable
The volatility in global markets gathered pace after the Bank of Japan (BOJ) sprang a major surprise by cutting its deposit rate into negative territory in an effort to boost inflation, having previously denied that such a move was being considered. Though the policy was applicable only to new rather than existing funds placed with the BOJ, the impact on Japanese government bonds (JGBs) and the Japanese yen was dramatic. Yields on JGB maturities of below 10 years quickly turned negative, and even the 10-year bond yield briefly dipped below zero. A flight to perceived safe havens prompted by market volatility at the start of the year had previously seen the yen rally over much of January, but the currency fell sharply following the BOJ’s January 29 announcement, only to quickly reverse course once more as volatility intensified, eventually rising to its highest level against the US dollar since late 2014.
Data from China underlined the ongoing slowdown in the country’s economy. Fourth-quarter GDP growth expanded by 6.8% year-on-year, and annual growth of 6.9% for 2015 as a whole was the slowest pace since 1990. Figures showed that China’s steel production and power generation declined in 2015 for the first time in at least 25 years. But there was better news from the services sector, which expanded by a healthy 8.3% in 2015, as the rebalancing of China’s economy away from manufacturing and construction continued. Nevertheless, investors remained uncertain about the extent of China’s slowdown, and also wary of the potential for China’s policymakers to undertake a further devaluation of the Chinese renminbi to help its manufacturers, especially in the wake of the poor communication of its intentions by the People’s Bank of China when the renminbi was last devalued in August 2015.
With little sign that China’s reduced demand for commodities would recover in the short term, most commodity prices remained under pressure. In an already oversupplied market—even before the start of any additional production by Iran, following the lifting of sanctions—oil prices fell to 12-year lows. They briefly recovered some of their losses on speculation that larger oil-producing countries might be discussing output cuts, before slumping once more. A notable exception to the commodity gloom was gold, which performed strongly as many investors sought shelter from the disruptions occurring in financial markets.
Signs of stress appeared in some emerging markets, especially among those heavily dependent on oil production for revenues. Nigeria requested an emergency loan from the World Bank and regional institutions to help fund a US$15 billion deficit in government finances, while Azerbaijan was reported to be in talks with the International Monetary Fund after its currency fell dramatically against the US dollar following the abandonment of a peg against the greenback in December. However, there was better news from some countries reliant on imports for most of their energy needs and seeing the benefit of lower energy costs, with India posting relatively strong GDP growth of 7.3% for the December-end quarter.
Our view remains that the global economy, while certainly slowing, continues to grow at an acceptable pace. The impact of China’s rebalancing is likely to remain a headwind, particularly for countries that have relied on its appetite for raw materials. But this is likely to be counterbalanced by the continuation of the various accommodative monetary policies that are in place around the world, as well as the boost to consumer spending power from lower energy prices in many countries, both of which could provide an offsetting stimulus for global demand.
European Growth Weak but Steady, with Further Easing Likely
Fourth-quarter GDP data for the eurozone confirmed a picture of weak growth mostly led by domestic consumption, but annual expansion of 1.5% for the whole of 2015 still represented the region’s strongest performance since 2011. Germany’s economy, the largest of any member country, saw a quarterly expansion of 0.3% in the final three months of the year, restrained by weakness in overseas markets. Italy, however, barely grew at all over the same period, while the Greek economy shrank by 0.6% quarter-on-quarter. Despite an uptick in eurozone inflation in January—with annual headline inflation rising to its highest level since 2014—consensus expectations remained that pricing pressures in the region would diminish once more in coming months, as the effect of lower oil prices takes hold.
Anticipating the effects of slower growth in export markets and further disinflationary pressures, the European Central Bank (ECB) wasted no time in making clear that another round of monetary easing could take place as early as March. Such hints prompted significant declines in eurozone bond yields, and by the end of January yields for all maturities of German Bunds of less than 10 years had turned negative. Yields tumbled even further after Sweden’s Riksbank surprised markets by cutting its benchmark interest rate further into negative territory than expected.
Europe was hit hard by the volatility seen in financial markets in recent weeks. Some European banks came under pressure, as investors worried about the lack of liquidity in certain relatively new debt instruments that formed part of their balance sheets. There were also concerns about the level of bad loans held by some Italian banks, although at the end of January a deal was reached between Italy and the European Union to allow the sale of such loans to private investors.
Political uncertainty was evident in several countries. The Spanish political system remained gridlocked, as further attempts were made to form a left-leaning government in the wake of December’s inconclusive elections. Having finally succeeded in getting its budget passed by the European Commission, Portugal’s socialist government rattled investors by announcing plans to reverse the privatization of the country’s national airline, leading to a selloff in Portuguese government bonds. The policies of Poland’s new government came under the spotlight after the country’s sovereign debt was downgraded by credit-rating agency Standard and Poor’s, which cited an erosion of independence among key public institutions.
For all the focus within markets on doom and gloom, we believe conditions in the eurozone are actually not too bad. Growth is weak but steady, and the picture on inflation has improved markedly from a year ago. Despite much speculation, the banking sector in general is in quite good shape, in our view, with capital in the system overall much higher than it has been in many years. Some banks have problems that need to be dealt with, but those issues are gradually being resolved by governments and the banks themselves. In terms of monetary policy, the ECB seems almost certain to announce further measures in March, maintaining the steady progressive easing that helps to provide investors with reassurance that the bank will remain a buyer of bonds for the foreseeable future.
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What Are the Risks?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size and lesser liquidity.