Lower for longer favors carry trades

Thought of the day

by Chief Investment Office 14 Nov 2019

The recent trend in hard economic data continues: overall weakness centered on manufacturing, offset by greater resilience in consumption.

German growth remains weak, but the economy, driven by consumption, narrowly avoided a technical recession in 3Q, with GDP increasing by 0.1% after a contraction of 0.2% in 2Q. Japanese GDP grew by a weaker-than-expected 0.2% y-o-y in 3Q, but domestic demand increased by 2.1% annualized. And in China, October industrial production renewed its slowdown, increasing by 4.7% y-o-y compared with 5.7% in September, while Fixed Asset Investment growth slowed to 5.2% y-o-y in January-October, down from 5.4% in January-September.

But there have been tentative signs of stabilization in the forward-looking survey data. The manufacturing PMI for Germany rose from 41.7 in September to 42.1 in October, and the US manufacturing ISM climbed to 48.3 from 47.8.

Reflecting recent more optimistic signs in the US-China trade dispute, the early indications of bottoming in the data, and the extent of easing already in place, a number of central banks are tilting back towards a neutral stance in the near term.

On Wednesday, Fed Chair Jay Powell testified before Congress's Joint Economic Committee and reiterated that current monetary policy was "likely to remain appropriate" as long as the economy develops in line with the Fed's expectations: moderate growth with a strong labor market and inflation near the 2% target. Earlier this week the Reserve Bank of New Zealand didn’t deliver an expected rate cut. While not ruling out further cuts, the RBNZ said current rates were appropriate following aggressive easing earlier this year. And the Reserve Bank of Australia when lowering rates in October said that it “also took into account the possibility that further easing could unintentionally convey an overly negative view of the economic outlook.”

While the outlook for further easing is less certain, the bar for tightening is high. The Fed, for example, is signaling that it may allow the economy to run hotter for longer. Fed Governor Lael Brainard recently said that the Fed might entertain “opportunistic reflation,” overlooking price increases perceived as temporary.

Against this backdrop we expect the rate environment to continue to be “lower for longer” and as a result we recommend focusing on earning yield. We are overweight US dollar-denominated emerging market sovereign bonds, which offer an attractive carry of more than 3% versus US Treasuries.

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