Rates, Tariffs, Brexit: Lower, Please

Q2 Market Commentary

Rates, Tariffs, Brexit: Lower, Please

We remain cautiously optimistic that the Fed will see the light, that Brexit will move in a benign fashion, and that tariff disputes will subside. Spread sectors and duration remain our focus.

“It’s déjà vu all over again.”
attributed to Yogi Berra


  • Global growth has improved from the worst-case fears of late 2018 and monetary policymakers have declared explicitly that their goal is to extend the expansion.
  • With the annual US growth rate slipping below 2% and inflation falling further, we believe the Fed will begin to discuss whether a policy cut is needed.
  • While risks of a “hard Brexit” have increased with the departure of UK Prime Minister Theresa May, we continue to believe a deal will be reached.
  • We expect global growth to remain sturdy, and for interest rates in the US to remain attractive compared with the rates of other developed market countries.
  • The global backdrop of low inflation, low interest rates and accommodative monetary policy underscores our resolve to stay the course with overweight spread products and a long duration complement.


At the turn of the year, we felt our call for spread sector outperformance depended on sturdy global growth and accommodative monetary policy. We were looking primarily for three scenarios: trend growth in the US helped by a more dovish Federal Reserve (Fed) policy stance, stabilization then improvement in the Chinese economy aided by a lessening of trade tensions, and stabilization in European growth while avoiding a tail- risk political event, particularly Brexit. Sound familiar? Up until a few weeks ago, everything played out largely according to script. The downward trajectory of growth abated and prospects slowly brightened across all three economic regions (the US, China and the eurozone). Until recently, spread sector outperformance has been exceptional (Exhibit 1).

Exhibit 1: YTD 2019 Excess Returns

Chart comparing Year to Date Ending 03 May 19 Excess Returns and 06 May 19 - 24 may 19 Excess Returns

Source: Bloomberg Barclays, J.P.Morgan, S&P Global Market Intelligence, a division  of S&P Global Inc., Western Asset, as of 24 May 2019. 1 S&P/LSTA Performing Loans Index excess return vs. 3-Month LIBOR. 2 06 May 2019 data unavailable.07May 19 - 24 May 19  used. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.


But as unlikely as it may seem, we now need help with those same scenarios. The Fed needs to move to a more dovish stance, trade tensions need to lessen and worst-case fears over Brexit need to recede. The good news is that global growth has improved from the worst-case fears of year-end 2018 and monetary policymakers have straightforwardly spoken to the need to extend the expansion. The bad news is the risks enumerated above threaten a further downshift in global growth.

The Fed needs to move to a more dovish stance, trade tensions need to lessen and worst-case fears over Brexit need to recede.

The Fed has been extremely clear that its intent is to keep policy on hold unless a meaningful change in conditions occurs. Its thesis is that the economy at trend growth—with financial conditions seemingly easy and inflation only temporarily below target—warrants patience. Indeed, in its dot plot, the Fed continues to signal that the next move will be an eventual tightening. But while the change in policy stance will be belated, expect the Fed to find an opportunity to message that it is open to the prospects of easing rates. Our view is that annualized US economic growth is slipping below 2%. Inflation not only remains below the Fed’s target, but has fallen further as the year has progressed. Indeed, the Fed’s confidence in its errant inflation projections is remarkable, given that core Personal Consumption Expenditures (PCE) has only exceeded 2% once in the last six years. Inflation expectations, as measured by TIPS (Treasury Inflation Protected Securities) breakevens, have fallen well below 2%. Lower growth, lower actual as well as expected inflation, and increasing risks to global growth in our view all make the point rather clearly that Fed Chair Jerome Powell’s “overarching goal” of extending the expansion needs lower, not higher policy rates. Our view is that the Fed will acknowledge the need to monitor developments closely with a view as to whether to ease policy.

We have been cautiously optimistic on Chinese growth, understanding the sustained monetary and fiscal stimuli that have been at work would slowly but surely gain traction. Indeed, the economic indicators have been signaling not just economic stabilization but improvement as well. Our view that the second half of 2019 would prove better than the first appeared to be coming home. Now the reignition of trade tensions has put that improvement at risk. Our expectation had been that there would be a trade deal, bringing down the temperature of US-China tensions. But we understand completely that the economic competition between these powers will be ongoing. We still hold out hope that a deal may yet be completed. But even if it is not, we expect Chinese growth, while weaker than otherwise, to remain sturdy. The need to successfully compete economically with the US in the face of escalating trade disputes will demand yet more stimulus, and we believe it will be forthcoming.

Trend growth in Europe is reckoned to be only in the neighborhood of 1.0% to 1.25% annually, so the bar for growth is low. Despite gathering political clouds, the economic backdrop for European growth had been quietly but steadily improving (Exhibit 2). Our view has been that such modest levels would be achieved absent a political shock, particularly Brexit. As Americans, the good news about Brexit is that however dysfunctional our politics seem, the British have managed to outdo us. With Prime Minister Theresa May’s departure, the risks of a “hard Brexit” have increased. Our base case, though, remains that a mutually palatable deal will be reached. This will take time, and weigh on business and investment sentiment.

As Americans, the good news about Brexit is that however dysfunctional our politics may seem, the British have managed to outdo us.

Exhibit 2: After Evidence of Weaker European Growth Earlier This Year, the Overall Outlook Is Now Improving

Source: Bloomberg, as of 28 May 19. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.


An investor looking at the reasonable prospect of moderate US and global growth, subdued inflation and determined monetary accommodation might well consider that spread products, with their higher yields, would be the prohibitive favorite in producing superior returns. With growth risks rising, this thesis is put into question. Concurrently, with growth risks rising, the advisability of holding long duration positions as a crucial strategic port- folio position is reinforced. Our view remains that US and global inflation will be extraordinarily slow in resuming any upward trend. A downshift in global growth brings an actual resumption of a downward trend back into play. Policymakers must be—and in our view will be—very attentive to this development. This reinforces the prospects for global sovereign and US Treasury yields to remain low or move lower.

Our thesis is that global growth will remain sturdy. This seemingly low bar for global growth is now being challenged, but we think optimism on this point remains warranted. The fledgling improvement we had been seeing in global economic data two weeks ago may become less pronounced, but we believe it is unlikely to be reversed. Furthermore, policy accommodation may be forthcoming to undergird the expansion, particularly from China and the US. Last, there is the very real prospect of positive surprises. Two weeks ago, market optimism of an impending trade deal was rampant. This has been replaced by extreme pessimism that a deal can be reached. Optimism that a “hard Brexit” was completely off the table abounded; now fear has taken its place. If these uncertainties are lifted, investors who exited spread positions will be hard pressed to reclaim positions.

Our thesis is that global growth will remain sturdy. This seemingly low bar for global growth is now being challenged, but we think optimism on this point remains warranted.

Furthermore, the world of yield starvation is coming very much back into play. Over 20% of the Global Aggregate index (some $10+ trillion of securities) have negative yields. Interest rates in the US of 2%+ are high by comparison. In the US investment-grade corporate bond market, yields and yield spreads are also the most generous. Low inflation, accommodative monetary policy, low worldwide interest rates and what had heretofore been a slowly improving global growth backdrop lead us to stay the course: overweight spread products with a long duration complement. It may take time, but good news may once again emerge.


Spread sectors refers to sectors of the bond market, such as taxable bonds that are not Treasury securities, and includes securities such as agency securities, asset-backed securities, corporate bonds, high-yield bonds and mortgage-backed securities.

Excess return refers to return above that of the index or often in the case of bonds it refers to the return of a non-Treasury security above that of a comparable maturity Treasury.

The S&P LSTA Performing Loan Index tracks the current outstanding balance and spread over LIBOR for fully funded term loans. The facilities included represent a broad cross section of performing leveraged loans syndicated in the U.S., including dollar-denominated loans to overseas issuers. The London Interbank Offered Rate (LIBOR) is the interest rate determined daily by a specific group of London banks for deposits of certain stated maturities.

The Federal Reserve Board (“Fed”) is responsible for the formulation of policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

The Federal Reserve’s dot plot shows the projections of the 12 members of the Federal Open Market Committee (FOMC) on where they think fed funds rate should be at the end of the various calendar years shown, as well as in the long run—the peak for the fed funds rate after the Fed has finished tightening or “normalizing” policy from its current levels. The dot plot is published after each Fed meeting.

The Personal Consumption Expenditures (PCE) Price Index is a measure of price changes in consumer goods and services; the measure includes data pertaining to durables, non-durables and services.. Core PCE excludes food & energy prices.

U.S. Treasury inflation protected securities (TIPS) are a special type of Treasury note or bond that offers protection from inflation. Like other Treasuries, an inflation-indexed security pays interest six months and pays the principal when the security matures. Also referred to as “Treasury inflation-indexed securities.”

The Barclays Capital Global Aggregate Index is an unmanaged index used as a broad measure of the global bond market.

The Citigroup Economic Surprise Indices are objective and quantitative measures of economic news defined as weighted historical standard deviations of data surprisesA positive reading of the Economic Surprise Index suggests that economic releases have on balance been beating consensus.


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Yields and dividends represent past performance and there is no guarantee they will continue to be paid.

U.S. Treasuries are direct debt obligations issued and backed by the "full faith and credit" of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.

U.S. Treasury Inflation Protected Securities (“TIPS”) are bonds that receive a fixed, stated rate of return, but they also increase their principal by the changes in the CPI-U (the non-seasonally adjusted U.S. city average of the all-item consumer price index for all urban consumers, published by the Bureau of Labor Statistics). TIPS, like most fixed income instruments with long maturities, are subject to price risk.

Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.