Still climbing, but the terrain grows rockier
- The global economy is facing increasing downward pressure, although we agree with the consensus that a recession isn’t quite yet in the cards.
- Lower (and in some cases negative) interest rates are complicating the investment outlook. Rates may still be too low, but we are not expecting a sharp climb.
- While we continue to favor more defensive positioning among and within most asset classes, we are still finding investment opportunities.
More money, more problems
The third quarter was marked by the continued
slowing of global economic growth, sprinkled with
a healthy dose of policy uncertainty. Nevertheless,
most major asset classes were able to build on
the solid gains they made in the first half of the
year. Unlike the market swoons of 2015 and 2018,
the August volatility was driven by a sharp drop
in global interest rates, not by panicked equity
investors. Indeed, the prevalence of negative
interest rates in global bond markets, resulting from
lackluster growth and dovish central banks, became
a source of concern in its own right as observers
justifiably pondered the longer-term implications.
Around the world, policy uncertainty — dominated by trade risks (Figure 1) — is dampening risk appetite and contributing to choppier market conditions. It may even be turning some recession indicators from yellow to red, especially those tied to global manufacturing. Yet while we continue to expect the slower global economy to be a headwind for investors, we are not expecting a U.S. recession or a further abrupt slowing of growth in other major economies.
Although recession risks are rising, we don’t see one materializing over the next year.
The global economy is slowing, but not in recession
Indeed, there was broad consensus at the Nuveen
Global Investment Committee meeting in September
that the global economy has slowed further and may
continue to do so over the coming months. Factory
output, as estimated by the Global Manufacturing
Purchasing Managers Index, is contracting. But
in a sign of what qualifies as good news these
days, the pace of contraction no longer appears to
be accelerating. Even so, manufacturing activity
remains weak in China and the eurozone, which have
been among the world’s most disappointing growth
stories to date. Europe’s consumers are driving
growth, while manufacturers continue to struggle.
The lack of investment in the U.K. due to Brexit-related uncertainty would be more concerning in
the absence of low unemployment and solid retail
In the U.S., few professional forecasters are calling for a recession in the next several quarters, but the broad consensus seems to be that we should be increasingly worried about one materializing. We agree that recession risks have risen in recent months. The U.S. Treasury yield curve is inverted at key intervals that have accurately predicted recessions in the past, and manufacturing is slowing. But most economic and market indicators we use to project U.S. recessions are still in “safe” territory: Consumers are optimistic about the future, builders are applying for permits and unemployment claims are near a 50-year low. Finally, despite third quarter volatility, financial market conditions have remained generally loose. With all of these positive data points, the Conference Board’s Leading Economic Indicators Index resumed its climb over the summer (Figure 2).
If we are wrong, it will probably be because the U.S. consumer falters unexpectedly despite the recent uptick in wage growth and personal savings rates. What could cause such a reversal? A further increase in tariffs on consumer goods coming from China or elsewhere is one possibility. A prolonged military conflict in the Middle East that disrupts the global market for oil could also be a factor. Or, we could see a policy shock outside the U.S., such as a messy “no deal” Brexit, prompting recessions across Europe.
I’d gladly pay you Tuesday for a German bund in 2029
Wimpy, the hapless character from the old Popeye
cartoons who routinely offers to pay people “on
Tuesday for a hamburger today,” would have thrived
in today’s interest rate environment in which money
can be worth more in the future than it is in the
present. At various points during the third quarter,
nearly one-third of all investment grade bonds
around the world were trading with negative interest
rates. That means a significant percentage of global
investors were willing to pay high enough prices to
guarantee losses on sovereign and corporate debt if
held to maturity. That’s a pretty shocking concept if
you step back and think about it.
So what explains the prevalence of negative interest rates? Disappointing data and diminished expectations about future growth have played a big role. As global growth surprises — the quality of data releases relative to consensus forecasts — stayed negative for most of 2019, interest rates on U.S. Treasuries and their closest counterparts plummeted. In September, however, positive surprises and negative surprises began to occur in roughly equal measure, coinciding with a mini-surge in rates around the world (Figure 3).
Global central banks are also helping to keep rates low, especially at the short end, thanks to interest rate cuts from the Federal Reserve, the European Central Bank and other central banks. When central banks load up their balance sheets with high quality bonds, there are fewer left for other investors at a time when the premium on safety has risen sharply. This inadequate supply of government bonds relative to demand — even allowing for the roughly $1 trillion in new U.S. Treasury issuance over the past year — is predictably leading to higher prices and thus lower yields.
Ultra-low interest rates may make stocks look relatively more attractive.
Our GIC spent a good deal of its September meeting talking about how to value risk-return tradeoffs on investments ranging from property deals to corporate bonds in an environment in which the risk-free rate is negative. Banks’ operating models certainly come under stress when interest rates fall below zero or when short-term rates are high relative to longer-term ones. That can depress credit creation and short circuit self-sustaining economic growth.Over time, interest rates on longer-term bonds should roughly correspond to the level of expected nominal GDP growth (inflation + real growth) over the term of the bond. Lately, that relationship has broken down in the eurozone and elsewhere (Figure 4). We think rates probably fell too far in the third quarter, but negative yields may be here to stay in at least some corners of the world — notably, Japan and Germany — which should keep demand strong for the 10-year U.S. Treasury. If and when interest rates do rise meaningfully, it will mean investors have become more willing to take risks based on an improving outlook.
Similarly, we would welcome a world in which major central banks no longer need to cut interest rates or buy bonds in the open market to instill confidence in the economy. That said, we view the ECB’s open-ended commitment to grow its balance sheet as a helpful policy measure since it will be hard to reverse absent substantial improvements in the eurozone economy. In the U.S., the Fed may slow or pause its interest rate cutting campaign as we head into 2020. The more extreme easing scenario priced into futures markets will only come about if growth meaningfully disappoints from here.
Invest in climbing gear, but wear a parachute
Nuveen’s Global Investment Committee represents
a wide range of asset classes and investment
strategies. But today portfolio managers are
virtually unanimous in moving into a more defensive
posture to prepare for slow global growth and to
help minimize the effects of a sharper slowdown or
recession. Our expectations for publicly traded asset
classes — stocks and bonds — are low compared
to what they’ve delivered in the past several years,
including gains made so far in 2019.
Even so, we cannot ignore the relatively wide value stocks offer today compared to the “risk-free” rates of return on cash or longer-term government bonds (Figure 5). This spread is not wide on account of stocks being cheap, but because interest rates on many bonds are close to their all-time lows and the cash rate continues to decline as the Fed eases.
Investment ideas: What’s changed? Trade tension has risen, rates have fallenAs we look to exploit mispricings in our respective markets while being cautious about the macroeconomic and geopolitical backdrop, our investment leaders offer up their key areas of focus:
- We prefer higher quality assets in taxable fixed income given the narrowing in credit spreads; emerging markets U.S.-denominated credit is still attractive compared to other markets, and we want to diversify out of more interest rate-sensitive sectors while avoiding excess risk in U.S. high yield corporate debt.
- Municipal bonds are benefiting from historically strong investor demand, including from overseas investors who value yield despite being ineligible for the tax benefits; the municipal yield curve remains upward sloping and rates are strongly positive, one reason we remain overweight both duration and credit risk.
- Real estate is an area where flexibility and selectivity is key. Our strategy for assessing private real estate properties has turned more defensive, given that we expect most returns to come from lease payments and not capital appreciation for the time being; in publicly listed real assets, we are reducing exposure to cyclical risk and favoring secular growth areas like data centers and other infrastructure.
- Within equities, we continue to target U.S. growth stocks with a defensive tilt when the price is right; we are becoming more selective within emerging markets, especially Brazil, given expectations of higher foreign investment demand and incidental benefits from the U.S./China trade war.