Fixed Income Outlook  |  Q4 2018

Trade war and rising rates create headwinds for global economy

Putnam Investments


  • The U.S. economy is poised to expand further this year, but growth will likely ease in 2019.
  • China and the United States are locked in a spiraling trade war.
  • We believe global yields will rise, but without disrupting asset markets.

The outlook for global economic growth is easing because of protectionist tariffs, weakness in emerging markets, and rising oil prices. While the U.S. economy is expanding at a strong pace this year, buoyed by government spending and tax cuts, growth will likely slow in 2019. Unemployment has touched multi-decade lows, inflation remains anchored, and the likelihood of a recession is relatively low. The United States, Mexico, and Canada reached a new trade deal that is a lot like NAFTA but with a few upgrades. However, trade tensions between the United States and China, the world’s two biggest economies, have worsened.

For fixed-income markets, this year has turned out to be more challenging than 2017. Rising interest rates, tariffs and the trade conflicts, higher oil prices, and political risks have weighed on bonds. The Federal Reserve has raised its benchmark interest rate three times in 2018 and continues to project one more hike before the end of the year, as well as three in 2019. That would push the federal funds rate above 3.00%. More importantly, the Fed removed a single word, “accommodative,’’ from its September 2018 rate statement, signaling to investors the economy can hold its own with little help from the central bank. While the yield on the benchmark 10-year Treasury has crossed the 3% psychological barrier, short-term rates have risen faster, resulting in a flatter yield curve. Higher rates typically create some challenges for fixed-income assets.

We believe bond yields will continue to drift higher over the course of 2018 and 2019 as interest-rate normalization continues in the United States and globally. The Fed has also stepped up the pace of its balance sheet reductions this year. Across the Atlantic Ocean, the European Central Bank (ECB) confirmed that it will cut bond buying in half in October 2018 and anticipates that new purchases will be halted by the end of the year. These moves will start the ECB on a tightening path similar to the Fed’s.

U.S. economy on a winning streak

The U.S. economy is heading into 2019 with significant momentum and the longest streak of job growth on record. The labor market remains strong as hiring has improved and wage gains have accelerated. The unemployment rate of 3.7% is the lowest since December 1969. The dollar has surged as rates moved higher and investors sought the safety of U.S. assets, including Treasuries, amid some turmoil in global fixed-income markets.

The economy grew at an annual rate of 4.2% in the second quarter of 2018, its best performance in nearly four years, boosted by robust consumer spending, solid business investment, and tax cuts. Consumer confidence hit an 18-year high in September, according to a recent survey from the Conference Board. But there are signs of some nervousness about the upward move in prices; consumers are sensitive to changes in prices of items they frequently purchase, and the recent increase in retail gasoline prices will not have gone unnoticed.

The Fed estimates GDP growth will ease slightly to 2.5% in 2019 from 2018. This is largely in line with our expectations for growth to slow next year as the effects of the fiscal stimulus abate. We continue to see the risks to growth as asymmetric. It is possible we are in the early stages of higher capital spending and productivity growth. That would allow economic expansion and strong wage gains without rising inflation and without the Fed shifting to a more aggressive path. However, that remains unlikely. Either the economy will slow, as fiscal stimulus wears off and higher rates restrain growth or, if fast growth continues, real rates will rise to the point they cause financial market instability.

Fed ends “accommodative” monetary policy era

The Fed raised rates in March, June, and September 2018, and signaled that another rate increase in 2018 was likely. The yield on the 10-year Treasury touched 3.26% in October 2018, its highest level since 2011. The two-year-note yield also hit its highest level in more than 10 years. Not surprisingly, the yield curve has been on a flattening trend. The U.S. economic recovery and a more determined Fed mean U.S. rates are likely to rise steadily. In addition, some Fed officials have indicated that it's likely the funds rate may be temporarily set above what they call the “neutral” rate that is neither restrictive nor simulative.

What’s driving the higher rates appears to be continued strong economic growth and some creeping signs of inflation. Inflation measures have moved above the Fed’s 2% target. In the 12-months through September, the consumer price index rose 2.3%, while the Fed’s preferred inflation gauge — the personal consumption expenditures (PCE) price index that excludes food and energy — hit 2% in August. FOMC officials will have two more months of inflation data before the December rate meeting.

Japan’s central bank remains cautious

While the Fed has been raising rates, Japan’s central bank has been relatively dovish on monetary policy. Japan’s economy is growing at a slow but fairly steady pace, but it is not fast enough for the Bank of Japan (BoJ) to alter monetary policy over the near term. The yields on Japanese government bonds, or JGBs, are influenced by the BoJ, global interest rates, and the upward pressure on Treasury yields. But equally, the BoJ’s stance on rates will keep Treasury yields lower than they would otherwise be.

The world’s third-largest economy, Japan grew an annualized 3.0% in the second quarter of 2018, its fastest pace since 2016. Capital spending has risen, consumption indicators have improved, and the labor market has firmed, with the unemployment rate falling to 2.4% in August 2018. But the improved economic performance was offset by worsening business confidence in the third quarter. The BoJ’s closely watched “tankan” survey, which measures sentiment among large manufacturers, fell in September from three months ago amid worsening global trade tensions. Inflation is on the rise, albeit at a painfully slow pace. September inflation surprised on the upside as the BoJ’s preferred core measure — prices in Tokyo — were 0.7% higher than a year earlier. But the central bank’s inflation target is still an awfully long way away.

China’s growth and trade gamble

China, the world’s second-biggest economy, is showing signs of slowing amid deleveraging and escalating trade tensions with the United States. Beijing has stepped up efforts to ease monetary policy and bank lending restrictions to lift growth. We believe the authorities have the policy tools, including control of the currency, to offset shocks to the economy. In October 2018, the U.S. Treasury Department stopped short of declaring China a currency manipulator in its semiannual report on foreign-exchange rates, averting an escalation of the trade war. It is still worth noting that the yuan has slid more than 5% against the dollar in the past six months, raising market speculation that China has been deliberately weakening its currency as trade tensions with the United States worsen.

President Trump has slapped tariffs on $250 billion in Chinese goods, and China has retaliated with tariffs on about $110 billion of U.S. products. On top of the escalating trade war, Trump recently accused China of meddling in the 2016 elections as well as in the upcoming midterms in November. Negotiations between the Trump administration and China have so far yielded few results.

China has little incentive to offer anything substantive. One reason is China has already floated a deal, supported by Treasury Secretary Steven Mnuchin, that was rejected. Second, whatever the United States has done so far has not changed the cost-and-benefit calculus as Beijing weighs its options. Third, China’s hopes of negotiating a free trade pact with Canada or Mexico was dealt a sharp setback by a provision in USMCA (the revised NAFTA) that aims to forbid such deals with “non-market” countries. China qualifies as a “non-market” country because its state-driven economic model doesn’t allow for capital to move freely in and out of the country due to capital controls. Lacking an incentive, China is sending signals they are not prepared to roll over and accede to U.S. demands.

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