Having disappointed the market earlier in June at the European Central Bank (ECB) meeting, Mario Draghi came out swinging at the central bank’s recent annual symposium in Portugal. He said additional stimulus, including rate cuts and further asset purchase programmes, would be delivered if the outlook doesn't improve and that such options would be deliberated “in the coming weeks”.
Furthermore, not only did Draghi indicate his readiness to act but the implication of a consensus amongst governing council members implies that this willingness extends beyond the end of his term.
The market expects the central bank to restart the corporate sector purchase programme rather than cut rates. While sceptical of the efficacy of such action, I am inclined to agree that this is moving into “base case” territory. ECB precedent on signaling policy changes suggests the probability has risen sharply.
Robust Dovish shift is another fillip for investment grade bonds
Demand for investment grade bonds was already strong before this fillip. Issuers were able to come to the market with little or no concessions on price, and inflows into the asset class were steady. Add to the cocktail the prospect of a few hundred billion of price-insensitive demand, record lows on government yields and an increased opportunity cost of not being invested and we have the makings of a very one-sided market.
Garnish with the cherry of a Trump Tweet that he plans to meet with President Xi at June’s G20 summit and now is not the time to be short investment grade credit, at least for the near-term.
Divergence between markets and fundamentals
Yet this macro doom and gloom remains strangely at odds with the positivity evidenced by equity markets and Fidelity’s own Gauges of Economic Activity in Real time (GEARs), both of which point to a more benign view of the world than indicated by interest rates and central bank talk.
Growth in the US was always destined to normalise after the shot in the arm it received from the fiscal stimulus and indeed the first half of 2019 looks set to return to trend at 2.5%.
Thank you. We've emailed you to confirm your subscription.
Fidelity’s US GEAR, led by the consumer, has reversed recent weakness while the Eurozone has also stabilised at subdued levels. Yes, capital expenditure (capex) looks soft and manufacturing is still struggling but leading indicators such as the NFIB survey’s capex intentions have recovered most of the losses seen in the last quarter of 2018 and Chinese leading indicators point to a more robust second half of the year.
What about inflation?
The elephant in the room of course is inflation which continues to disappoint on both sides of the Atlantic. This is the air cover by which both the ECB and the Fed can justify pre-emptive action. US Core Personal Consumption Expenditure (PCE) came in at 1.6% in April and the soft core Consumer Price Index print suggests it will fall further in May.
Fed chair Jerome Powell has argued that much of the weakness reflects "transitory" or "idiosyncratic" factors, and he has pointed to the Dallas Fed “trimmed mean PCE” as a less volatile measure of core inflation. Here the direction is up not down.
All of this could therefore portend pain to come further down the line. A stabilisation in the macro environment that makes central bank action less necessary would unwind the squeeze in fixed income seen over recent months. For now though, this is a risk for another day. Bad news is good news once again.
Fixed income securities: Investments (such as bonds) that provide a return in the form of fixed periodic payments and the eventual return of the original amount invested at maturity.
Investment grade: a rating that indicates a bond has a relatively low risk of default.
The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Investors should note that the views expressed may no longer be current and may have already been acted upon. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. Due to the greater possibility of default an investment in a corporate bond is generally less secure than an investment in government bonds. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.