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Investment Commentary




Bond Market Signaling Risk to Inflation Expectations

Sovereign bond markets in the past month have priced in a further drop in global inflation expectations and are signaling a risk of a prolonged global slowdown. For example, German Bund yields have fallen further in negative territory and for the first time the 30 Year Bund is now sporting a negative yield of -0.14%. Moreover, the U.S. 30 Year bond yield has fallen materially by 0.52% to 2.14%. In the U.S., the yield curve inversion at front-end of the Treasury curve (3-month -5 Year yield spread) is persisting and the 2-10 Year spread has now fully flattened at only 0.03%. The Fed is broadly expected to cut rates again at its September meeting. Yet, the message from these lower yields is that Central Banks are still not dovish enough considering this growth uncertainty. The underlying issue is the negative business sentiment (due to trade and other geopolitical conflicts) which is weighing down the global economy, trade and capital expenditures. Apart from soft global manufacturing surveys, the most recent U.S. ISM Non-Manufacturing Index has also indicated that sentiment in the service industries has recently started to soften.

In our view, the bond market is leading the Fed towards more aggressive accommodation in the coming quarters. The good news is that (all else equal) lower real interest rates are generally asset friendly and global corporate credit spreads remain in check. The question is whether monetary action alone will be enough to shield and prolong the business and corporate profit cycles. Bond market price action implies that the Fed is likely at the beginning of a full easing cycle, beyond pre-emptive ‘insurance’ rate cuts that the Fed suggested at its July meeting.





From our portfolio perspective, we continue to lean on income generating instruments that benefit from a lower interest rate environment. We also maintain our preference for defensive large cap corporations that offer healthy balance sheets, capital return potential and more visible earnings/cash flow profiles. In general, we are avoiding labor intensive industries that are likely more vulnerable in terms of profit margins; as the labor market continues to tighten. The National Income and Products Account (NIPA) data indicate that labor costs are continuing to rise at a rapid pace. We note that the latest Q2 U.S. GDP revisions have pointed to U.S.  domestic margin compression, which historically has led to cash flow vulnerabilities; particularly for small/mid-sized businesses. This is significant since these companies provide the bulk of the jobs in the economy. Given this downward pressure on profits, we favor exposure to high profit margin sectors such as technology, communication services and healthcare.


Markets are likely going to continue handicapping the outlook for global corporate confidence, which tends to lead consumer confidence. In terms of U.S. corporate earnings expectations, the bar continues to be low for Q3 2019, but it is higher for Q4 2019 and 2020 as consensus expectations assume expanding margins. As output gaps continue to close, we see the cost and availability of skilled labor as an impediment to margins. Moreover, manufacturing new orders need to stabilize; as contractionary thresholds (e.g. ISM New Orders below 50) can cause U.S. earnings growth to turn negative. Thus, policy action is needed to improve corporate visibility. Otherwise, there is a risk for further earnings revisions. In China, we highlight the recent drop in producer prices which raises the risk of loss of corporate pricing power. Rising Chinese consumer price inflation reduces the probability of currency devaluation.





Lastly, on a more positive note, U.S. household balance sheets remain healthy and the U.S. savings rate remains high at 8%. The U.S. labor market is also very tight and record job openings are keeping jobless claims subdued. We would also argue that aging demographics are likely to keep the U.S. unemployment rate in a low range (similarly to Japan).



In conclusion, sovereign bond markets have raised growth and inflation concerns. This price action is likely front-running Central Bank policy accommodation e.g. interest rate cuts and a return to global quantitative easing if the current global growth slowdown persists. A medium-term catalyst for CEO visibility and capital spending would be a clear and ‘good enough’ U.S.-China trade deal; that would lift the current disruption to global supply chains and global trade. However, nearly 9 months into 2019, the Chinese negotiating team does not appear ready to yield on critical issues such as intellectual property and protection against forced technology transfers. Hence, it’s plausible that a sustaining deal may remain elusive. Such a scenario will likely keep Global Central Banks as the main source of policy support.


Christos Charalambous CFA

Senior Strategist

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