Investors’ focus centered on emerging markets as less supportive external conditions exacerbated the situation in select countries. Emerging markets (EM) faced a more challenging macro backdrop coming into August, with a strengthening U.S. dollar and the Federal Reserve on the move, and two economies in particular garnered headlines: The month began after Turkey’s central bank unexpectedly did not raise interest rates and instead delivered marginal policy adjustments, pressuring the lira lower. The economic situation deteriorated further when a political spat with the U.S. over the detention of an American pastor resulted in sanctions and a doubling of steel and aluminum import tariffs, exacerbating vulnerabilities in Turkey’s already fragile economy. As the month ended, the spotlight shifted to Argentina (and its currency). With an impending recession and the peso under pressure, Argentina took a different approach from Turkey, though with similar consequences: President Mauricio Macri made a surprise appeal to the IMF, seeking expedited payments under its $50-billion bailout program. However, the televised petition rekindled concerns around Argentina’s financing capacity, sending the peso to fresh lows even as the central bank hiked its policy rate 20 percentage points over the month to 60%. On the trade front, tensions between the U.S. and China continued to escalate as both sides announced additional tariffs, while Mexico and the U.S. came to a tentative agreement in the context of NAFTA negotiations.
Sentiment soured toward emerging markets while developed market assets remained largely resilient.EM equities and debt were lower on the month, but currencies in particular bore the brunt of the stress in the sector. The Argentinian peso and Turkish lira depreciated a staggering 25% and 26%, respectively, just in August – both were nearly 50% lower for the year. South Africa, a country more vulnerable to external pressures with a widening current account deficit and a high-beta currency, endured a 9.5% depreciation in the rand. Other EM currencies also suffered, albeit due in part to other idiosyncratic factors: The Brazilian real fell 7.3% amid uncertainty over upcoming elections in October, and the Russian ruble fell 7.4% on the heels of fresh U.S. sanctions for the alleged poisoning of a former Russian spy in the UK. EM performance marked a stark turnaround from the double-digit gains of 2017, when investors had a more “love ’em” mentality. The losses weren’t limited to emerging markets, though: Eurozone bank stocks, represented by the Euro Stoxx Banks Index, fell 10.8% after the European Central Bank (ECB) expressed concern about the region’s financial exposure to Turkey. Meanwhile, U.S. equities remained largely resilient, supported by strong corporate earnings and encouraging developments in trade talks with Mexico. The S&P 500 rose 3.3% to set a new high, and the tech-heavy NASDAQ crossed 8,000 for the first time even after posting a gain of 5.9%. A notable exception in developed markets, Italian 10-year government bond spreads widened considerably versus German bunds as budget concerns swirled.
With turmoil elsewhere, markets focused less on the annual gathering of central bankers at Jackson Hole. In Jerome Powell’s first speech as Fed Chairman at the conference, he defended a gradual approach to policy normalization (despite some earlier criticism from the Trump administration) and solidified expectations for a September rate hike. The nautically-themed speech focused on the uncertainty of economic estimates of long-term rates for fed funds, unemployment and inflation, and reinforced the importance of a flexible approach to monetary policy. The symposium came this year amid solid fundamentals in the U.S. that supported the Fed’s case for continued rate hikes. The U.S. unemployment rate fell to 3.9% in August, and U.S. inflation posted its largest jump since September 2008 as core CPI rose to 2.4% year-on-year, due in part to the pressures of recent tariffs on various prices and core inputs.
Putting EM Currency Moves in Context Emerging market (EM) currencies have come under significant pressure in 2018, but the story may not be quite as alarming as some headlines suggest. In the context of a less supportive external backdrop, including a resurgent U.S. dollar and global trade tensions, the performance of EM currencies isn’t all that unusual. The chart plots the year-to-date returns of various EM currencies against expected returns implied by their historical relationship – or beta – to the U.S. Dollar Index (DXY). Most EM currencies have moved in line with what would be expected given the appreciation of the U.S. dollar. A few notable outliers reflect idiosyncratic factors: Argentina and Turkey, whose currencies have both lost nearly half their value, are more externally vulnerable due to their heavy reliance on dollar-denominated short-term financing. Others with larger-than-expected depreciation include the Brazilian real (election uncertainty), South African rand (also externally vulnerable), and Russian ruble (sanctions pressure).
Market snapshot
EQUITIES
Developed market stocks1 rose 1.2% as strong fundamentals and gains in U.S. equities carried the broader index into positive territory. Stocks in the U.S.2 rallied 3.3%, reaching new all-time highs, supported by strong earnings, particularly in technology companies, and favorable economic data. Japanese equities3increased 1.4% amid mixed economic data, while European equities4 declined 2.2% as trade and geopolitical tensions weighed on investors.
Overall, emerging market5 (EM) stocks fell 2.7% in August, led by weakness in EMEA and Latin America, while fears of contagion from crises in Turkey and Argentina caused a steep decline in EM currencies. In Brazil6, stocks declined 3.2% as broader EM volatility and upcoming local elections kept investors risk averse. Chinese7 equities fell 5.1% due to ongoing trade tensions with the U.S., disappointing economic data, and further depreciation of the yuan. However, Indian stocks8 rose 2.9%, driven by strong earnings and improving economic data, and despite a 7.3% decline in the ruble, Russian9 stocks rose 1.1% as oil prices recovered in the second half of the month.
DEVELOPED MARKET DEBT
Developed market debt prices generally rose and yields fell in August as investors sought refuge from the turmoil in emerging markets. In the U.S., the two-year yield ended the month four basis points (bps) lower at 2.63%, while the 10-year yield fell 10 bps to 2.86%. In the eurozone, fear that Turkey’s crisis, in particular, could spread to the region also weighed on yields, with the 10-year German bund yield falling 12 bps to 0.33%. On the monetary policy front, Federal Reserve Chair Jerome Powell reaffirmed the Fed’s gradual path to normalization in his speech at the Jackson Hole Symposium, while the Bank of England unanimously decided to raise its policy rate by 25 bps to 0.75% – the highest level since 2009 – after recent growth data suggested the slowdown in the first quarter was only temporary.
INFLATION-LINKED DEBT
Global inflation-linked bond (ILBs) returns were mixed across countries but generally underperformed comparable nominal sovereign bonds in August. U.S. Treasury Inflation Protected Securities (TIPS) returned 0.72%, as represented by the Bloomberg Barclays U.S. TIPS Index. U.S. real yields rallied across the curve on the back of safe-haven demand due to escalating trade tensions and a rout in emerging market assets. The U.S. breakeven inflation (BEI) curve flattened, with short-term expectations supported by a rebound in oil futures and a stronger core CPI, while long-term expectations moved lower on trade-related growth concerns. In Italy, real yields sold off as the populist coalition government prepared its new budget plan, which was believed to increase spending and deviate from previous commitments with Europe. In Japan, real yields saw a rare, one-day jump following the Bank of Japan’s latest policy decision to allow 10-year yields to move in a wider range of up to 0.2%.
CREDIT
Global investment grade (IG) credit10 spreads widened 5 bps in August, and the sector returned 0.20%, underperforming like-duration global government bonds by ‒0.31%. In addition to the pressure from events in emerging markets and recent M&A-related supply, metals and mining companies experienced weakness due to declines in copper and gold prices.
Despite the intensifying issues in select emerging markets, global high yield bonds11 continued to post strong returns, up 0.6%, thanks to better-than-expected earnings, a fresh high for the S&P 500, retail inflows and subdued supply. With five- and 10-year government yields dropping by about 10 bps over the month, higher-quality double-B rated credits outperformed lower-quality triple-C credits – for only the second time this year.
EMERGING MARKET DEBT
Emerging market (EM) debt posted negative returns in August, as did all of its sub-sectors. In spite of a move lower in underlying U.S. Treasury yields, widening spreads drove negative returns in external debt. On the local side, higher index yields and general pressure on EM currencies, primarily due to the situation in Turkey, drove the negative performance. Turkey and Argentina were notable underperformers, in both local and external debt; each faced political and macroeconomic challenges that led to sharp currency depreciation and market scrutiny of their external financing vulnerabilities. Venezuela also meaningfully underperformed the external bond index as it issued a new currency, effectively devaluing its current currency by 95% in a bid to combat hyperinflation.
MORTGAGE-BACKED SECURITIES
Agency MBS12 returned 0.61% and underperformed like-duration Treasuries by 14 bps during the month. Spreads widened modestly as rates rallied and supply remained elevated. Despite the rally, higher coupons outperformed lower coupons; Ginnie Mae MBS lagged conventional MBS; and 15-year MBS versus 30-year MBS were mixed. Gross MBS issuance increased while prepayment speeds declined relative to July. Non-agency residential MBS outperformed like-duration Treasuries during August, and non-agency commercial MBS13 returned 1.07%, outperforming like-duration Treasuries by 28 bps.
MUNICIPAL BONDS
The Bloomberg Barclays Municipal Bond Index posted a positive return of 0.26% in August, bringing year-to-date returns to 0.25%. Munis underperformed Treasuries over the month, particularly at the front end of the yield curve. The Bloomberg Barclays High Yield Municipal Bond Index returned 0.80%, bringing year-to-date returns to 4.86%. August supply of $33 billion was up 25% versus the previous month but still down 13% year-over-year, an effect of U.S. tax reform, which had encouraged high muni issuance late last year. On the credit front, California experienced more wildfires than usual this summer, and although most municipalities seem resilient, fiscally constrained issuers and less economically vibrant counties could exhibit modest credit deterioration, with state and federal aid unlikely to fully offset the decline in general fund receipts.
CURRENCIES
Although the U.S. dollar ended the month 0.6% stronger against G10 counterparts, it reversed course after a lofty start: U.S. President Donald Trump continued his criticism of interest rate hikes, economic data came in weaker than expected and positive developments in trade talks made headlines. Emerging market currencies came under considerable pressure in August, in particular the Turkish lira and the Argentine peso, which both weakened more than 20% as political and macroeconomic challenges came to the fore. The euro weakened 0.8% on soft economic data and the fear of contagion from Turkey’s crisis. The British pound fell 1.3% as the chance of a no-deal Brexit increased, overwhelming strong economic data and a rate hike by the Bank of England. The Japanese yen strengthened 0.8% over the month thanks to safe-haven inflows and an upside surprise in Q2 GDP growth.
COMMODITIES
Commodities delivered mixed returns in August. In energy, crude oil rallied into the end of the month on the expectation that U.S. sanctions on Iranian oil exports will tighten global supplies. Prices were further supported after the U.S. Energy Information Administration (EIA) confirmed a larger-than-expected draw in inventories, while natural gas rose on warmer weather. The agricultural sector posted losses across the board following the World Agriculture Supply and Demand Estimates (WASDE) from the U.S. Department of Agriculture, which showed a record yield projection for corn and a near-record for soybeans amid optimal growing conditions. Continued oversupply and a rout in emerging market currencies weighed on coffee and sugar prices, though the latter recovered by the end of the month based on a lower production outlook from Europe and Brazil. Base metals were negatively affected by the downturn in emerging markets and escalating trade tensions between the U.S. and China. Precious metals also underperformed, with gold falling despite the rally in real yields; platinum declined amid the depreciation in the South African rand.
Outlook
Based on PIMCO’s cyclical outlook from March 2018.
PIMCO expects world GDP growth to remain above-trend at 3.0%‒3.5% in 2018, with low but gently rising inflation. Still-favorable fiscal support suggests that solid growth will continue for the rest of 2018. Compared with our December forecast, we see marginally higher 2018 GDP growth in the U.S., eurozone, U.K. and China, while we lowered our estimates for Mexico and India. The causes of the stronger expansion are more uncertain and could affect its durability beyond 2018. Our inflation forecasts for 2018 have also risen slightly since our December forecast in response to a higher oil price trajectory.
In the U.S., we look for growth of 2.25%–2.75% in 2018. Household and corporate tax cuts should boost growth by 0.3 percentage point in 2018, with another 0.3 percentage point coming from higher federal government spending resulting from the two-year budget deal. With unemployment dropping below 4%, we expect some upward pressure on wages and consumer prices, and core inflation to be above 2% over the course of 2018. Under new leadership, the Federal Reserve is expected to continue tightening gradually; we expect three rate hikes total this year, with a fourth likely if economic and financial conditions are favorable.
For the eurozone, we expect growth will be in a range of 2.25%‒2.75% this year, about the same pace as 2017. The expansion has been broad-based across the region, but political challenges highlight some fragility. Core inflation, though, is expected to remain low due to low wage pressures and the appreciation of the euro in 2017. We expect the European Central Bank to end its bond purchase program by the end of the year, though maturing bonds will be reinvested for some time. We do not foresee the first rate increase until mid-2019.
In the U.K., we expect above-consensus growth in the range of 1.5%–2.0% in 2018. Our base case is for a relatively smooth separation from the European Union, which would contribute to business confidence and investment picking up. After seven years of austerity, we also see some scope for stronger government spending. Inflation should fall back toward the 2% target by year-end, with the effect of sterling’s depreciation in 2017 fading. The Bank of England will likely follow a very gradual path higher.
Japan’s GDP growth is expected to remain firm at 1.0%–1.5% in 2018. Fiscal policy should remain supportive ahead of the planned value-added tax hike in 2019. With unemployment below 3% and job growth accelerating, wage growth should pick up further, helping core inflation rise over the year to slightly below 1%. With the appreciating yen providing disinflationary headwinds and the newly appointed deputy governors tilting the Bank of Japan leadership somewhat more dovish, the BOJ may not tweak its yield curve control policy until 2019.
In China, we expect a controlled deceleration in growth to 6.0% –7.0% this year, from 6.8% in 2017.The authorities’ focus is likely to be on controlling financial excesses, particularly in the shadow banking system, and on some fiscal consolidation, chiefly by local governments. We expect inflation to accelerate to 2.5% on stronger core inflation and higher oil prices. We are broadly neutral on the yuan and generally expect the authorities to control capital flows tightly to keep exchange rate volatility low.
In Brazil, Russia, India and Mexico, we expect growth to collectively rise to 4% in 2018, slightly above consensus, with modest upside risk from the growth rebound in India. Emerging markets are catching up to the recovery in developed markets, with improving fundamentals and greater differentiation among countries. This recovery is likely to be shallower and slower than others, however, and a deteriorating external backdrop could weigh on the asset class; EM potential growth has fallen, and key political events are likely to keep investors cautious. We expect inflation to stabilize around 4.1%, also above consensus, as most of the decline in EM inflation thus far appears cyclical rather than structural.
FOOTNOTES:
1MSCI World Index, 2S&P 500 Index, 3Nikkei 225 Index (NKY Index), 4MSCI Europe Index (MSDEE15N INDEX), 5MSCI Emerging Markets Index Daily Net TR, 6IBOVESPA Index (IBOV Index), 7Shanghai Composite Index (SHCOMP Index), 8S&P BSE SENSEX Index (SENSEX Index), 9MICEX Index (INDEXCF Index), 10Barclays Global Aggregate Credit USD Hedged Index, 11BofA Merrill Lynch Developed Markets High Yield Index, Constrained, 12Barclays Fixed Rate MBS Index (Total Return, Unhedged), 13Barclays Investment Grade Non-Agency MBS Index
