A review of last month’s market-moving events across countries and asset classes.
In the World
A reprieve in trade tensions between the U.S. and China bolstered investor confidence in October even as political uncertainty increased around the globe. Washington and Beijing announced details of a potential deal – coined as “phase one” – for the U.S. to forego the next round of scheduled tariffs in exchange for increased agricultural purchases by China. While President Donald Trump described the interim agreement as “substantial” and negotiations indicated a desire to limit further escalations, the details fell short of addressing underlying structural issues between both administrations. Meanwhile, impeachment proceedings against Trump advanced as the House of Representatives passed a resolution on 31 October that formally laid out its plan for the investigation. Across the Atlantic, the Brexit deadline was postponed to the end of January, with Prime Minister Boris Johnson calling for a general election in December in an attempt to solidify support for his proposed withdrawal agreement. Elsewhere, major political demonstrations continued in Hong Kong and began in a number of countries – including Iraq, Chile, Spain, Ecuador, and Lebanon – stemming from grievances that included sovereignty, corruption, and the increased cost of living.
Central banks maintained accommodative policy as concerns grew amid generally weaker data. Despite better-than-expected U.S. Q3 real GDP growth of 1.9% annualized, strong consumer spending and faltering business investment painted a more mixed picture of the U.S economy. In particular, while the U.S. jobless rate reached a half-century low of 3.5%, the ISM purchasing managers’ index (PMI) contracted in September to its weakest level since June 2009, and the Chicago PMI fell to its lowest level since December 2015. The PMI trend was similar in the eurozone and Japan, reflecting a deepening global manufacturing recession. The IMF again downgraded its estimate for 2019 global growth to 3.0%, representing the lowest rate of expansion since the financial crisis. Against this backdrop, the Federal Reserve lowered its target fed funds rate by 25 basis points (bps) again in a widely anticipated move, although Chairman Jerome Powell indicated that any future cuts would be reliant on a material deterioration in the economy. Elsewhere, the European Central Bank (ECB) and the Bank of Japan (BOJ) left rates unchanged, with the former emphasizing stimulus measures announced last month and the latter slightly tweaking its guidance to allow for rate cuts in the future.
The renewed optimism about U.S.–China trade generally outweighed concerns over softer economic data and provided a boost to risk assets. Global equities posted strong returns in October – both in developed markets (+2.5%) and emerging markets (+4.2%) – on improved U.S.–China trade sentiment, positive Brexit developments, and continued accommodation by central banks. The S&P 500 set all-time highs and ended the month 2.2% higher, though the move appeared driven by more defensive sectors (see chart). The U.S. equity return also lagged other developed markets as the U.S. dollar weakened (–2.0% based on DXY). In a reversal of the recent trends where equities and bonds rallied in tandem, government bond yields across major developed economies broadly rose: The 10-year German yield rose 16 bps, the U.K. 10-year rose 14 bps, and the U.S. 10-year 3 bps. Meanwhile, credit markets were mixed over the month: Investment grade bond spreads tightened modestly, while high yield spreads appeared to price in the weaker fundamental data and widened.
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Under the Hood U.S. equity markets hit record highs in October, surpassing the prior peak in July, as investor confidence rose on indications of progress in U.S.–China trade talks and interest rate cuts by the Federal Reserve. While the peak-to-peak story struck an optimistic tone, not all sectors participated in these fresh gains: Cyclical sectors that had led the rally through July, including financial and consumer discretionary stocks (i.e., sectors with more exposure to the business cycle), have generally lagged since then, displaced by defensive sectors like utilities and real estate – a cohort that tends to outperform in more adverse economic environments. Investors’ shift to defense may indicate a sense of unease beneath the recent market rally, particularly given weaker trends in manufacturing data, business sentiment, and private investment overall.
In the Markets
EQUITIES
Developed market stocks1 increased 2.5% in October amid mixed economic data, positive global trade developments, and continued delays on Brexit. U.S. equities4 climbed 2.2% to new highs following better-than-expected U.S. earnings and a strong October employment report. The Fed announced a widely expected third rate cut given the mixed economic data, but also indicated a pause on further cuts. European equities5 increased 0.9% as the U.S. imposed new tariffs on EU goods and the ECB left rates unchanged. Japanese equities6 rallied 5.4% in conjunction with global stock markets, while the BOJ announced rates will stay at current or lower levels as long as needed.
The improvement in U.S.−China trade sentiment also broadly supported emerging market equities,7 which rose 4.2% over the month despite idiosyncratic political unrest. In Brazil,8 stocks rose 2.4% as the Brazilian real rallied, boosted by optimism over pension reform. In China, despite weak economic data, local equities9 climbed 0.8%, supported by the improved tone of trade talks. In India,10 stocks rose 3.9% on the de-escalation in geopolitical risk and upcoming domestic reforms. Russian equities11 shot up 6.2% as Brent crude oil prices continued to rally and the Bank of Russia cut rates, indicating further easing.
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DEVELOPED MARKET DEBT
Developed market bond yields broadly rose in October as trade tensions eased. In the U.S., yields rose for most of the month, with the 10-year Treasury yield peaking at 1.84% on October 28, but then fell following the Fed’s widely expected 25-bp rate cut and rhetoric that suggested an end to the cutting cycle. The 10-year yield ended the month 3 bps higher at 1.69%, while the two-year yield fell 10 bps to 1.52%, contributing to a steeper yield curve. Meanwhile, the ECB, Bank of England, and BOJ held their policy rates steady but maintained accommodative tones. In Europe, 10-year bund and gilt yields rose 16 bps and 14 bps to −0.41% and 0.63%, respectively. A similar move occurred in Japan where the 10-year yield ended 8 bps higher at −0.13%.
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INFLATION-LINKED DEBT
Global inflation-linked bonds (ILBs) posted mixed returns across major markets in October. In the U.S., Treasury Inflation-Protected Securities (TIPS) ended the month with positive absolute returns and outperformed comparable nominal Treasuries. U.S. breakeven inflation (BEI) expectations finished the month in positive territory, supported by risk-on sentiment due to easing trade tensions and strong auction demand. However, that sentiment soured by month-end as China appeared unwilling to negotiate on several tough points and the cancellation of the APEC meeting in Chile created uncertainty around a planned meeting between Trump and Xi. Outside the U.S., U.K. breakevens sold off sharply while optimism about a Brexit deal pushed the British pound higher. Some Brexit-related developments remained in the background as Prime Minister Boris Johnson accepted a three-month extension offered by the EU and called for a general election on 12 December to try to break the deadlock in Parliament.
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CREDIT
Global investment grade credit12 spreads tightened 4 bps in October, and the sector returned 0.27% for the month, outperforming like-duration global government bonds by 0.49%. The modest narrowing in spreads stemmed from less negative sentiment around U.S.−China trade talks and global growth, as well as moderating supply; October issuance of roughly $65 billion was almost half of September’s. Domestic industries such as telecom and REITs outperformed, while energy broadly lagged.
Global high yield bond13 spreads tightened 8 bps in October. The sector returned 0.23% for the month, outperforming like-duration Treasuries by 0.06%. High yield bonds provided modest gains as investors absorbed earnings, a partial trade deal with China, and a Fed rate cut. The energy sector underperformed in October (−2.77%), continuing the theme for 2019 so far. The higher-quality BB segment returned 0.48% for the month, while the CCC segment returned −0.45%.
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EMERGING MARKET DEBT
Emerging market (EM) debt broadly posted positive performance in October. External EM debt returned 0.37%,14 driven primarily by a 15-bp tightening in spreads, and local debt posted stronger returns of 2.90%,15 while local rates rallied modestly and currencies appreciated against the U.S. dollar. EM investor sentiment generally improved over the month in tandem with broader risk sentiment as U.S. – China trade tensions eased – with optimism around a “phase-one” deal – and Brexit developments made a no-deal situation less likely.
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MORTGAGE-BACKED SECURITIES
Agency MBS16 returned 0.35%, outperforming like-duration Treasuries by 9 bps. October was the 13th month of the Fed’s balance-sheet unwinding: The Fed sold $20 billion in MBS over the month and has cumulatively sold $340 billion. However, the pay-downs on the Fed’s holdings caused it to exceed the $20 billion cap, and it began to reinvest the additional $7 billion back into agency MBS. Mortgages modestly outperformed despite several negative surprises, such as higher-than-expected prepayment speeds and rate volatility. Higher coupon MBS underperformed lower coupons, 30-years underperformed 15-years, and Fannie Mae underperformed Ginnie Mae. Gross MBS issuance remained robust at $167 billion, a 5% decrease versus September. Prepayment speeds increased 11% for September (most recent data available). Non-agency residential MBS spreads were unchanged in October, while non-agency commercial MBS returned 0.33%, outperforming like-duration Treasuries by 6 bps.
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MUNICIPAL BONDS
The Bloomberg Barclays Municipal Bond Index returned 0.18% in October, bringing the total return to 6.94% for the year. Munis outperformed the U.S. Treasury index slightly over the month, with mixed performance across the curve. High yield munis underperformed investment grade munis, returning −0.21% for October, bringing the year-to-date return to 9.92%. Positive returns in the transportation and resource recovery sectors contributed to performance for high yield munis over the month. Total muni supply of $48 billion in October was up 32% versus the previous month and 30% year-over-year. Muni fund flows remained robust, marking 42 straight weeks of positive inflows. For October, investment inflows totaled $6.7 billion, which brought year-to-date inflows to $75 billion and extended the record for inflows.
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CURRENCIES
The U.S. dollar ended the month weaker (−2.0% based on DXY) than its developed-market counterparts, as the Fed cut its policy rate and risk sentiment improved following the temporary reprieve in U.S.−China tensions. Reflecting this dollar weakness and indications of a Brexit breakthrough, the euro strengthened 2.3% versus the dollar. Similarly, the British pound strengthened 5.3% versus the dollar as a no-deal Brexit appeared less likely. The Japanese yen, a traditional “safe-haven” currency, remained generally unchanged versus the dollar as the improvement in risk sentiment was outweighed by dollar weakness. The Chinese yuan strengthened 1.6% against the dollar as optimism arose over a potential “phase one” trade deal between the U.S. and China.
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COMMODITIES
Commodity returns were positive overall in October. Oil prices ended the month unchanged as rising U.S. inventories into month-end offset both optimism on trade and increased geopolitical tensions. In its latest monthly report, the International Energy Agency (IEA) reduced its demand growth forecast for 2019 and 2020 by 0.1 million b/d; oil demand is expected to grow 1.2 million b/d in 2020. Natural gas prices rebounded despite strong injections into storage as forecasts for colder weather raised expectations for heating demand. Agricultural commodities were stronger over the month, supported by increased optimism for U.S. agricultural exports to China. Base metals also posted gains, driven by zinc and aluminum; precious metals continued to march higher.
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Outlook
Based on PIMCO’s Cyclical Outlook from September 2019.
We believe the global economy is about to enter a low-growth “window of weakness” as ongoing trade tensions and heightened political uncertainty continue to act as a drag on global trade, manufacturing activity, and business investment. In our baseline forecast, the low-growth period of vulnerability – with trade, monetary, and fiscal policy acting as swing factors – gives way to a moderate recovery in U.S. and global growth in the course of 2020.
In the U.S., we continue to expect growth to slow to 1.25%–1.75% in 2020 from a peak of 3.2% in the second quarter of 2018. Slower global growth and elevated trade tensions are expected to depress investment and export growth, while slower business output and lower profit growth slow labor markets, weighing on consumption. Core inflation is likely to firm somewhat to the 2.25%−2.75% range due to the recent tariffs on Chinese goods, though it is likely to moderate in later 2020. After cutting rates three times in as many meetings, the Federal Reserve has indicated that it may moderate or pause this cycle. Still, we believe more accommodation may be needed in the quarters ahead.
For the eurozone, we see the continuation of a 1% growth, 1% inflation economy. Ongoing trade tensions are expected to exert a significant drag on growth, somewhat offset by supportive domestic conditions, including easy financial conditions, modest fiscal stimulus, and remaining pent-up demand. Core inflation could rise a bit over the next year in response to rising wages, but weak growth suggests that margin pressure on businesses will continue, limiting the pass-through of higher labor costs. While the European Central Bank may cut the policy rate a little further, we expect the focus to remain on forward guidance, targeted longer-term refinancing operations (TLTROs), and asset purchases.
In the U.K., we expect real growth in the range of 0.75%–1.25% in 2020, modestly below trend. We anticipate an orderly Brexit, either through an amended withdrawal agreement or a relatively orderly no-deal exit. However, we see headwinds from weak global trade, Brexit-related uncertainty, and possible disturbances in the event of a no-deal exit weighing on growth. We expect core CPI inflation to remain stable at or close to the 2% target. While wage growth has picked up, we think firms are likely to absorb higher labor costs. The Bank of England will likely keep its policy rate unchanged at 0.75%, but we expect a cut in the event of a no-deal exit.
Japan’s GDP growth is expected to slow to a 0.25%–0.75% range in 2020 from an estimated 1.1% this year. Although we expect domestic demand to remain resilient thanks to a tight labor market and anticipated fiscal accommodation, the balance of risk remains on the downside due to external factors. Core inflation is expected to remain low at 0.5%–1%, with most of the impact from the consumption tax hike offset by lower mobile phone charges and free nursery education. The hurdle for deeper negative interest rates remains high, but there is clear appetite for fiscal stimulus from both the Bank of Japan and the government.
In China, we see growth slowing in 2020 to a 5.0%‒6.0% range from an estimated 6.1% in 2019 due to the trade conflict, rising unemployment, weakening consumption, and sluggish business investment. We expect fiscal stimulus of around 1% of GDP, likely front-loaded in the first quarter of 2020. Inflation should remain benign at 1.5%–2.5%, and we expect the People’s Bank of China to cut rates by 50 basis points, in addition to reductions in bank reserve requirement ratios. We also expect further moderate yuan depreciation against the U.S. dollar to cushion the trade war’s impact on manufacturing.
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