Kathleen Gaffney

December’s volatility is a final reminder that 2018 is shaping up much differently than 2017’s tranquil markets.

Kathleen C. Gaffney, Director of Diversified Fixed Income at Eaton Vance Management, notes the bond markets are in the midst of an important transition that will require new thinking going forward.

“Blindly reaching for yield and other strategies that worked well in recent years may be facing a reckoning. The question is whether recent volatility represents a real shift in long-term fundamentals, or is emotionally driven.

“The main concerns driving volatility are: global growth, tariffs, a flattening yield curve, oil prices and credit spreads. As investors tend to look back at the most recent crisis when volatility picks up, we compare today’s scenario to the last growth scare from 2015, and what looks different now.”

China and global growth

In 2015, the source of worry was China’s slowing economy and credit contraction. Fears of a “hard landing” for China dominated the headlines, as the outflow of capital worsened over the course of the year. These fears eventually dissipated, but not before the market contended with months of volatility in equity and income markets.

Today, the market is grappling with similar concerns about the outlook for global growth. Not unlike 2015, the increase in volatility is viewed as a sign global growth is slowing. In reality, the real economy is doing quite well. Financial markets continue to adjust to a higher cost of capital as liquidity is drained from the system. As we’ve explained previously, we don’t expect this adjustment to be linear.

What has changed from 2015 is the threat of a trade war. While the tit-for-tat tariff battle between the U.S. and China receives the most attention, we think the real story is about global power and influence. The uncertainty over a trade war and global growth is distracting from the real news, in our view, that there is a technology arms race between China and the U.S. over intellectual property. While China’s command-and-control policy gives the country a major long-term advantage, the U.S. wields tremendous leverage in the short term over China with regard to technology.

This arms race shifted this week after Huawei’s chief financial officer (CFO) was arrested in Canada for extradition to the U.S. Prior to the arrest, all eyes were on the outcome of the dinner with President Trump and President Xi at the G-20. It appeared after the dinner that a truce had been declared, though details were vague. Negotiations will now continue until March. However, the Huawei CFO’s arrest shows that the rising tensions between China and the U.S. are not going away. The U.S. is taking a tougher stance behind the scenes designed to garner support from its allies and pressure China to make real concessions regarding intellectual property.

There is a risk that China reacts more aggressively, but its ultimate goal is to be self-sufficient in semiconductor manufacturing by 2025. This is part of Xi’s signature plan for 12 industries to be “Made in China by 2025.” For now, China is not protesting very loudly. So while the trade war fears may dissipate, the arms race around technology will remain, and we think it will have major implications for both the technology supply chain and the market.

Signal and noise

Sorting through the uncertainty and the noise in the headlines, we see signals that have grabbed our attention, and we believe hold the key to better positioning in a volatile market environment:

1. Ignore the yield curve inversion. It has become a cocktail party topic. We believe the economy is still growing, but moderating as the Federal Reserve continues on a gradual path to raise rates and return the income markets to a normal or neutral level of interest rates. The Fed wants to be gradual but we do not expect a linear march upward. Ample supply driven by the government’s financing needs due to the tax cut have momentarily created an inverted yield curve (see below). Technical influences are not fundamental, and we believe a recession at this time is unlikely.

2. Ignore falling oil prices. OPEC is broken and politics have created a power struggle between the Saudis and Russia. Supply and demand are tighter than the market currently believes.

3. Don’t buy the dip just yet. Credit spreads are widening, but they are only off record lows and are nowhere near average. Some may see a buying opportunity now. We disagree and think investors may want to stay disciplined and focused.

For example, the technology sector has taken it on the chin. High-priced stocks are falling for myriad of reasons, but one specifically is export controls that the U.S. could put in place more broadly if China does not make some important concessions on intellectual property such as the requirement for foreigners to transfer their technology to China in return for market access.

In our view, the U.S.-China technology arms race and global trade will affect companies in different ways, much in the way rising interest rates affects companies in different ways. There will be individual credit stories that create investment opportunities in the new environment. By panicking over short-term headlines, investors may miss the idiosyncratic names that stand out in a very volatile market.

Bottom line: Investors pay a heavy price for short-term reactions to news events when they succumb to the noise of daily up-and-down markets. We believe investors should tune out near-term noise in the markets and instead think differently about where opportunities may be.

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“However, we believe the long-term case for emerging markets (EM) in bond portfolios is still strong — especially if you know where to look”, says Kathleen C. Gaffney, Director of Diversified Fixed Income, Eaton Vance.

“In fact, one of our major themes is investing away from the U.S., both in terms of the dollar, rate risk and fundamentals,” she adds.

“It’s important to remember that developed and emerging markets are at different stages in their cycles. For example, in the U.S., we have low but rising inflation as the Federal Reserve unwinds its balance sheet and gradually hikes rates. U.S. GDP growth has been slow and steady, averaging around 2% the past few years.

“In EM, the picture is quite different. Many individual countries are growing fast, and most central banks are not hiking rates. In fact, those that have been hiking have broadly been defending their currencies. Also, much of the economic growth in EM is organic, rather than being based on mergers, acquisitions and financial engineering.”

EM currently offers high but generally falling inflation, which provides opportunities away from the U.S. into a more global positioning, the prospect of investing in higher real rates and an inflation hedge.

“Anti-globalization is in the headlines, but individual countries offer the opportunity for positive momentum as they find their own way in this new global environment.

“In EM, we certainly have political risk, but that offers opportunity for improvement. The impact of politics in selection may serve as an opportunity for differentiation and return, especially as developed central banks remove liquidity.

Credit quality is higher in EM from a broad balance sheet standpoint, with generally lower leverage. Also, as more investors become comfortable with the sector, EM companies can benefit from greater access to capital. And as EM companies tap the markets for financing, they have made improvements in transparency and disclosure. These are all signs of economies and markets maturing.”

She further notes: The dollar’s role Although the U.S. dollar has rebounded, we see this as a pause within a longer-term downtrend versus global currency competitors. The dollar has enjoyed its status as the world’s reserve currency, but has borne the brunt of the slowdown in growth since the global financial crisis.

The Fed is leading the way among global central banks in unwinding quantitative easing, which may account for the dollar’s recent strength. However, other central banks in Europe, Asia and South America may not be too far behind the Fed. Therefore, rates may start to converge as other central banks catch up to the Fed.

Also, some foreign governments are reducing their appetite for U.S. Treasury bonds, and some like China are diversifying their currency reserves. This lowered demand may start weighing on the dollar again soon.

The other factor that we believe will weigh on the dollar is our view on rising U.S. inflation. Of course, inflation tends to reduce the value of a currency. The U.S. is starting fiscal stimulus with tax cuts and higher deficits at a time when labor markets and capacity are both very tight. That could fan the inflation flames, and 5-year breakeven rates are moving up as well in the U.S.

Sentiment and trade wars

We believe it’s important to take a long-term view on EM currencies and bonds, because the sector can be influenced by changes in sentiment. It is oftentimes a shift in sentiment that can provide an opportunity.

The recent EM weakness has been driven by fears over the potential impact of a rising dollar, rising rates and trade tensions. There are also concerns over political instability in individual EM countries such as Brazil, Mexico and Turkey.

However, we believe EM has some secular tailwinds, including rising population growth and improving standard of living for the middle classes, stable inflation and still-favorable monetary policy. A rising consumer class, helped by the right policy mix, can serve as an engine of growth. Further, we believe EM are in a better position now than before the financial crisis. Fundamentals have improved, more countries are reforming to increase competitiveness in the global markets, and they are less dependent on capital inflows for investment.

She concludes “ We believe it’s a mistake for bond investors to give up on EM in their portfolio due to recent price weakness driven by trade fears and a rising U.S. dollar. EM can play an important role for long-term investors who can find opportunities in individual regions, countries, sectors and companies.”

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