Summer of Discontent: Market Volatility Underscores Fragility of Aging Expansion

by Scott Mather of PIMCO, 8/9/19

The last few days have highlighted the inherent fragility in markets – and the growth outlook globally – as a confluence of news headlines have weighed on investor sentiment and spurred both a sell-off in risk assets and a rally in traditional “safe-haven” assets. In the days following the Federal Reserve meeting in late July, U.S. equities fell sharply and U.S. high yield spreads widened while the Japanese yen rallied and the U.S. 10-year Treasury yield fell to levels last seen just before the U.S. elections in late 2016.

The proximate causes of the volatility have been building sources of uncertainty, initially from a Fed press conference that appeared less accommodative than markets had hoped and then from escalating tensions between the U.S. and China given a surprise tariff announcement by the U.S. and an unexpected currency adjustment by China.

The root causes of the decline in investors’ risk appetite, however, may run deeper.

Trouble brewing?

A backdrop of slowing global growth has meant that shocks to confidence from factors like global trade tensions and monetary policy news can have an outsized impact on markets. Global manufacturing had already been in recession even prior to the recent trade escalation, which is likely weighing even more on business sentiment and investment as a result. With growth globally at low levels, not much of a shock is needed to tip economies into a broad-based slowdown or outright recession.

Another factor that may weigh on market sentiment is the recognition that the impact of central bank support is likely to be diminished. After years of low-rate policy intended to pull forward demand and provide stimulus to a lackluster growth and inflation environment, monetary policy may be both exhausted and less effective. This means that the Fed’s recent pivot to “insurance cuts” – while contributing to easier financial conditions – may not be enough to prevent the Fed from revisiting zero interest rates again in the next downturn. Moreover, even rock-bottom interest rates may not be enough to lift the economy out of recession in the future.

While we still expect a baseline where growth continues in the near term, we have noted the rising probabilities of recession and an expectation for it over a secular horizon. The very inverted U.S. yield curve likely reflects this same perspective. As the fundamental backdrop remains fragile, so too are markets where valuations remain elevated from a long-term perspective across asset classes. In part, then, the market reaction, including the dramatic decline in yields, may reflect a reassessment of the evolving probabilities for a downturn.

Emphasis on resiliency

So what are the implications for investors? We continue to believe this is a time to emphasize more defensive and higher-quality strategies.

U.S. rates, even as yields have declined, have the most room to fall, and they still provide higher yields than their developed market counterparts. In fact, in an environment where the Fed is biased toward lower rates and is likely to take policy rates to zero in the next recession, U.S. interest rate exposure may be a compelling source of capital gains.

Diversified risk exposures – from senior tranches of securitized debt to strong credits within sectors that have better fundamentals such as financials – may also prove more resilient in a volatile market environment.

Ultimately, we think investors should focus on diversification and resiliency in a world where disruptions to both the economy and markets will likely create a bumpier ride ahead than what the markets have faced for the better part of a decade since the last recession.

Scott Mather is CIO of U.S. core strategies at PIMCO and a member of the Investment Committee.

Summer of Discontent: Market Volatility Underscores Fragility of Aging Expansion

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