The outlook for fixed income in 2019

Global Fundamental Outlook

Growth – Slowing to below trend before stabilising

Global growth is expected to continue to slow in 2019 before finding a base mid-year as it becomes supported by an easing of financial conditions and accommodating fiscal policy. China will play a significant role in helping stabilise global growth. Global growth will return to just above trend, allowing an ongoing reduction in available capacity as we end 2019. The US will continue to be the outperforming economy, whilst stabilisation in China and Europe are essential if global growth is to return to above trend. Australia will continue to be an underperformer, burdened by high household debt and deteriorating financial conditions driven by weak housing and tighter credit conditions.

Inflation – Easing before stabilising

Headline inflation will continue to be driven by commodity prices, most notably oil. Whilst supply constraints will support production input prices, a stabilisation in global demand and a stable to weaker USD will be required to see inflation rise. Core inflation should remain supressed short term but continue to slowly move higher as output gaps continue to close, or indeed become positive as economies return to above potential growth later in 2019. Whilst structural forces remain a cap on inflation longer term, cyclical driven inflation is still likely.

Financial conditions – Supportive then tighter

After a strong period of tightening, we expect financial conditions to be more supportive as we enter 2019. In 2018, financial conditions tightened through monetary policy and a reduction in liquidity via various channels. This was followed by increased volatility and weakening asset markets, leading to further deterioration in financial conditions. In 2019, if growth stabilises as expected, capacity constraints will once again lead to developed market monetary policy tightening, led by the US. Australia however, is more likely to cut rates.

Key risks to watch

European growth and sovereign debt risks

As European growth falters, falling below trend, sovereign debt issues will once again come to the fore. Whilst there has been genuine repair in some European countries, such as Ireland, Spain and Portugal, Europe is only as strong as its weakest link. Italy will remain a focus for concern. With more fractured national political systems across Europe compared to a decade ago, offset to some degree by an improved capital position within the banking system, it remains to be seen how much volatility a new sovereign debt issue will create.

China deleveraging

A tightening in credit conditions weighed heavily on the Chinese economy through 2018 and consequently on global growth. Despite various measures introduced by Chinese officials, growth has not rebounded to the desired extent, however there are some early signs that there may be some stabilisation to this trend. It is hoped that the policy measures to date plus additional easing will be enough to stabilise growth in 2019.

US – China trade

Whilst the US-China trade conflict was not the main driver of global growth weakness in 2018, it did add to the slowing, having an outsized impact on investor sentiment. Any reprieve here would provide welcome support to investor sentiment. With the rising risk of lower growth in both China and US we think we will see some resolution of this conflict, even if it doesn’t solve all the issues in question.

Australian housing, debt and unemployment

Further weakening continues to occur in the Australian housing market, as the impacts of macro-prudential policy are combined with a general tightening of credit standards by major lenders, including rate increases by some lenders. Inflationary pressure continues to be limited, and there are some signs that business sentiment has declined. High household debt and low wage growth has constrained household consumption on a per capita basis whilst employment growth has remained solid supporting aggregate income growth. With this backdrop the Reserve Bank of Australia (RBA) may remain on hold but the risk of further easing has substantially increased.

The key swing factor here remains the labour market; to the extent that strong employment growth is maintained, the RBA will likely look through housing declines, however, should any weakening in consumption feed into the labour market, the pressure for rate cuts will grow. The risks for a more aggressive rate cut cycle increase if a weakening labour market feeds into additional housing market weakness. Current forecasts are for a peak-to-trough fall in the housing market of 25 per cent, of which 10 per cent has already occurred.

Key fixed income views on markets in 2019

• With a more dovish stance by global policy makers, risk assets will find a reprieve as policy easing occurs and growth stabilises, but the likelihood of volatility remains high. The global economic cycle is mature and in a ‘late cycle’ regime, with two possible paths. Either growth fails to stabilise and we risk a recession, or growth stabilises in already capacity constrained economies and inflation risks rise.
• Credit: The outlook for credit is cautiously constructive. Our focus is on shorter maturities and holding lower levels of aggregate credit risk, targeting a higher running yield rather than capital gains through credit  spread compression. The trigger to strategically add risk will be based on achieving better valuations. Corporate leverage has deteriorated, but the ability to service debt remains high, with stable growth and interest rates remaining low. Nonetheless, the fundamental tailwinds to credit performance of the past number of years are waning. Over the medium term, we are focusing on sectors and issuers that will perform well in an environment where credit spread volatility increases modestly. Our preference is for exposures in defensive, or non-cyclical industries, or those companies that can illustrate solid deleveraging stories.
• Interest Rates: Central banks will remain dovish for much of 2019 supporting lower real yields, despite valuations indicating nominal yields are too low. With our expectation of growth stabilising later in 2019 and dovish policy, we also expect it to put upward pressure on inflation, driven further again, with stability in oil and commodity prices. Nominal yields should remain capped for the first half of 2019 as these countervailing forces play out and uncertainty remains. Therefore, we prefer to concentrate risk in relative value opportunities or country-specific themes rather than outright global views at present. In Australia we have a preference to be long duration in shorter-dated maturities, positioning for lower yields. Australian yields should be bias towards falling relative to other global rates. The US remains our favoured short duration position based on ongoing, above-trend growth and tight capacity constraints, particularly on a relative basis. 
• Yield Curves: The outlook for yield curves is complex, differing across regions. We expect a steeper yield curve in the US and China, and a flatter yield curve in Europe and the UK, whilst Australia will be caught between these forces as well as influenced by an increasing risk of monetary policy easing by the RBA.