Late cycle environment

It is becoming increasingly evident that we are in a late cycle environment. Growth is average, and while still positive it is beginning to roll over. Even the United States, whose growth has powered ahead of the rest of the world, is beginning to show some signs of slowing. 

The outlook on Europe is concerning, with internal growth slowing and Italy firmly in recession, but perhaps even more concerning for Europe is the growth outlook for China following a poor showing in 2018. China data is improving, however, and stimulus is showing tentative signs of coming through, but the data is notoriously opaque and we are not yet ready to call the historically small stimulus package a success yet.

Flight to quality

With the data still lagging markets despite the best efforts of policy makers, the important question remains where to for markets from here? If the growth outlook improves, will risk assets continue to rally? We believe that this story is already priced in. What if the growth outlook deteriorates meaningfully? Then we are likely to see a substantial sell off. As a result, we prefer to remain defensive. But what does this mean in practice? 

When risk assets come under pressure, there is usually a ‘flight-to-quality’, and so-called safe havens such as gold and US treasuries attract investors. Unlike the precious metal, US treasuries are a yielding asset, which makes them more attractive for income funds, but like any other asset they are still subject to supply and demand dynamics. 

In the case of US treasuries, this is influenced heavily on the supply side by the issuance calendar - driven by the spending requirements of the US treasury Department (tax cuts do have to be funded from somewhere) - and on the demand side by investors, including the US Federal Reserve. In both cases, investors were rightly concerned in late 2018. 

With the US Federal Reserve announcing the winding down of its quantitative easing program, and record levels of issuance from the US treasury to fund the growing deficit, there were worries of a supply glut combined with the world’s largest source of demand drying up. Intuitively, one would assume this would cause a spike in yields and losses for holders of US treasuries.

US treasuries in the spotlight

But despite this backdrop, US treasuries showed their strength as a safe-haven asset, with yields ending 2018 close to where they began as equity markets erased their year-to-date gains in the final quarter of the year. Conversely, one would assume that with the substantial rally in risk assets that we have seen so far this year, US treasuries would sell off significantly. 

But market participants haven’t fully bought into the risk rally, and with fundamental economic data languishing, US treasury yields held up even as risk assets performed exceptionally well. As we have seen trade tensions ratchet up in recent weeks, US treasuries are again back in the spotlight. While we believe that the medium-term impact on both of the world’s leading economies is relatively small and manageable, the risk of short-term disruption and a hit to business and consumer confidence (and possible USD boost) could be a major setback.

With the first signs of tensions returning, characteristically announced via Twitter by the US President, US treasury yields fell, and have continued to fall as tensions continue and risk assets have begun to retrace some of their 2019 gains. With this uncertain backdrop, we continue to hold US treasuries for both defensiveness and diversification and believe that there is a strong argument for the asset remaining resilient and range-bound for the foreseeable future. 

This article was first published by FT Adviser:

Eugene Philalithis

Eugene Philalithis

Head of Multi Asset Investment Management, Europe