By Tommy Wilkes
LONDON (Reuters) – After possibly the best first-half of a year ever for world markets, investors now find themselves hoping for a familiar fallback to keep the party going: central banks wading in with more stimulus.
Some are even betting the recent wave of pessimism about the global economic outlook is misplaced, despite the possibility of a swift end to the newly agreed U.S.-China trade truce and bond markets flashing recession warnings.
Few are optimistic enough to expect as stellar a run for markets as in the first six months of 2019, when global equities soared 15%, U.S. government bonds returned 7% and commodity prices climbed as central banks promised more stimulus.
(Graphic: Global markets in H1 – https://tmsnrt.rs/2FEK8yw)
And risks abound, not least from trade tensions between the world’s two biggest economies and elevated share and bond valuations, which may tempt investors to sell and book profits.
Potential hazards litter the horizon, including Federal Reserve policy meetings on July 30-31 and September 17-18 and Britain’s next date to leave the European Union on Oct. 31. Mario Draghi’s eight-year term as European Central Bank chief ends the same day; his successor may oversee the reintroduction of quantitative easing before year-end.
But investors’ addiction to central bank largesse has many believing that the end of a decade-long bull run — and the longest economic expansion on record — will be postponed.
“It’s almost like bad news becomes good news,” said Jim Leaviss, a fixed income fund manager at M&G, predicting that weak economic data would spur central banks into launching a new round of monetary easing, as they have already signaled.
Markets’ dependency on central bank stimulus has created a disconnect in asset pricing that has dominated 2019.
While government bond yields in Germany and the United States have plummeted — which many investors say is a clear sign of nervousness about the outlook — equity markets have soared back towards record levels.
“One of the key themes we’ve focused on is that there is misplaced macro pessimism,” said Joseph Little, chief strategist at HSBC Global Asset Management.
“So if you get anything reasonably constructive in terms of economic news, politics, corporate profits, or the news is not as bad as the market discounts, then there is scope for a number of risky assets to perform well in the second half of the year.”
While equities are retesting 2019 highs, investors have entered the second half of the year in a cautious mood as data points to slowing growth momentum across the world.
Demand for government debt is predicted to remain high — Goldman Sachs (NYSE:) said their downside risk scenario for the 10-year German Bund (), the go-to safe-haven European government bond, is to yield around -0.5%. It hit a record -0.34% low last week.
But investors are hardly panicking. Yields on junk-rated company debt, usually shunned during troubled times, are near their lowest in over a year, down some 2 percentage points since January <.merh0a0>.
In a world where an estimated $13 trillion of fixed income assets carry sub-0% yields, money managers are likely to continue diversifying into lower-rated — riskier — securities.
What’s more, rock-bottom volatility — swings in prices — favors seeking “carry”, a strategy where investors sell lower-yield assets to buy higher-yielding securities.
“The question (for credit investors) is are we going to see a significant increase in (company) default risks?” said Eric Brard, head of fixed income at Amundi Asset Management.
“We are in a period of slowing growth but we don’t expect a recession,” he told Reuters, noting yield premiums on investment-grade corporate debt were still 40 to 50 basis points away from their tightest levels over underlying benchmarks.
PUT TO THE TEST
The disconnect between buoyant equities and nervous bonds may be explainable if fixed income investors are simply adjusting to lower “neutral” policy rates in the world’s big economies, rather than anticipating a major downturn.
Barclays (LON:) analysts believe just that, meaning the “stock market move is more consistent with the bond rally”.
Others are less sure. Colin Harte, head of research for BNP Paribas (PA:) Asset Management’s multi-asset solutions team, predicts investor faith in central banks will be tested later this year.
He believes markets’ current disposition is sustainable only if “Goldilocks” conditions, of economic growth without much inflation, remain in place.
The risk is that markets are underplaying the trade war impact and not yet pricing in how a broader retrenchment from the “high point” of globalization will impact the world economy.
“If that is the case, monetary policy won’t work,” he said. “Markets may be quite disappointed.”