In the World
In stark contrast to the end of 2018, December 2019 featured strong risk asset performance across the globe, boosted in part by favorable developments in U.S.–China trade discussions. The U.S. and China announced an agreement on a first-stage trade deal, which included higher purchases of American goods by China and lower U.S. tariffs on Chinese goods. In addition to the decrease in trade tensions, more clarity on Brexit due to the Conservative Party’s resounding victory spurred demand for riskier assets; emerging (MSCI EM*) and developed market equities (MSCI World) posted positive returns (7.5% and 3.0%, respectively), while U.S. equity indices (S&P 500) closed the month at new highs – distinctly different from the nearly double-digit negative returns (–9.0%) for the S&P 500 in December 2018. Developed market sovereign bond yields predominantly rose over the month, with the U.S. 10-year Treasury yield up 14 basis points (bps) and the U.K. gilt 10-year yield up 13 bps. Credit markets also reflected the more robust risk appetite: Credit spreads (Bloomberg Barclays High Yield, U.S. Aggregate Credit, and Global Aggregate Credit indices) tightened, and, in a reversal from earlier this year, the lowest-quality junk bonds in the U.S. (rated triple-C) returned 5.7% in December. Reflecting this risk-on atmosphere, as well as some mixed domestic data, the U.S. dollar weakened significantly.
Central banks generally held policy steady against a backdrop of mixed fundamentals. In the U.S., the fastest pace of payroll gains since last January and another drop in initial jobless claims were balanced by a further dip in manufacturing purchasing managers’ indices (PMIs) to deeper contractionary levels. Consumer confidence remained robust, and inflation trended higher despite disappointing retail sales. Some U.S. trends were mirrored in the rest of the world as manufacturing PMIs in the U.K., eurozone, and Japan also dipped further into contractionary territory. Against this backdrop, global central banks held policy steady: The Federal Reserve voted unanimously to maintain current interest rates and indicated the need to see material deterioration in economic data to warrant further rate cuts; the Bank of England (BOE), citing tentative signs of stabilizing financial conditions, also held rates steady by a majority vote of 7-2; the Bank of Japan (BOJ), likewise, held rates steady. In addition, Japan’s Cabinet approved a $120 billion fiscal stimulus package in an effort to ward off global risks. Of note, the Swedish central bank raised rates again – in a departure from the easing stance of other central banks – returning to zero and ending its negative rate regime.
While trade tensions subsided, civil unrest escalated over the month. Political tensions continued throughout the world in December; pro-democracy protests in Hong Kong entered their seventh month, while new protests in India emerged over a controversial new “fast-track” citizenship law that some asserted discriminated against Muslims. Tensions in the Middle East also escalated, as supporters of an Iran-backed militia attempted to storm the U.S. Embassy in Baghdad. The situation exacerbated relations between the U.S. and Iran, and the Trump administration blamed Iran for orchestrating the attack. In the U.S., the Democrat-controlled House of Representatives voted along party lines to officially impeach President Donald Trump on two articles: abuse of power and obstruction of Congress. Trump will face trial in the Republican-controlled Senate in early 2020, where a two-thirds vote is required for conviction. Despite impeachment-related strife between the president and Congress, a resolution was reached on the U.S. Mexico Canada Agreement – also known as NAFTA 2.0 – and it was passed by the House.
*MSCI EM Net Total Return Index
In the Markets
Developed market stocks1 rallied 3.0% into record territory in December as trade and geopolitical headwinds dissipated. U.S. equities2 climbed 3.0% amid strong employment data, passage of the United States Mexico Canada Agreement (USMCA), and a highly anticipated Phase 1 trade deal between the U.S. and China. European equities3 increased 2.1% as Christine Lagarde, in her debut as president of the European Central Bank (ECB), announced that the bank sees signs of economic stabilization. Meanwhile, the Conservative Party swept U.K. general elections, providing greater clarity on Brexit. Japanese equities4 returned 1.7%, supported by the passing of a large economic stimulus package.
Emerging market equities5 rallied 7.5% over the month as trade optimism and stimulus in China lifted global sentiment. In Brazil6, stocks soared 6.9%, and the real rallied on news of the U.S.−China trade deal and China’s stimulus as China is a major importer of Latin American commodities. Chinese local equities7 rose 6.2% after the People’s Bank of China reduced bank reserve requirements, freeing up liquidity for bank lending. In India8, the world’s third largest oil consumer, stocks rose 1.1%, buoyed by positive trade sentiment despite rising oil prices. Russian equities9 rose 4.7% as oil rallied on news that OPEC was considering additional production cuts.
DEVELOPED MARKET DEBT
Positive trade and Brexit developments supported investor sentiment in December, contributing to higher developed market yields and steeper yield curves. The U.S. 10-year Treasury yield rose 14 basis points (bps) to 1.92% with the spread between the two-year and 10-year yields ending the month on a high for the year. In Europe, the German 10-year bund yield ended 18 bps higher at –0.19%, and the 10-year yield in the U.K., further boosted by the general election results, rose 13 bps to 0.82%. Yields in Japan also rose, with the 10-year government bond yield ending 6 bps higher at 0.01%. Meanwhile, central banks – including the Fed, ECB, and BOJ – broadly held rates steady this month amid some signs of economic stabilization.
Global inflation-linked bonds (ILBs) posted negative absolute returns but outperformed their nominal counterparts in December. Inflation expectations rose amid the risk-on move across markets led by the news of a Phase 1 trade deal between the U.S. and China and higher energy prices. In the U.S., Treasury Inflation-Protected Securities (TIPS) posted positive absolute returns and outperformed nominal Treasuries. U.S. breakevens moved higher, consistent with the moves in equities, crude oil, and nominal yields. Outside the U.S., U.K. breakevens rose but lagged the rally seen in other major markets. The U.K. pound rallied significantly following the U.K. general election, in which the Conservatives won a comfortable majority in Parliament, clearing much Brexit-related uncertainty, but subsequently repriced lower as the market absorbed the election outcome.
Global investment grade credit10 spreads tightened 9 bps in December, ending the year at 92 bps, their lowest level since early 2018. The sector returned 0.18% for the month, outperforming like-duration global government bonds by 0.88%. Cyclical industries modestly outperformed, and risk markets reacted positively to reduced uncertainty around U.S.−China trade negotiations and Brexit.
Global high yield bond11 spreads tightened 42 bps in December, and the sector returned 2.09% for the month, outperforming like-duration Treasuries by 2.13%. Yields on below investment grade bonds declined sharply in December as sentiment received a boost from a Phase 1 trade deal between the U.S. and China. Energy was the largest outperformer in the month, although it still meaningfully lagged the broader index over the course of 2019. The higher-quality BB segment returned 1.25% for the month, while the CCC segment returned 5.65%.
EMERGING MARKET DEBT
As risk sentiment generally improved, emerging market (EM) debt broadly posted positive performance in December. External debt returned 1.88%12, driven by a 32-bp tightening in spreads, which outweighed a 14-bp rise in the underlying U.S. 10-year Treasury yield13. Local debt posted stronger returns of 4.13%14 as local rates fell modestly and currencies appreciated strongly on the back of U.S. dollar weakness. EM investor sentiment turned positive when a Phase 1 trade deal was reached and the U.S. House of Representatives passed the USMCA.
Agency MBS15 returned 0.28%, outperforming like-duration Treasuries by 34 bps. December was the 15th month of the Federal Reserve’s balance-sheet unwinding: The Fed has cumulatively sold $380 billion in agency MBS, and its monthly runoff exceeded the $20 billion cap again, which allowed the Fed to reinvest the additional $7 billion back into agency MBS over the month. The December recovery in MBS was mainly driven by a favorable prepayment report, a steeper yield curve, and declining seasonal issuance. Higher coupons underperformed lower coupons, 30-year securities were mixed versus 15-year, and Ginnie Mae MBS underperformed Fannie Mae MBS. Gross MBS issuance decreased 3% versus November but remained strong at $165 billion. In November, prepayment speeds decreased 19% (most recent data available), which was slower than consensus expectations. Non-agency residential MBS spreads remained unchanged in December, while non-agency commercial MBS returned −0.10%16, outperforming like-duration Treasuries by 11 bps.
The Bloomberg Barclays Municipal Bond Index returned 0.31% in December, bringing the total return to 7.54% for the year. Munis outperformed U.S. Treasuries, as well as the Bloomberg Barclays U.S. Aggregate Index in December, as demand continued to buoy performance. High yield munis slightly underperformed investment grade munis over the month, returning 0.30%, which brought the year-to-date return to 10.68%. High yield performance was driven primarily by positive returns in Puerto Rico, as well as in the resource recovery and lease-backed sectors. Total muni supply was $39 billion in December, maintaining the trend of increased taxable issuance. Supply was down 14% compared to November, but up 77% year-over-year. Muni fund flows remained robust, marking 52 straight weeks of inflows: Investment inflows totaled $9.5 billion in December, which brought year-to-date flows to $93.6 billion, surpassing 2009 ($78.6 billion) and setting a new record.
The U.S. dollar ended the month weaker (−2.0% based on DXY) than its developed-market counterparts on a combination of softer economic data, signaling of a likely extended pause in rate changes from the Federal Reserve, and improved investor sentiment as a Phase 1 trade deal was reached. Reflecting dollar weakness in spite of generally mixed activity data, the euro strengthened 1.7% versus the dollar. Similarly, the British pound strengthened 2.5% versus the dollar; initially, the strong result for the Conservative Party in the national election supported the pound, but later, the announcement that Prime Minister Boris Johnson would codify a December 2020 Brexit deadline in law was interpreted as increasing the possibility of a no-deal Brexit. Despite the improved risk sentiment overall, the Japanese yen – a traditional “safe-haven” currency – strengthened 0.8% versus the weakening dollar.
Commodity returns were positive in December, with all sectors ending the month higher. In energy, optimism around trade between the U.S. and China and among the U.S., Mexico, and Canada, rising tensions in the Middle East, and deeper OPEC+ production cuts supported prices. Forecasts for rising temperatures offset larger-than-expected declines in stockpiles, and natural gas prices declined. Agricultural products soared amid expectations for a trade truce to boost U.S. agricultural exports to China; soybean and wheat prices hit their highest levels since summer 2018. Coffee rallied in December owing to tightening supplies in Brazil. Base metals also moved higher, buoyed by encouraging economic data out of China and an improving trade backdrop. Despite improving sentiment, precious metals also remained well bid; gold prices surpassed $1,500/ounce even with the rally in risk assets.
Based on PIMCO’s Cyclical Outlook from January 2020
Recession risks, which had been elevated during the middle part of 2019, have diminished in recent months, helped by additional global monetary easing, a trade truce between the U.S. and China, better prospects for an orderly Brexit, and early signs of a rebound in global purchasing managers’ indices (PMIs). As a consequence, we are now more confident in our baseline forecast that the current "window of weakness" for global growth will give way to a moderate recovery during 2020. Although the “time to recession” has increased, it is worth noting that monetary policymakers now have even less space to guard against future recessions after easing policy in 2019.
In the U.S., we expect growth to slow to 1.5%–2.0% in 2020 from an estimated 2.3% in 2019. We see a sharper growth deceleration in the near term due to the lagged effects of weak global growth, heightened business uncertainty, and slower corporate profit growth, followed by a reacceleration in the second half of 2020 due to easier financial conditions from government and central bank actions as well as higher expected exports to China under the Phase 1 trade deal. With a range of 1.75%–2.25%, core inflation is likely to firm modestly in the next few months from 1.8% last year before moderating later in 2020. Persistently below-target inflation suggests a higher tolerance for overshoots, and thus, a higher threshold for rate hikes from the Federal Reserve. While the Fed is expected to remain on hold, our view is their next move is more likely to be a cut than a hike.
For the euro area, we expect growth to reaccelerate gradually on the back of an improved global trade environment and ongoing support from monetary and fiscal conditions. We see euro area growth at around 1.0% in 2020. Inflation looks set to remain low, also around 1.0% on balance, with the impact of recent wage increases muted in the weak growth environment. We think the European Central Bank is likely to keep the policy rate at −0.50% and continue net asset purchases of €20 billion per month.
In the U.K., we expect growth of 0.75%–1.25% in 2020, modestly below trend.With the U.K. set to formally leave the EU at the end of January, uncertainty about future trading arrangements will likely weigh on business investment and sentiment. However, improving global trade and some fiscal easing should boost activity, especially in the second half of the year. CPI inflation looks set to be below the Bank of England’s 2% target in 2020, in part because of scheduled cuts in regulated electricity and energy prices. We expect the policy rate to remain unchanged at 0.75% but with some risk of a cut in the first half of the year if activity fails to pick up.
In Japan, our forecast is for growth to slow to 0.25%–0.75% in 2020 from an estimated 0.9% in 2019. The VAT hike in the fourth quarter of 2019 is likely to slow growth in the first half, but a large fiscal stimulus package and steady domestic private demand should boost activity in the second half. Inflation is expected to remain low at 0.25% –0.75%. In case of downside risks to global growth, more fiscal support is likely, and we expect the Bank of Japan to keep interest rates unchanged given improving external risks.
In China, we see growth slowing to 5.0%–6.0% in 2020 from an estimated 6.1% in 2019. The Phase 1 trade deal should boost business and consumer sentiment, helping to stabilize slowing trends in the economy. Fiscal support of around 1% of GDP, focusing on infrastructure investment, should also cushion growth. Consumer price inflation has breached the central bank’s 3.0% target recently and is likely to stay in the 3.0%– 4.0% range in 2020. The People’s Bank of China is effectively on hold in an effort to anchor inflation expectations. We expect 2020 will bring a moderately stronger yuan to limit pass-through from import prices under the trade deal with the U.S.