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Googling ‘deglobalization’ will yield the following definition: the process of diminishing interdependence and integration between certain units around the world, typically nation-states. It is widely used to describe the periods of history when economic trade and investment between countries decline. But before, first a quick take on the state of affairs.
The January US Fed decision to take a prolonged pause in its interest rate cycle, has depressed implied & realized volatility in rate and credit markets over Q1 2019. We do not see many catalysts on the horizon that might disturb this condition. Over the next six months, the ECB’s agenda will be filled with detailed communication on TLTRO and the potential for depo-tiering so as to protect the fragile EU banking system. They will downplay low growth and point to an improving global growth (China & US) outlook.
Market based EU inflation expectations de-anchored. These confront us with the uncomfortable truth that the ECB will never hit its mandated inflation objective over the next decade. The ECB has lost many inflation battles, but is required to continuously fight the war promising victory at 2.00% inflation. On the one hand, upside modest inflation surprises will be translated by mere consolidation in rates and credit spreads around current levels. Forward pricing in rates only point to soft upside normalization in long rates. On the other hand, downside surprises might provide more oxygen to the positive bond momentum that kickstarted global bond markets at the start of Q4 2018.
So, how would global bond markets price and behave under conditions that see deglobalization spreading at the margin? The short answer is steady with interesting fixed income investments across the board.
No panic, we will not be catapulted towards levels of trade of some 20 years ago. The formation of the European Monetary Union and the entry of China into the WTO in 2001 shifted globalization into high gear. However, IMF and World Bank data reveal that global trade (imports/exports) as a percentage of GDP started stalling over 2010-2011. This rupture went hand in hand with tepid productivity growth ranging between 0.00% and 1.00%. The technological revolution we go through has not yet evolved into a broad-based productivity growth spurt. Mending will require cooperation and trust between the worlds’ economic growth engines: China, the US and the EU. That is where a lot question marks pop up.
Politicians putting the nation-state and identity theme central in their strategies are winning elections. Increasing inequality is destroying the appeal of mainstream political parties. Over the past three years election results, across the globe, confirm the potential for political strategies that seek and test moral borders. The “America First” recipe is spreading globally. This clearly skews the balance of risk towards declining economic trade and investments. A longer-term downward adjustment in global growth potential has not been priced into all corners of financial markets.
It is fair to say that the secular stagnation paradigm is gaining momentum. Fixed income allocators should pay attention. Secular stagnation is characterized by depressed interested rates (negative real rates) as a result of unfavorable demographics, extremely accommodative monetary policies, excess savings generation over hesitant, uncertain investment cycles and deficient domestic demand. Inequality is a reality and renders ailing domestic demand persistent. Unlocking secular stagnation steering towards secular inclusive growth will take a generation.
Next to trade, we note diminishing interdependence in the financial market place. Can deglobalization hit capital streams as well? The evidence is mounting. Domestic US investor base has seen a notable rise in US Treasury holdings, interbank EU markets remain dysfunctional, foreign holdings of Italian government bonds keep falling and some emerging markets are re-dollarizing.
We should brace for a continued fall in expected returns across bond sectors, from government to IG and HY credit. Positive bond momentum returned to markets some 6 months ago and has plenty of room to run.
Deglobalization might see a continuation of the USD appreciation trend. The range bound USD index (DXY index) turned decisively bearish between 2001 and 2007, an episode characterized by rapid globalization and deregulation. A false trend reversal signal appears when the Great Financial Crisis impacts. The true reversal takes hold during 2011. We fail to discern elements that might change this USD supportive trend.
USD index across an episode of globalization & deregulation (USD negative)
vs. deglobalization & regulation (USD positive)
Source: Bloomberg, DPAM
Central banks continue to compete at the level of balance sheet size rather than at the level of policy rates. That’s why currency valuation is less driven by interest rate differentials and more influenced by unconventional policy strategy. Unconventional becomes conventional. We are unrelentless in our call to diversify across global bond sectors. Appreciate the value of EMU government bonds and the potential present in maturing European IG and HY markets. Multicurrency exposures should be taken prudently but with confidence. Global unconstrained bonds and Emerging Market Local Currency government bonds are solutions that turn your fixed income component into a key driver of total return.