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By John Lovito - November 9, 2018
The U.S. Federal Reserve Bank has been consistently—but predictably—raising rates since 2015, and that'll likely going to continue for the next year or so. But in the meantime, other central banks around the world are on a bit of a different path.
For example, the Europeans aren't in a position to raise rates right now—they're only tapering their quantitative easing. But we're seeing some data to suggest that the European Central Bank might start raising rates in the middle of next year.
What does this mean for the fixed income investor? Well, it means they might want to think twice before putting money into non-U.S. sovereign debt, even in the developed world. While I'm predicting another U.S. rate hike in December—and three more in 2019—investors know what they're in for when they invest in debt issued by the United States. The big rate moves are, in my opinion, behind us.
Click on my latest quarterly outlook video below for more detail about some of the data we're seeing from around the world, and why I think non-sovereign debt could underperform in the near-term.
Obviously, the Federal Reserve has raised rates over the last year or year and a half. We see that continuing into 2019. I think we get one more rate hike from the U.S. in 2018 and three more in 2019. And we'll rest at the area of around 3% for the U.S. rates. Now, outside the US, it's a little bit different. Let's start with Europe, the European Centrtal Bank (ECB). The ECB has begun to pull back on accommodation, but not by raising rates. What they're doing right now is reducing their quantitative easing, and by the end of the year there'll be done with QE and then they'll focus on 2019 with regard to raising rates.
But even then we don't expect rates to go up until say next summer. What will really drive the ECB is what happens with the inflation outlook. So far, inflation's been very mild, but we are beginning to see signs of wage pressure beginning to build within Europe, as well as in certain countries, overall inflation is beginning to rise slightly. So if that trend continues and it becomes more widespread, then you'll see the ECB begin to act on rates. Well for us, you know, we definitely would avoid the non-U.S. sovereign in the developed world relative to the U.S. We've already had the adjustment in the U.S. with regard to higher rates. There should be more stability going forward. Now rates could move a little bit higher still in the U.S., particularly if inflation moves up a little bit higher, but the big move is behind us.
Elsewhere, because we've had the more aggressive monetary policy, those rates have more room to rise going forward. So we would focus a little bit more in the U.S. now, and eventually when those rates move higher then you can diversify again.
We've seen emerging markets come under more pressure. If you look at what happened over the last three months—really since May—it's been one of the worst return periods for emerging markets over the last decade, decade and a half. The higher rates in the U.S., the increased dollar, it does put pressure on these countries. On top of that, we have the looming trade war with China. That is something that we're going to have to really keep a close eye on for the remainder of this year into 2019.
A lot of the emerging market countries depend on global growth and depend on global trade. And trade tariffs and trade wars really don't bode well for global trade. And that could put more stress on those economies as well. I don't really think anybody knows where it ends because there's still so much uncertainty. Now, as you mentioned, this has been more than just China. Now elsewhere, we have seen some resolutions. We have a resolution now with regard to trade with Mexico and Canada with a new NAFTA.
We're not necessarily at resolution yet, but we're in a better place with Europe in terms of not having the rhetoric that we saw earlier in the summer. But where we still see the rhetoric and where we still see the action is with China. And in the end, that's really the most important element of the trade war. Where it plays out, it's going to be really determined I think over the next couple of months—between now and end of the year. The U.S. is clearly determined to have China changes its actions, and I think they're going to be persistent in terms of getting to that point.
Now that said, we do think that both sides want to find a deal in the end. The question is "what is the compromise?" And, to be honest, I don't know what that compromise is. But in the end, we do think that there will be something, probably early next year, that will find enough give and take on both sides that we can avoid going into a full-fledged trade war. But the percentage and the chances of that happening are growing by the day.
Right now, given the uncertainties between trade war. Given the uncertainties elsewhere as well between Brexit and the Italian negotiations around their debt, we think there's enough event risks between now and the end of the year—and into the first quarter—it probably pays to be a little bit more cautious with regard to your fixed income investing. So the way we look at the fixed income market right now is that overall rates will be fairly mild in terms of the direction. Some countries will be rising more than the U.S. But in general, rates will be fairly modest.
But what we're really keeping an eye on is the level of risk with regard to non-sovereign debt. If you look at the performance really over the last year, it's been pretty good. The stronger economy here in the U.S. and stable economy outside the U.S. has been a good environment for risk assets. And so they've tightened and they've appreciated relative to sovereign. We think that's where you want to be a little bit more cautious right now. Given these event risks, you can see the non-sovereign debt underperforming, we think, over the next three to six months—not in a major way, but where you have a better opportunity to invest down the road.
So the idea now is to be close to home with regard to your overall portfolio duration. Also, have it be a little bit more cautious with regard to your non-sovereign sectors and wait for a better opportunity to purchase down the road.
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The Federal Reserve surprised markets with an emergency 0.50% rate cut on March 3. Our investment managers explore the move and potential market responses.
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First Quarter 2020
For the first time in more than 10 years, the Federal Reserve cut short-term interest rate—a move Fixed Income Co-CIO John Lovito says “provides a cushion for U.S. economic growth and inflation.”
July 2019
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.