In the first half of 2019, the yields on the 10-year and three-month Treasury bonds briefly inverted, stoking fears of a recession. However, the immediate implications of this development could be limited as the yield relationship between two-year and 10-year bonds remained positive throughout the period. Historically, the 2yr/10yr part of the curve inverts an average of three-and-a-half months prior to that of the 3m/10yr relationship, suggesting the inversion seen earlier this year did not fit the usual pattern, though we have since seen further inversions.
Moreover, a yield curve inversion, even when sustained, may signal an approaching recession anytime in the subsequent six months to four years, depending on the growth outlook. At present, GDP growth has been less impressive than in previous cycles, suggesting we may have further to go before the economy overheats. Growth is expected to be moderately positive for the next six-to-12 months, at least in the US, subject to risks such as a further escalation of trade tariffs.
The Fed, having been spooked by the growth slowdown in late 2018, is likely to keep rates on hold and refrain from further normalization of its balance sheet until stronger economic data emerges. There is limited pressure to tighten policy while unemployment is low and inflation remains contained. Therefore, we do not believe a recession driven by a monetary policy mistake is imminent, despite being in the late stage of this cycle.
Credit Risks Mount
While rates remain low and household debt levels are not extended, corporate leverage is high. It seems less likely that companies will borrow significantly more without a big increase in demand for new issuance. Investment grade credit spreads have tightened in 2019 in both the US and Europe. Spreads in the high yield market have also compressed in the first half, thanks to more lenient monetary policy and changing market dynamics. Issuance in the high yield market has declined, while it has increased in leveraged loans.
Not only has the amount of leveraged loan issuance increased, but there has been deterioration in credit quality, with more and more loans being issued at the lower end of the credit spectrum; in our view, this could be an early indicator of excess. Equally, the trend toward issuing more European debt at BBB-ratings level and below suggests that risks may be building for when the cycle finally turns. Thus far, however, the banking system appears to be stable with central banks anxious not to withdraw liquidity too quickly.
Opportunities Beyond the US
n Europe, yields look rich in countries such as Germany and the UK where levels of political risk and subpar growth are of concern. At the same time, countries such as Italy are showing signs of stabilization: for example, non-performing Italian loans have fallen sharply as a percentage of total loans. However, Italy also remains exposed to political risk and we are cautious on Italian spreads.
In our view, there is more value to be had in emerging markets, where real yields still look attractive versus developed market yields, subject to trade risk. China continues to offer opportunities for higher yields as more of its onshore bonds become available to global investors through index inclusion. Moreover, following the sell-off in 2018 and further fears caused by a ratcheting up of the trade dispute in May, EM currencies continue to appear undervalued (Figure 3). They have not yet participated to the same degree as EM equities and bonds in the global rally in the first half of 2019, thanks in part to the continuing strength of the US dollar. (See Investment Theme: Emerging-Market Giants Drive Growth Despite Trade Risk).