Policy
Despite its substantial decline, the 10-year Treasury yield still appears reasonably valued relative to our base case scenario of a flat or slightly weaker U.S. dollar. In this <i>Special Report</i> we outline our Treasury valuation framework, in which the dollar plays a key role.
With global bond yields converging toward the lower levels of the NIRP countries, it still makes sense to favor markets with higher nominal and real yields and steeper curves, like U.S. Treasuries (especially U.S. TIPS) and U.K. Gilts.
Stay cautious. The Fed is only beginning to acknowledge what markets already realize. Eventually, they will back off, which reduces the odds of a further sustained equity decline. So far, however, the central bank is lagging deflationary forces acting on the U.S. economy, markets and profits. The weak ISM surveys are consistent with this. The risk is that employment follows suit.
The BoJ's latest rate cut will not have much impact on the Japanese economy or currency. The BoJ and ECB are closer to the end rather than the beginning of their unconventional policies. The biggest policy event of the year will be a 180-degree reversal from the Fed. The divergence in monetary policies that drove the euro and yen lower is largely over.
DM central banks are shifting back into easing mode, with the BoJ's surprise cut the most dramatic example. Japan's adoption of negative rates represents another deflation-fighting step, ultimately leading to a price-level targeting regime and debt monetization. While the real yen will ultimately decline, near-term strength would force more aggressive policy. Stay neutral global equities, preparing to decrease exposure on any sustained rebound. U.S. 10-year yields are still on track to reach our target of 1.5% by year-end.
Oil markets will continue to be buffeted by Russian overtures to OPEC suggesting a desire to orchestrate a production cut-back, while uncertainty over the Fed's next move keeps markets on edge.
Rising demand for U.S. dollars in EM and further yen depreciation, if it transpires, assures global exchange rate volatility will rise. Rising currency volatility, especially in the RMB, will push the global risk premium higher, weighing on global share prices. In Turkey, a wage-inflation spiral is unfolding and the central bank is behind the curve; the currency will plummet further.
Maintain an above-benchmark portfolio duration since, favoring markets with the highest real yields that stand out in a world where 65% of Developed Market government bonds trade with a negative yield.
It is highly unusual for equities to enter a bear market without the economy going into recession. Since we see the risk of recession as low, we recommend a neutral allocation between bonds and equities.
Any recovery in risk assets and selloff in safe havens is unlikely to extend into the cyclical horizon.