As we look forward to 2019, we see further divergence of what the US Federal Reserve (Fed) will be doing relative to other central banks in terms of tightening the various forms of monetary policy that have been employed over the last decade. The Fed will continue to tighten monetary policy toward neutral policy settings over 2019. One key theme we’ll see is the impact from the unwinding of Quantitative Easing (QE) at a time of higher treasury bond supply.
A reassertion of inflation, especially wages inflation, will likely occupy the market’s focus and will dominate the broader commonly assumed disinflationary themes of the past decade, such as demographics, technological change and disruption.
For the US, the markets will grapple with properly pricing in tight monetary policy that is above neutral cash rates. It has been forgotten over the past decade that monetary policy has two sides, easy and tight.
Overall we continue to expect yields to rise further in 2019 and for the yield curve to become flatter as this occurs, but the broader trend is for a higher rates structure. Ultimately this is good for investors, but we do need to manage the journey along the way.
Where do you see the most important opportunities and risks within your asset class?
The key risk that needs to be watched and managed for fixed interest investors is interest rate risk, or more specifically, duration in a rising rate environment. In the case of Australian fixed interest, whilst we think this risk is relatively low given the Reserve Bank of Australia (RBA) is likely to be on hold over 2019 at a cash rate of 1.5%, Australian bond yields can lift in the short term on the back rising US yields. This creates for us both a risk that needs to be managed, but also great opportunities to add duration to capture higher yields that may not ultimately be sustained in markets.
In credit markets on the other hand, participating in the income remains an important source of excess return for investors. But the manner in which we participate is important at this more mature phase of the credit cycle. Whilst we don’t see credit markets as imminently risky, it is worthwhile continuing to be prudent when investing in corporate debt, favouring defensive sectors and being biased towards the higher credit quality spectrum. There have been some pockets of the Australian credit markets that have underperformed this year where we’ve had minimal exposure. One example is Australian AAA rated residential mortgage backed securities for obvious reasons. But at some stage, pricing is likely to get to levels where the breakeven returns are very much in favour of investors. This is an area we’ll be watching with interest over 2019 and looking to exploit.
How have your experiences in 2018 shifted your approach or outlook for 2019?
In many ways, 2018 was a year when we witnessed the shift in market thinking from the past decade where ultra-easy monetary and fiscal policies had supported economies to one where, at least in certain economies like the US, the degree of policy accommodation needed to be reined in. We think this paradigm shift will accelerate through the course of 2019. As such, our portfolio strategies will take this dynamic into account and we think a very flexible approach when dealing with both interest rate and credits risks will be paramount in navigating 2019 and beyond.
Which chart do you think will be a key indicator for 2019?
The one chart to continue to watch in 2019 will be the wages inflation in each economy. It is the ultimate validation of the effectiveness of monetary policy – of course, this comes with long and variable lags.
Markets had incorrectly assumed in the post-GFC era that relationships, like the Philips Curve, are no longer applicable. 2019 should confirm that they are indeed valid relationships, where economies operating above full employment will in due course produce wages inflation, which the central bank will ultimately need to respond to.
Clearly this is very relevant in the US, but even in economies like Australia which of course is lagging the US in terms of the monetary policy cycle, it is important to watch wages as a barometer of the positive offsets of consumption, infrastructure and exports relative to the slowing housing construction story.
Even in Australia, markets could at some stage in 2019 start grappling with some form of tightening monetary policy cycle over the subsequent two to three years (2020 and 2021). These dynamics need to be managed and will likely create opportunities for active managers.
You can read further insights and analysis from the team at Janus Henderson here