A decade after the global financial crisis peaked in 2008, financial markets have only just begun to correct the asset price distortions that were created by the massive quantitative easing (QE) programme undertaken by the US Federal Reserve.
QE was originally deployed to stabilise financial markets, but instead of being a limited intervention, it expanded and became an ongoing endeavour. It succeeded in pushing down bond yields and pushing up asset prices, steering many investors towards riskier assets while also keeping the costs of capital artificially suppressed.
But continuous QE also led to ongoing price distortions in bonds and equities, while incentivising leverage and rewarding complacency among investors who appeared to view persistently low yields and the Fed's "buyer of last resort" role as a permanent arrangement.
However, those conditions are neither normal nor permanent, and we expect the reversal of QE to have significant impacts on bond and equity markets alike in the upcoming year.
In October we saw bond and equity markets in the US decline concurrently as rates rose. That may seem anomalous, but because bonds and equities were equally propped up by Fed intervention, they have been equally vulnerable to the opposite effect as Fed policy unwinds.
Investors that are not prepared for concurrent price corrections in US treasuries (UST) and other asset classes in 2019 may be exposed to unintended risks.
Perfect storm: Three key factors are lining up to drive treasury yields higher: increased borrowing needs from the US government, a decline in UST buying from the Fed and foreign governments, and rising inflationary pressures.
The first storm on the horizon is the growing fiscal deficit. Increased spending from the Trump administration, along with tax cuts, and ongoing mandatory spending are projected to drive the fiscal deficit towards 5% of GDP, in our analysis. That increases the already high borrowing needs of the US government.
The second storm is diminished official buying demand, both domestically from the Fed, as well as externally from foreign governments. This leaves a large funding gap that will need to be filled by price-sensitive investors, who would need to roughly triple their current levels of buying to fill the void.
Those two dynamics alone would probably be enough to drive yields higher. But a third storm is brewing in the form of inflation. Wage pressures have been rising on exceptional strength in the US labour market, which is further constrained by Trump administration restrictions on both legal and illegal immigration. Additionally, late-cycle fiscal stimulus, deregulation and tax cuts have added fuel to an already strong economy.
Sector tariffs are also expected to raise costs for consumers. Each of these conditions has inflationary implications. Given the current environment, we expect the Fed to continue hiking rates towards the neutral rate in 2019. Taken together, all of the aforementioned factors form a perfect storm of rate pressures that will drive US treasury yields higher in the upcoming year.
Europe remains vulnerable: Political and structural risks are also growing across Europe. Five years ago, European voters were focused on traditional issues such as the economy, fiscal spending and unemployment. Today, European Commission surveys indicate much stronger voter concern about immigration and terrorism.
That shift in focus has been reflected in the political landscape. Support for far-right nationalist parties has grown in several euro-zone countries, notably including France, Germany, Italy and Austria, among others. Outside of the euro zone, countries like Hungary, Poland and the Czech Republic have slid even further towards protectionism and far-right nationalism, increasingly emulating the Russian approach to governance.
This is a worrying trend for European integration, in our view, as inward-looking governments are less likely to work together in a time of crisis.
Currently, European political and structural risks can be most acutely seen in Italy, where disparate political parties in the governing coalition share common ground on euroscepticism, protectionism and increased fiscal spending.
Of primary concern for Europe is the risk that Italian debt would become unsustainable at a 10-year yield around 3.6%, in our analysis. While a crisis is not imminent, the likelihood that the EU would come together to bail out Italy as it did for Greece in 2011 appears far less likely today.
In 2011, there was barely enough political cohesion to hold the union together, but leaders at the time saw the greater good of doing so. Today, fewer people in power share that same thinking.
Some emerging markets better prepared: Local-currency emerging markets show the highest level of undervaluation across the global fixed-income markets. But it's important to recognise that the asset class is not uniform.
Individual countries are far more distinct than they were decades ago. Several have diversified their economies, significantly broadened their local-currency debt markets, expanded their domestic investor bases and built up resilience to external shocks. Others continue to have persistent structural imbalances, unreliable institutions and fragile economies. It's crucial to accurately identify those differences.
In 2019, it will be increasingly important to identify countries that offer idiosyncratic value that is less correlated to broad-based beta (market) risks, as rising rates in the US should affect individual countries in starkly different ways. Countries with low-rate environments, or large structural imbalances and economic soft spots, could be vulnerable to external rate shocks.
Countries with stronger economies, balanced current accounts and relatively higher yields should be in a stronger position to absorb rate shifts of 100 basis points or higher.
Bonds and equities: Overall, we think it's important to recognise that the state of the world that investors have become accustomed to for the last decade is not going to continue indefinitely. In 2019, we expect treasury yields to rise and various asset classes to endure price corrections as monetary accommodation unwinds.
The challenge for investors will be that the traditional diversifying relationship between bonds and equities may not hold true as UST yields rise.
Michael Hasenstab is portfolio manager and chief investment officer for Templeton Global Macro at Franklin Templeton Investments.
