The fears that had cast a pall over January weighed on the markets in early February as well, but sentiment improved sharply as the month progressed. The Bank of Japan’s (BOJ) move into negative policy rates led to concerns of policy exhaustion, which further muddled the macro backdrop. However, comments from central bankers, solid U.S. economic fundamentals and a turn higher in oil prices underpinned a dramatic shift in sentiment.

Encouraging U.S. economic data contributed to an improvement in global risk appetite. Consumption patterns and even manufacturing trends were better than anticipated. In addition, various measures indicated a trend toward higher inflation.

Investors marveled at yet another V-shaped trajectory in the markets in February, but concerns still lingered. After another sharp sell-off to start the month, most risk assets retraced much of their losses by month-end. Still, the dramatic improvement was not enough to counter the declines in risk assets for the year so far, suggesting investors remained anxious about the challenges facing the global economy.

In the world

INFLATION TRENDS TAKE A TURN FOR THE BETTER

Core inflation data (excluding food and energy) as measured by both CPI and PCE are now clearly on an upward trend. January’s data releases helped confirm this trend in two ways: The monthly increases beat consensus expectations and the prior-month’s gains were revised up. While the Federal Reserve's (Fed) preferred measure (core PCE) remains below its 2% target, the trend is encouraging for the Fed given its long-fought battle to dispel fears of deflation. Looking ahead, as the economy reaches full employment, job growth may slow but should be accompanied by an increase in wages – which is a key, but thus far largely absent, part of the inflation pipeline.

Although January’s fears seeped into February, market sentiment improved sharply as the month progressed. Global growth and deflation fears gained momentum at the start of the month as the BOJ introduced negative interest rate policy. While the move was intended to calm markets, it appeared to do the opposite: Investors began to focus on the potentially adverse consequences of negative rates and the possibility that central bank policies were reaching the limits of their effectiveness. With oil prices declining, concerns over Chinese policy lingering and U.S. recession worries gaining steam, strongly negative sentiment gripped markets and another bout of volatility ensued. Just as dramatic as the sell-off in risk assets was the shift in sentiment in the second half of the month. While there was no single catalyst, a number of factors supported the change. First, Federal Reserve Bank of New York President William Dudley dismissed concerns about the likelihood of negative interest rate policy in the U.S. and highlighted domestic growth momentum. Second, People’s Bank of China (PBOC) Governor Zhou gave a rare interview and provided some clarity around China’s currency policies, stating that he saw no basis for further currency depreciation. Third, speculation that oil producers were holding discussions on potential output adjustments sparked a rally in oil markets.

Global risk appetite during the second half of the month was further bolstered by indications that the U.S. economy remained healthy. While markets have frequently questioned the resiliency of the U.S. economy during the seven-year (and counting) economic expansion, data in February largely depicted a healthy economy. In fact, some of the data released during the month actually exceeded expectations. Concerns over a possible recession in the U.S. manufacturing sector abated somewhat as both factory and survey data showed improvement, suggesting that recent weakness may not be indicative of a prolonged retrenchment. Retail sales data revealed that cheaper gas and a strong labor market – with the unemployment rate below 5% and wages rising faster than expected – continued to encourage consumer spending. Perhaps the most encouraging sign, though, was the trend higher in inflation. Core CPI posted its third straight year-over-year improvement with a 2.2% pace, while core PCE (the Fed’s preferred measure) moved up to 1.7% year-over-year, its strongest pace in three years.

Despite the shift in sentiment and dramatic rally, investor anxiety was still evident. The impressive rally later in the month was all the more noteworthy considering how much recession fears dominated financial markets in the first half of the month. In the first 11 days of February, the U.S. 10-year Treasury rate was driven to a one-year low of 1.66% – a full 60 basis points (bps) below year-end levels – while inflation expectations (derived from inflation-linked securities) fell to post-crisis lows, global equities1 dropped more than 5% and high yield spreads2 widened more than 100 bps. Yet the subsequent rally was equally striking: Equities erased much of the month’s losses, high yield spreads actually ended the month tighter and inflation expectations were higher. Still, most asset markets remained worse off for the year, which signaled lingering market unease. Perhaps most telling, bond market yields remained lower on the month despite the shift in risk appetite, suggesting that the fears dominating the early part of the month hadn’t dissipated so much as moved to the background.

In the markets

‘V’ FOR VOLATILITY
Most risk assets experienced a V-shaped trajectory in February as the global pessimism that gripped markets in the early weeks of the month faded steadily through month-end and risk appetite returned. While investors had become increasingly concerned about global growth and the potential for a near-term recession, reassuring rhetoric from central bankers and a turn higher in oil prices contributed to a shift in sentiment, as did a better tone in economic data. Ultimately though, the rally in risk assets served only to offset the initial sell-off in early February, and did little to retrace the damage done in January. Only time will tell if global economic trends will sustain investor sentiment and bring about a full reversal of the sluggish start to 2016.

DEVELOPED MARKET DEBT
Global recessionary fears and negative central bank policy rates created weak sentiment and drove developed market yields broadly lower during February. Although sentiment recovered during the month’s second half, yields remained low. Ten-year yields in the U.S., eurozone, UK, Japan and Australia were lower by 15 bps and 25 bps over the month. Eurozone peripheral yields, which were flat to somewhat higher, proved the only exception. While U.S. economic data continued to reveal domestic strength, market expectations for a March interest rate hike from the Fed were negligible given the weaker external environment. Elsewhere, markets continued to expect additional accommodation from the European Central Bank (ECB) at its March meeting, while fears that Britain may leave the EU (Brexit) drove demand for UK gilts. Finally, Japanese yields dropped on fallout from January’s surprise easing from the BOJ and expectations for additional action in March.

CREDIT
Global investment grade credit spreads³ widened 4 bps in February but finished the month on a strong note, retracing much of the widening in the first half of February thanks to an oil-fueled rally and a rebounding equity market. Global investment grade credit returned 0.7%, given falling global government bond yields, and fundamentals outside of commodity-related sectors remained supportive of valuations looking forward.

February was a tale of two halves for global high yield,⁴ with the first half down alongside higher equity volatility and lower oil prices and the second half up on a sharp improvement in commodities, signs of stability in global banks and improving U.S. economic data. Spreads ended the month flat, but returns were positive for the first time in four months.

DEVELOPED MARKET EQUITIES
After a volatile month, developed market equities⁵ ended down 0.7%. They began the month in steep decline and then rallied into month-end on positive economic data out of the U.S. and speculation of additional monetary easing in Asia and Europe. U.S. equities⁶ followed the path down and up, amid improving consumer data, but returned -0.1% for the month as a whole. In Europe, equities⁷ declined 2.1% as inflation remained weak across the region, raising speculation that the ECB would review and possibly reconsider its current monetary policy. Japanese equities⁸ declined significantly, returning -8.4% as the stronger yen and questions around the effectiveness of BOJ policies fueled risk-off sentiment.

EMERGING MARKET EQUITIES
In emerging markets, equities⁹ ended slightly down, returning -0.2% amid mixed returns at the country level. Chinese stocks¹⁰ returned -1.8% as additional easing measures and rare comments made by the PBOC in defense of the yuan relieved some worry around the Chinese economy. In Brazil, stocks¹¹ rallied 5.9% during the month despite an additional credit rating downgrade by Moody’s. A nascent reduction in concern around China’s growth outlook eased demand concerns for Brazil’s export-driven economy. Russian equities¹² advanced 3.1% as rising oil prices lifted the value of assets in the world’s biggest energy exporter.

MORTGAGE-BACKED SECURITIES
Agency mortgage-backed securities (MBS)¹³ underperformed like-duration Treasuries by 14 bps. Underperformance was particularly noticeable for securities with coupons in the middle of the range because they are the most vulnerable to prepayments. Ginnie Mae MBS underperformed conventional MBS due to supply pressure, and 15-year MBS marginally outperformed 30-year MBS. Prepayment speeds announced at the beginning of the month declined, but the average refinancing index level during February jumped more than 50% as mortgage rates fell. Non-agency MBS prices declined amid the broader market volatility, with year-to-date performance largely in line with broader credit markets. However, market technicals remain favorable, collateral performance has been stable and housing fundamentals should be well insulated from global macroeconomic concerns.

INFLATION-LINKED DEBT
Global inflation-linked bonds (ILBs)¹⁴ almost universally lagged nominal sovereign bonds as inflation expectations slid lower in February, despite the rebound in oil prices and other risk assets over the latter half of the month. U.S. Treasury Inflation-Protected Securities (TIPS) were the exception, ending roughly in line with nominal Treasuries after inflation expectations rebounded mid-month from their lowest levels since the global financial crisis. U.S. breakeven inflation (BEI) was supported by stronger-than-anticipated data on wages and the CPI, as well as the modest improvement in oil prices. In contrast, eurozone breakeven rates were plagued by supply pressures throughout February and plunged lower into month-end as the initial February HICP data slipped back into deflationary territory. UK breakevens were similarly pressured by supply as well as disappointing inflation readings.

MUNICIPAL BONDS
Municipals¹⁵ posted gains but gave back some of their recent outperformance relative to Treasuries and corporate bonds over the past few months. Yields dipped near all-time lows early in the month as a flight to quality prevailed in the market, but intermediate and long-term muni rates ended higher after sentiment shifted mid-month. Technicals remained supportive: Muni funds took in $4.2 billion, continuing a trend of strong demand and supply picked up after January’s muted levels, but year-to-date issuance remained roughly 10% below that of 2015.

In credit news, discussions picked up in Washington around a solution for Puerto Rico’s debt crisis. The U.S. Treasury weighed in with a plan for a federally appointed oversight council and a “Super Chapter 9” bankruptcy process. The proposal was met with mixed opinions by market participants, as it explicitly prioritizes pensioners over bondholders.

EMERGING MARKET DEBT
Emerging market assets gained, as tighter index spreads and lower U.S. Treasury yields aided external debt,¹⁶ while generally lower yields and stronger currencies propelled local currency debt.¹⁷ Across external debt, high-yielding Latin American and African bonds led the way as commodity prices firmed during the month’s second half. The gains in external debt for commodity exporters, however, did not translate into local currency strength – exporter currencies remained weaker at month-end, whereas the currencies of European commodity importers held gains from earlier in the month. Elsewhere, the Mexican central bank surprised markets with a 50-bp hike designed to support the currency. Finally, S&P and Moody’s both downgraded Brazil, citing a weaker fiscal anchor and high debt servicing costs as factors. Oil exporters Saudi Arabia and Kazakhstan were also downgraded.

COMMODITIES
Commodities posted marginal losses in February as declines in energy and agriculture overwhelmed gains in precious and industrial metals. Natural gas underperformed within the energy sector on warm weather and strong production numbers. Brent crude oil ended the month relatively flat, albeit with quite a bit of intra-month volatility, while WTI sold off on heavy imports into the U.S. With the exception of sugar, which gained nearly 10%, the majority of the agriculture complex faced headwinds in part from an impending South American harvest. Gold was the top performer for the month, supported by continued safe-haven demand amid market uncertainty and macro weakness. Industrial metals were volatile throughout the month but ended on a positive note in part because of favorable PBOC actions.

CURRENCIES
The U.S. dollar ended February slightly weaker against most major currencies despite a strong rally in the second half of the month. Technical headwinds and weak U.S. manufacturing data pushed the dollar down before positive economic data pulled it back up mid-month. The Japanese yen surged as risk-off sentiment early in the month outweighed surprise accommodation by the BOJ in late January. In Europe, the euro gained modestly despite expectations of additional ECB easing in March, while the pound sterling slipped on Brexit fears. The rebound in commodity prices in the second half of the month helped select developed market currencies (Canada, Australia), although emerging market commodity importers (Poland, Israel) tended to outgain exporters (Russia, Mexico). In Asia, the Chinese yuan was steady, but the Indian rupee dropped due to foreign outflows and the Korean won weakened on geopolitical tensions.

Outlook

PIMCO expects the world’s major economies to continue converging in 2016 while central bank policies diverge. The U.S. recovery will remain on a fairly stable trajectory. Growth in Europe and Japan is projected to increase only modestly, while BRIM (Brazil, Russia, India, Mexico) economies should see gradual improvement. The Fed will maintain its bias toward raising rates, but most other central banks will likely ease policy through rate cuts or quantitative easing (QE), or at least keep rates on hold.

In the U.S., our baseline expectation is for slightly above-trend economic growth of 2.0%–2.5% over the year with underlying inflation of 1.5%–2.0%. With job growth expected to slow as the economy reaches full employment, personal spending will be tied more closely to real wages, which should improve modestly. Given soft global demand and a strong U.S. dollar, we anticipate little boost from international trade. On the positive side, government spending will provide a modest fiscal boost. We believe the market remains too sanguine about the potential for rate hikes in 2016, though the Fed will continue to be data-dependent and mindful of international developments.

For the eurozone, we anticipate above-trend GDP growth of about 1.5%. The ECBʹs ongoing QE measures will keep bank lending rates low across both core and peripheral countries, boosting loan growth. Similarly, modestly improving sentiment and employment should support domestic demand. Headline inflation will depend on the path of oil prices and the euro, but core inflation is likely to remain below the ECB’s definition of price stability. Persistently below-target inflation should open the door to expansion of the existing easing program.

Japanese GDP growth should increase modestly to about 1% in 2016. The slowdown in China and other trading partners will remain a headwind to net exports, and domestic policies have not provided the boost many hoped for. That said, Japan’s shift in fiscal policy goals – an important new development – could be supportive of stronger growth. Headline inflation could advance toward 1%, but will likely remain below the BOJ^,s target of 2%. Amid concern that the quantitative and qualitative easing (QQE) program could run up against technical limits, the BOJ introduced negative interest rates in late January, but the implications for inflation and growth remain unclear.

Our outlook for China is little changed with expectations for growth around 6% and headline inflation about 2%. We still believe China possesses the “will and the wallet” to deal with the challenges of slower growth and pivot toward a service economy; however, the task is difficult and policy mistakes are still possible. We anticipate additional easing via cuts to the deposit rate and required reserve ratio. We also see a likely rise in the budget deficit due to quasi-fiscal financing of local public works as China uses leverage to support its economy in the near term.

We expect BRIM growth to increase modestly to 1.25%–2.25%. An important driver of our lower-than-consensus forecast is the extended contraction in Brazil, given the sharp drop in confidence and elevated political uncertainty. Russia is also expected to contract in 2016, albeit at a slower pace than previously. Meanwhile, both India and Mexico should grow in line with consensus. We forecast 2016 headline CPI inflation in BRIM at 6% (consensus at 5.9%), but Brazil remains the outlier with higher-than-consensus inflation.

Of Note

U.S. RECESSION? THE NUMBERS DON’T ADD UP
Risk of a U.S. recession in 2016 has been on the rise in recent months – or at least that is what the press would have you believe. The data does show a deceleration: U.S. GDP growth slowed from 2.5% in 2014 to 1.9% over the four quarters of 2015, with Q4 growth at just 1%. And markets appeared to question the Fed’s December rate hike: Treasury rates rallied, equities sold off and credit spreads widened.

Aside from the gloomy sentiment, what does the data tell us? Both of PIMCO’s models that examine the likelihood of recession suggest the probability is higher than it has been in a while. But a closer look confirms that the risk of recession remains low and is still significantly lower than at the onset of previous recessions. In addition, the economy has so far shown none of the typical warning signs that preceded past recessions: no overconsumption, no overinvestment and no overheating. Nor are there any signs of overkill by the Fed, which has contributed to past downturns. In our view, fears of a recession in 2016 are overdone.

Appendix

DISCLOSURES

© PIMCO

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