The Times Are a--Changin'

INFLATION TRENDS TAKE A TURN FOR THE BETTER
The last few years have not been kind to market-based measures of inflation expectations. Tumbling energy prices since the middle of 2014 have helped knock down breakeven rates (the difference in yields between nominal and comparable inflation-linked bonds), despite the Fed’s efforts to reflate the economy, with each leg lower in oil prices seeming to result in a similar decline in inflation expectations. But as commodities have trudged higher recently and fears of recession have diminished, breakevens have risen from depressed levels. The recovery in breakevens has come alongside a sustained uptick in core inflation and a dovish Fed that may be tolerant of overshoots of its inflation target. Markets may be starting to appreciate the value of protecting against the risk of rising inflation.

Soothing central banks, headlined by the Fed, helped accelerate the market’s upward trajectory from the month prior. Central banks generally continued to calm markets in March, a little over a month after the Bank of Japan’s surprise shift to negative interest rate policy had achieved the exact opposite. Early in the month, the ECB delivered an expanded easing plan that featured a mix of lower rates, larger monthly purchases and expansion of the range of assets to include corporate bonds. ECB President Draghi also signaled a shift in focus toward credit expansion over more negative rates, boosting risk assets (even as the euro appreciated). Then in the week following, the Fed provided a “dovish pause” in its divergent monetary policy: The median “dot” (the federal funds rate targets provided by the individual Federal Open Market Committee members) showed that expected hikes for 2016 had dropped by half, while Fed Chair Yellen struck a cautious tone in several speeches, indicating that global developments very much weighed on the Fed’s outlook. The fact that she continued to see some slack in the labor market even as core inflation measures were beginning to turn higher suggested the Fed may even let the economy “run hot.” Markets took notice of the dovishness: Equities rose nearly 7% in the month, credit spreads tightened considerably, inflation expectations moved higher and the U.S. dollar fell.

Global risk appetite continued to return despite – or perhaps in recognition of – a fundamental backdrop that remained underwhelming but expansionary. Like the outsized market moves in early 2016, the strong rally in March belied a fundamental picture that had not changed much. In fact, though recession fears continued to recede in March, economic indicators were mixed, with soft Q1 GDP growth for the U.S. offset by impressive job gains, a sustained uptick in core inflation and continued signs of improvement in manufacturing. Business sentiment indicators such as purchasing manager indices (PMIs) were also broadly expansionary – though with a decelerating trend – in the eurozone. Even much maligned Chinese PMIs improved in the month. Thus, global growth momentum remained essentially the same: tepid and underwhelming, but with few signs of an imminent recession.

Shifting political winds highlighted one of the complicating factors of the global macro landscape. Markets took a backseat to the tragic attacks in Brussels. The second act of European terrorism within four months heightened tensions in a region already challenged by a growing migrant crisis. The March agreement between the European Union (EU) and Turkey to reduce the flow of refugees into Europe highlighted a growing trend toward nationalistic sentiment that could have repercussions for the political landscape in the region, including in the U.K. as the “Brexit” referendum approaches. This nationalistic trend was also apparent in the U.S., particularly as the Democratic and Republican presidential nomination process gathered steam in March. Highly charged topics such as immigration figured prominently across state caucuses and primaries. Meanwhile in Brazil, the political drama continued to unfold, though signs that embattled President Rousseff’s term could end prematurely cheered markets, with Brazilian equities gaining 17% in the month. Brazil helped drive impressive gains for emerging markets more broadly, both in equities and local currency bonds. It was clear from developments in March that shifting political winds will continue to be an important consideration for both developed and emerging markets.

In the markets

WHEN ARE WE GETTING BACK TOGETHER?
Risk assets such as equities typically exhibit an inverse relationship with perceived “safe-haven” investments like U.S. Treasury bonds. As a result, shifts in risk appetite typically cause Treasury yields, which move opposite bond prices, to follow (at least directionally) moves in broad equity indexes like the S&P 500. That relationship seemed to diverge recently, however, after dovish communications from Fed Chair Yellen resulted in a concurrent drop in yields and rally in equities. In a sign that central bank policy continues to affect all types of assets, the Fed’s current stance appears to be beneficial for both risk and safe-haven investments alike … at least for now.

DEVELOPED MARKET DEBT
Global recessionary fears subsided and dovish central bank commentary drove developed market yields broadly higher during March. Five-year yields in the U.S., eurozone, U.K., Japan and Australia increased modestly over the month as inflation expectations rebounded from prior month lows, while eurozone peripheral yields compressed. U.S. economic data continued to indicate measured domestic strength, but market expectations of additional Federal Reserve rate hikes throughout the first half of the year remained negligible given the depressed external environment; the FOMC’s own “dot plot,” showing members’ fed funds target-rate projections, reinforced these expectations. The European Central Bank (ECB) delivered additional accommodation by knocking its deposit rate another 10 bps into negative territory to -0.4%, but also signaled it would not move lower as negative interest rate policies put pressure on banks, in particular. The Bank of Japan (BOJ) also emphasized that additional quantitative easing would be preferable to further negative interest rate policies.

CREDIT
Global investment grade credit spreads¹ tightened 25 bps in March, due in large part to the ECB’s surprise decision to expand its asset purchase program to include corporate bonds. This, combined with a dovish Fed tone that stressed the data dependency of its policy, helped contribute to shrinking risk premiums, a decline in the U.S. dollar and stabilization in commodities during the month.

Global high yield² extended a historic rally in March amid the dovish global central bank policy narrative, slight improvements in economic releases and an influx of flows. Spreads and yields compressed by over 75 bps, and the sector return for the month was 4.3%, bringing year-to-date performance back into positive territory. The lowest-quality cohort, rated CCC and lower, was the strongest-performing segment, up nearly 10%.

EQUITIES
Developed market equities³ ended March up 6.8% on dovish comments from Fed chair Yellen, which implied lower rates for longer and provided a boost to stocks around the world. U.S. equities⁴ returned 6.8% as consumer confidence rose and worries of a recession subsided. In Europe, equities⁵ advanced only 1.4%; comments from ECB President Draghi removed the possibility of further rate cuts, which led some investors to question the central bank’s ability to implement effective monetary policy moving forward.

In emerging markets⁶, a rebound in commodities and dovish statements from the Fed drove equities to their strongest monthly return since 2009 at 13.2%. Chinese equities⁷ returned 11.8% as the country’s stock market and currency stabilized. In Brazil⁸, stocks rallied 17.0%, the largest monthly gain in 16 years, benefitting from the overall improvement in emerging market assets and growing expectations of a long-awaited change in government. Indian equities⁹ rose 10.5%.

MORTGAGE-BACKED SECURITIES
Agency MBS¹⁰ outperformed like-duration Treasuries by 15 bps amid increasing demand from overseas investors and money managers. Securities with higher coupons outperformed those with lower coupons as mortgage rates rose and refinancing concerns declined. Ginnie Mae MBS underperformed conventional MBS despite an improving demand picture overseas, due to ample supply and scarce bank demand. Relative performance between 30-year and 15-year MBS was mixed, with lower-coupon 15-year MBS outperforming and higher- coupon 15-years underperforming. Fed purchases remained limited to approximately 25% of gross issuance. Non-Agency MBS performance rebounded in March, although the sector has largely lagged broader corporate markets. Technicals remain favorable, underlying collateral performance has been stable and housing fundamentals should continue to be well insulated from broader macroeconomic concerns.

INFLATION-LINKED DEBT
Global inflation-linked bonds (ILBs)¹¹ markets posted strong returns in March, both on an absolute basis and relative to their nominal peers, as inflation expectations were buoyed by supportive central banks and improving risk sentiment. U.S. TIPS were among the top-performing ILB markets, with breakeven inflation (BEI) levels rallying on the back of higher oil prices, a dovish tone to March’s Fed meeting and a continued higher trend in core CPI. European ILB markets were also supported by an accommodative central bank: The ECB delivered a package of new easing measures that exceeded market expectations. In the U.K., BEI levels moved sharply higher early in the month in line with European markets before losing steam into month-end, due in part to modestly disappointing headline CPI.

MUNICIPAL BONDS
The municipal market¹² was negative for much of March before turning positive during the last week of the month. The yield curve flattened, with front-end yields moving higher while longer-duration securities benefited from falling municipal rates. After a nearly nine-month partisan standoff, Pennsylvania passed a budget for the fiscal 2016 year. Democratic Governor Tom Wolf gave up his push for tax increases to further boost education spending – at least until the next round of budget negotiations. Pennsylvania’s compromise leaves Illinois as the only state yet to pass a budget. House Republicans unveiled legislation that provides Puerto Rico with a path toward broad debt restructuring. The proposed bill stops short of granting the island access to Chapter 9 bankruptcy, but empowers a five-person oversight board to audit the government, seek efficiencies and manage any potential restructuring.

EMERGING MARKET DEBT
Emerging market debt returns were robust in March. Stronger currencies and lower index yields drove the best local currency debt¹³ monthly returns since 2008, and tighter index spreads benefited external debt¹⁴. Every country’s sub-index in both the local and external indices posted positive absolute returns. Brazil outperformed across asset classes as investors welcomed reports of a potential government regime change. Within local debt, currencies gained due to sustained policy accommodation from the ECB, Fed and BOJ. Both Colombia and Russia posted double-digit gains as oil prices rose. Similarly, across external debt, Latin American and African countries drove performance given the rally in commodity prices.

COMMODITIES
Commodities posted positive returns for the month, led primarily by the energy and agriculture sectors. In energy, crude oil rallied about $3 to finish the month just under $40. U.S. production has been declining sharply, although the market still faces the weight of high inventories. In agriculture, coffee and sugar were among the top performers, supported by Brazilian currency strength. Wheat also posted positive returns as winter crops faced adverse weather conditions. Within the industrial metals complex, individual commodities gave a mixed performance but an overall positive return for the sector, while precious metals were supported primarily by gains in silver – and platinum for indexes that include it – and gold remained flat for the month.

CURRENCIES
The U.S. dollar ended March weaker against all major counterparts, following the dovish FOMC decision in the middle of the month and Yellen’s late-month speech. After the ECB announced additional accommodation, ECB President Draghi backed away from further negative interest rate policies, resulting in a surge in the euro. Currencies of emerging market commodity exporters (Russia, Mexico) appreciated as oil prices firmed, while the Brazilian real also benefited from further signs of a potential regime change in the government. In Asia, the Chinese yuan remained steady as the People’s Bank of China reassured markets there is no need to devalue, and the Korean won surged from February lows as the central bank kept its policy rate on hold.

Outlook

PIMCO expects global economic and policy divergence will continue to provide a mix of risks, opportunities and volatility. While markets have largely rebounded from the downturn at the beginning of the year, we have lowered our 2016 forecasts for global growth and inflation in light of the weaker economic momentum as well as some tightening in financial conditions at the onset of the year. Importantly, we do not expect a global or U.S. recession over the cyclical horizon. While the three C’s – China, commodities and central banks – have been calmer recently, their paths forward will be key swing factors for the global outlook.

In the U.S., our expectation is for above-trend economic growth in a 1.75%–2.25% range in 2016. We expect the “delicate handoff” from slowing job growth to higher wages to succeed as the main driver of income creation, supporting further gains in consumer spending. Assuming a gradual lift in crude oil prices by year-end, headline inflation (as measured by the CPI) is likely to hover in the 1.0%–1.5% range before rising to 2% by year-end. With PCE inflation (personal consumption expenditures inflation, which is expected to run about 0.5% below CPI inflation) remaining below the Fed’s 2% target and global developments still posing considerable risks to the outlook, we expect the Fed to move cautiously, raising rates only once or twice this year.

For the eurozone, we anticipate trend-like GDP growth in the 1.0%–1.5% range.We expect the headwinds for growth from weak global demand and the tightening of financial conditions earlier this year to be roughly offset by the lagged effects of the weaker euro on exports, and for low oil prices and rising employment to support consumption. The ECB’s March easing package should also be mildly supportive for growth. Yet, with inflation likely to continue to undershoot the ECB’s objective of “below but close to 2%,” further easing later this year may be in the pipeline.

Japanese GDP growth will likely be in the 0.25%–0.75% range in 2016. With China slowing and the benefits from past yen depreciation petering out, the external sector will continue to be a small drag for economic activity. Inflation looks set to continue to fall short of the BOJ’s 2% target – our forecast is for headline inflation in a range of 0.25%–0.75%. Against this backdrop, we anticipate further easing measures by the BOJ during the year.

Our outlook for China is for growth in a 5.5%–6.5% range and headline inflation around 1.25%. China’s transition from “old” (industrial, state-owned and export-oriented) to “new” (service sector, private and consumption-oriented) growth drivers continues to sputter. As such, we expect “official” GDP growth to fall short of the government’s 6.5%–7% target range for three reasons: room for monetary policy easing is limited as it could accelerate capital outflows and put downward pressure on the yuan; the government seems unwilling to meaningfully expand fiscal policy; and volatility in the equity market and overcapacity in the property market have increased uncertainty, weighing on consumer confidence.

We expect BRIM growth will be in line with consensus at 0.75%–1.25%.India is forecast to grow at a 7.3% pace this year, about the same as last year, while Mexico should see a slight acceleration to 2.8% growth this year. In Brazil, the political situation remains fluid with many market participants suggesting that a regime change could provide a catalyst for reforms. In Russia, we think the sharp adjustment in unit labor costs presents an opportunity to rebalance the economy longer term, and a further recovery in oil prices would help to end the current recession.

Of note

IN SIGHT BREXIT RISKS BREWING
The possibility that Great Britain could exit the EU – or “Brexit” – has received considerable market focus with the June 23 referendum approaching. As markets have buzzed over concerns of a global slowdown, Europe’s migration crisis and, most recently, the tragic terrorist attack in Brussels, speculation over a “yes” vote has continued to build. Currency markets have priced in a steep spike in volatility around the time of the vote, so twists and turns in the debate will likely continue to drive headlines and test UK markets.

Polls suggest a tight vote, and while our base case is for the UK to remain in the EU, we assign a significant probability – as high as 40% – to a Brexit event. If the UK does ultimately vote to leave, the market response depends on what kind of separation ensues. We see two possible scenarios. The first: a co-operative separation accompanied by tempered negotiations leading to a relatively benign macroeconomic impact. The second scenario would be an unpleasant divorce, under which volatility could last longer. If it were to occur, there also could be further pressure on the British pound, but also with support for gilts as rate-hike expectations are pushed even further down the road.

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