Bond Market Observations: Coping with Climate Change

A few more pieces have fit into place of the economic and financial market puzzle that we have been staring at for so long. It is not that US economic data have been especially encouraging. The first-quarter pothole was a little deeper and more bone jarring than expected, and household and business surveys on the outlook have continued mostly to run ahead of official statistics. The Washington political scene still does not make sense. The atmosphere of antagonism may be short of its all-time worst—after all, no one has been caned on the Senate floor and the president has not yet fired a pistol off the back porch of the White House. Nonetheless, the prospect for cooperation between the two parties seems remote; a lot of oxygen under the Capitol dome is sucked up by pursuing scandals at the cost of framing economic policies and spasms of concern about the viability of the Trump administration trigger bouts of financial market volatility. While the French presidential-election result was reassuring, President Emmanuel Macron will need to pivot from campaigning to governing which, judging by recent US experience, could pose a challenge. In addition, other major risk events dot the European calendar.

Nevertheless, we take some comfort in the observation that investors now seem more resigned that slow economic growth, low real interest rates and compressed risk spreads reflect the climate to come, not the weather of the moment. The lining is silver in this dark economic cloud because this climate allows central banks to renormalize the stances of their policies slowly and to a previously unthinkably low cruising altitude for nominal policy rates. With growth slow, large firms can muscle into a bigger market share in order to raise profit margins. They can do so without stretching their balance sheets, while supporting their share values and while justifying narrow credit risk spreads. In these circumstances, financial-market volatility will mostly remain low in a world that delivers neither economic growth nor drama. This implies that there are selective investable opportunities in corporate credit.