Highlights from last month

As the Duke and Duchess of Sussex sealed their lifelong union, political relationships across the world were less harmonious. A political crisis in Italy, the eurozone’s third-largest economy, briefly sent shockwaves through global markets: Coalition talks collapsed after Italian President Sergio Mattarella blocked the proposed nomination of a euro-skeptic finance minister by the two populist-leaning parties (Five Star Movement and the League) who were trying to form a government. While the impasse proved short-lived and an agreement was reached, the episode weighed on risk sentiment. Meanwhile, the U.S.-North Korean relationship appeared to sour once more when the highly anticipated June meeting between Trump and Kim Jong Un was announced to be off, but the meeting was back on again within days. Political tensions between the U.S. and its allies also flared after the U.S. announced a new round of sanctions on Iran and its official withdrawal from the Joint Comprehensive Plan of Action, which sought to curb Iran’s nuclear program. Elsewhere, trade talks continued throughout the month between the U.S. and multiple trading partners, including China, Europe and NAFTA parties (Canada and Mexico), though limited action was taken.

Growth trends in the U.S. and Europe appeared to diverge, while a stronger dollar sparked some vulnerability in emerging markets. In the U.S., the unemployment rate continued its steady downward trend, shedding 0.2% to 3.9% – the lowest since December 2000. A robust increase in industrial production also signaled an expanding economy, and inflation measures remained rel="noopener noreferrer" solid even with a milder-than-expected 2.1% print in core CPI. With little to warrant a change in the outlook, the Federal Reserve held rates steady and reaffirmed its “symmetric” 2% inflation target, suggesting a modest inflation overshoot may not cause a faster pace in rate hikes. While the sanguine data kept the U.S. on firm footing, Europe’s growth trajectory appeared to soften on the margin; the region’s composite PMI fell to 54.1, an 18-month low. In addition, some emerging economies faced volatility: Higher Treasury yields and a surging dollar fueled declines in the Argentine peso and the Turkish lira and raised concern that broader emerging markets may not be able to withstand tighter U.S. monetary policy. Policymakers in both Argentina and Turkey took action in a bid to restore confidence: Argentina hiked rates by 12.75% to 40% and appealed to the IMF for financing, while Turkey, under pressure from high inflation, tightened one of its policy rates by 3%.

Market returns were mixed in May as geopolitical uncertainty weighed on risk sentiment and contributed to bouts of market volatility. The fluid political developments in Italy pressured Italian government bonds, and two-year yields briefly surpassed 2.78% ‒ a rise of more than 300 basis points from the beginning of the month. Meanwhile, most developed market yields fell as investors flocked to traditional “safe-haven” assets such as U.S. Treasuries, German bunds and U.K. gilts. In commodity markets, concern over tightening supply boosted oil prices, and Brent briefly crossed $80 per barrel ‒ its highest level in three years ‒ before ending the month slightly above $77. The U.S. dollar continued to strengthen against most developed and emerging market currencies. In emerging markets, the Argentine peso fell the most with a nearly 18% tumble. The surging dollar, along with idiosyncratic risks, pressured emerging market equities (MSCI Emerging Markets Index Daily Net TR) as well, which fell 3.5%. Developed market equity indexes, however, ended the month higher, with a 2.4% gain for U.S. equities (S&P 500 Index).

Chart 1

Chart of the Month: ‘Somebody That I Used to Know’
Rising risks in peripheral Europe, reminiscent of the crisis years, returned to the headlines in May as political upheaval in Italy spurred market volatility. Discussions for a governing coalition between populist parties, the League and Five Star Movement, collapsed after Italian President Sergio Mattarella blocked their euro-skeptic nominee for finance minister, which momentarily raised the prospect of new and uncertain elections. Italian yields rose dramatically in a matter of weeks as German yields fell (top panel), and the spread between Italian and German government bond yields, a barometer of peripheral risk, widened to levels last seen in 2013 (bottom panel). However, the coalition held firm and did eventually form a government, though risk appetites soured and volatility shifted higher across markets.

Market snapshot


Developed market stocks1 rose 0.6% over the month as fundamentals remained resilient and Q1 earnings continued to provide positive surprises. Despite geopolitical headlines, stocks in the U.S.2 increased 2.4% on strong earnings and stable economic data. European equities3 rose only 0.1% after political developments in Italy caused risk markets to retreat and nearly erased earlier gains. Finally, stocks in Japan4 declined 1.2% due to concerns over U.S. tariffs and broader “risk-off” sentiment.

Overall, emerging markets5 stocks lost 3.5% in May, largely driven by weakness in Latin America and further appreciation of the U.S. dollar. In Brazil6, stocks fell 10.9% as the Central Bank of Brazil unexpectedly reversed its trend of easing policy, keeping the Selic rate unchanged, and domestic labor strikes rattled markets. Chinese7 equities held on to gains of 0.7% after geopolitical concerns caused stocks to sell off in the second half of the month. Indian8 stocks rose 0.7% on positive economic data and a pullback in energy prices. In Russia9, stocks rose 0.1% amid mixed economic data and geopolitical tensions.


Developed market yields broadly fell in May as risk appetite waned during turmoil in some emerging market countries and then in Italy. In the U.S., a strong fundamental backdrop along with an uptick in oil prices contributed to rising yields in the first half of May, with the 10-year Treasury yield hitting 3.11% on 17 March, its highest level since 2011. However, this trend reversed when political turmoil in Italy spurred a rally in traditional “safe-haven” assets and the U.S. 10-year yield ended the month 9 basis points (bps) lower at 2.86%. In the eurozone, German bunds also rallied, with the 10-year yield falling 22 bps to 0.34%. In the U.K., soft economic data and the Bank of England’s decision to leave rates unchanged contributed to falling yields there; the 10-year rate ended the month 19 bps lower at 1.23%.


Global inflation-linked bonds (ILBs) posted overall positive absolute returns in May. Global breakeven inflation (BEI) rates generally fell across countries, as sliding oil prices and risk-off trading over the last half of the month weighed on inflation expectations. The Bloomberg Barclays U.S. TIPS (Treasury Inflation Protected Securities) Index returned 0.43% for the month. Movements in real yields were mixed across the curve, lagging the "safe-haven" rally in nominal U.S. bonds. U.S. BEI trended higher to begin the month before sharply reversing in line with crude oil as OPEC members signaled the possibility of increasing supply. In the U.K., index-linked gilts posted gains. U.K. rates rallied across the curve in light of political concerns in peripheral Europe. Despite the drop in oil prices, spot front-end U.K. breakevens outperformed while the back end slipped lower. In Europe, Italian linkers posted steep losses and sharply underperformed their nominal counterparts after a potential new coalition government of two populist parties fell apart.


Global investment grade (IG) credit10 spreads widened 13 bps in May, and the sector underperformed like-duration global government bonds by ‒0.71%. Spread widening primarily occurred in the second half of the month when global volatility rose due to increased political uncertainty in Italy and U.S. trade.

Global high yield bond11 prices came under pressure for the month alongside increased volatility in equities, Treasuries and oil prices. With speculative grade yields about 20 bps higher at 5.8% and government yields lower, spreads widened by close to 30 bps in May. Returns for the broader asset class were down by 25 bps, but this was entirely driven by higher-quality, double-B rated bonds, with single-Bs flat and triple-Cs up 27 bps.


Emerging market (EM) debt posted negative returns in May across all sub-sectors. Higher index yields and EM currency depreciation drove negative performance in local debt as the U.S. dollar strengthened and U.S. rates were volatile. On the external side, spread widening and generally higher underlying U.S. Treasury yields drove returns. Turkey was a notable underperformer in both external and local debt, driven by concerns over central bank independence and high inflation. Argentina also meaningfully lagged external and local debt indexes: Peso depreciation continued amid persistent inflation, despite the central bank’s efforts to arrest its slide.


Agency MBS12 returned 0.70% and underperformed like-duration Treasuries by 5 bps during the month. In aggregate MBS modestly underperformed; but if the extreme underperformance of 5% and higher coupon securities could be removed, MBS would have outperformed like-duration Treasuries. Higher- coupon Ginnie Mae MBS outperformed conventional MBS, while 15-year MBS underperformed their 30-year counterparts. Gross MBS issuance increased 6% in May, and prepayment speeds decreased 3% in April (most recent data). Non-agency residential MBS underperformed like-duration Treasuries during the month, while non-agency commercial MBS13 returned 0.81%, outperforming like-duration Treasuries by 1 bp.


The Bloomberg Barclays Municipal Bond Index returned 1.15% in May, bringing the year-to-date return to ‒0.33%. Short and long ends of the municipal curve outperformed like-maturity Treasuries; lower credit quality munis also outperformed, and the Bloomberg Barclays High Yield Municipal Bond Index returned 2.09%, bringing the year-to-date return to 3.15%. Muni supply was flat month-over-month at $30 billion but was still down year-over-year. The light supply was expected after the surge in muni issuance in late 2017 (leading up to U.S. tax reform and the subsequent prohibition of advance refundings). Muni fund flows were positive in May, with weekly inflows averaging $150 million, according to ICI.


The U.S. dollar rallied over the month. Expectations for a strengthening U.S. economy gained steam and higher U.S. yields drove rate differentials with other countries wider, which put pressure on emerging market (EM) currencies in particular. Among EMs, the Argentine peso and Turkish lira fell sharply due to concerns over worsening inflation dynamics and, in Turkey, central bank independence. The euro also struggled in the face of dollar strength; the euro fell 2.5% as political uncertainty in Italy raised the fear that the country could exit the eurozone. The British pound fell to a near five-month low against the dollar. Traditional “safe-haven” assets like the Swiss franc and Japanese yen were both in demand toward the end of the month against a backdrop of elevated market volatility. Both currencies finished May nearly 1% stronger. 


Commodities delivered broad-based gains in May. In energy, crude oil surpassed $80 per barrel for the first time in nearly four years as the Trump administration’s decision to pull out of the Iran nuclear deal stoked fears of tighter supplies; further declines in Venezuelan production also supported the market. However, crude prices pared gains after Saudi Arabia and Russia signaled the possibility of easing current supply curbs. Natural gas gained on expectations for warmer temperatures across the U.S. In agriculture, dry weather supported wheat prices in mid-month, while cotton surged on poor growing conditions. Both coffee and sugar prices benefitted from the Brazilian truckers’ strike, and threatened tariffs from China weighed on soybeans. In base metals, nickel continued to lead the complex on strong demand; aluminum rose thanks to the continued outage at a Brazilian alumina refinery. Upbeat data from China buoyed copper prices, and gold lagged silver and platinum.

Appendix Table


Based on PIMCO’s cyclical outlook from March 2018.

PIMCO expects world GDP growth to remain above-trend at 3.0%‒3.5% in 2018, in a “Goldilocks” environment of synchronized global growth and low but gently rising inflation. Still-favorable financial conditions and fiscal support suggest that the Goldilocks environment will continue in 2018. Compared with our December forecast, we now see marginally higher 2018 GDP growth in the U.S., eurozone, U.K. and China, while we lowered our estimates for Mexico and India. The causes of the stronger expansion are more uncertain ‒ favorable shorter-term financial conditions versus a possible longer-term increase in productivity ‒ and these could affect its durability beyond 2018. Our inflation forecasts for 2018 have also risen slightly since our December forecast in response to a higher oil price trajectory.

In the U.S., we look for above-consensus growth of 2.25%–2.75% in 2018. Household and corporate tax cuts should boost growth by 0.3 percentage points in 2018, with another 0.3 percentage points coming from higher federal government spending resulting from the two-year budget deal. With unemployment dropping below 4%, we expect some upward pressure on wages and consumer prices, and core inflation to rise above 2% over the course of 2018. Under new leadership, the Federal Reserve is expected to continue tightening gradually; we expect three rate hikes this year, with a fourth likely if economic and financial conditions remain favorable.

For the eurozone, we expect growth will be in a range of 2.25%‒2.75% this year, about the same pace as 2017. The expansion is now broad-based across the region, with growth momentum strong and financial conditions favorable. Core inflation, though, is expected to remain very low, creeping only marginally above 1% this year due to low wage pressures and the appreciation of the euro rel="noopener noreferrer" in 2017. We expect the European Central Bank to end its bond purchase program in September or, after a short taper, by December, though maturing bonds will be reinvested for some time. We do not foresee the first rate increase until mid-2019. 

In the U.K., we expect above-consensus growth in the range of 1.5%–2.0% in 2018. Our base case is for a relatively smooth separation from the European Union, which would contribute to business confidence and investment picking up. After seven years of austerity, we also see some scope for stronger government spending. Inflation should fall back toward the 2% target by year-end, with the effect of sterling’s depreciation in 2017 fading. The Bank of England will likely follow a very gradual path higher.  

Japan’s GDP growth is expected to remain firm at 1.0%–1.5% in 2018. Fiscal policy should remain supportive ahead of the planned value-added tax hike in 2019. With unemployment below 3% and job growth accelerating, wage growth should pick up further, helping core inflation rise over the year to slightly below 1%. With the appreciating yen providing disinflationary headwinds and the newly appointed deputy governors tilting the Bank of Japan leadership somewhat more dovish, the BOJ may not tweak its yield curve control policy until 2019.

In China, we expect a controlled deceleration in growth to 6.0%–7.0% this year, from 6.8% in 2017. The authorities’ focus is likely to be on controlling financial excesses, particularly in the shadow banking system, and on some fiscal consolidation, chiefly by local governments. We expect inflation to accelerate to 2.5% on stronger core inflation and higher oil prices, inducing the People’s Bank of China to tighten policy by raising official interest rates, versus the consensus expectation of no hikes. We are broadly neutral on the yuan and expect the authorities to control capital flows tightly to keep exchange rate volatility low.

In Brazil, Russia, India and Mexico, we expect growth to collectively rise to 4% in 2018, slightly above consensus, with modest upside risk from the growth rebound in India. Emerging markets are catching up to the recovery in developed markets, with improving fundamentals and greater differentiation among countries. This recovery is likely to be shallower and slower than others, however; EM potential growth has fallen, and key political events are likely to keep investors cautious. We expect inflation to stabilize around 4.1%, also above consensus, as most of the decline in EM inflation thus far appears cyclical rather than structural.

Australia in Focus

The RBA reiterated its outlook for a gradually improving economy that will eventually, but not immediately, require higher policy rates, and so the market began to push expectations for the next rate move well into 2019. More benign wage growth and employment data over May helped this sentiment, and also helped drive Australia’s yields lower, with short-end rates experiencing the largest declines. This was despite a more growth-positive Australian 2018-19 Federal budget released in May, which included a forecast for a small surplus by fiscal year 2019‒2020 with net debt peaking one year earlier at 18.6% of GDP. While the fiscal impulse from the budget still points to an overall small fiscal drag, off-balance-sheet infrastructure and state government spending projects remain at historically elevated levels.

1MSCI World Index, 2S&P 500 Index, 3MSCI Europe Index (MSDEE15N INDEX), 4Nikkei 225 Index (NKY Index), 5MSCI Emerging Markets Index Daily Net TR, 6IBOVESPA Index (IBOV Index), 7Shanghai Composite Index (SHCOMP Index), 8S&P BSE SENSEX Index (SENSEX Index), 9MICEX Index (INDEXCF Index), 10Barclays Global Aggregate Credit USD Hedged Index, 11BofA Merrill Lynch Developed Markets High Yield Index, Constrained, 12Barclays Fixed Rate MBS Index (Total Return, Unhedged), 13Barclays Investment Grade Non-Agency MBS Index

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