PICKING UP THE PACE
The FOMC meeting minutes released in May communicated an inclination by Fed members to increase rates this summer if U.S. economic data continued on its current trajectory. This hawkish surprise caused an immediate spike in the market’s expectations for a summer hike. The market-implied probability of at least one rate hike by the Fed’s July 2016 meeting increased to more than 50% by month-end – a stark contrast to the near-zero probability at the height of February’s risk aversion. During the month, a parade of Fed officials, touting the strength of the U.S. economy, reinforced the hawkish tone and supported market expectations for a faster hiking path. This repricing in markets is likely welcomed by the Fed, as it provides the optionality to move without surprising – and derailing – markets.

A seemingly hawkish Fed highlighted May’s news. The release of the FOMC’s minutes revealed that most participants saw a June rate hike as appropriate as long as the economy continued to improve along its current trajectory. The market-implied probability of a June hike jumped to over 30% (from about 10% at April month-end), and the odds of at least one rate hike by July ended the month just above 50/50. Nudging market expectations higher is critical from the Fed’s perspective, as it grants policymakers some optionality to raise rates without surprising and derailing markets. Following the Fed’s remarks, G7 leaders met in Japan and vowed to utilize all available policy tools to boost global growth, but disagreements over currency policy and coordinated fiscal stimulus signaled a fragility to what some have speculated to be a tacit agreement between central bankers to support currency stability. Meanwhile, Prime Minister Abe announced a two-and-a-half-year delay to his planned sales tax hike in the most recent effort to fight flagging inflation and meager growth in Japan. In the eurozone, the IMF brokered another financial aid package for Greece to ease the country’s debt burden. Political uncertainties were also in the spotlight again this month as Donald Trump solidified his candidacy for the Republican Party in the U.S., while the Brazilian Senate voted to suspend President Rousseff and installed Vice President Temer as the interim president as Rousseff awaits trial for impeachment.

Economic data, particularly in the U.S., was reasonably balanced and provided a stable backdrop that supported the Fed’s desire to hike “in coming months.” Steadily increasing payrolls and a gradual pickup in wages sent U.S. consumers on a much-delayed spending spree as May’s household expenditures data jumped the most in nearly seven years. This was welcome news for policymakers, indicating a potential bounce back from a less-than-impressive Q1 GDP growth rate of 0.8% (which was revised higher but less than anticipated). Growth in the quarter was weighed down by lukewarm spending and a drop in business investment. While the slow growth environment continued to hamper the outlook for businesses, real estate markets remained a bright spot: rising home prices, sales and new construction all reinforced healthy underlying growth trends. Elsewhere, Germany continued to benefit from easy monetary policy and a cyclical recovery in the eurozone, as a surge in building and construction propelled economic expansion in the first quarter to its fastest pace in two years. Growth in China, however, appeared to slip as the impact from stimulus measures in recent months began to wane.

The market’s reaction to a more hawkish Fed was surprisingly sanguine. Despite the Fed’s unexpectedly hawkish turn, most risk assets were well behaved during the month. While the U.S. curve flattened (with front-end rates rising) and the dollar strengthened in anticipation of a summer rate hike, developed market equities experienced modest gains and high yield credit spreads tightened. U.S. equities rallied 1.5%, while volatility, as measured by the CBOE’s VIX index, continued to hover near lows not seen since before the China-induced sell-off in August 2015. A firming of oil prices supported the rally as supply disruptions in Canada and Nigeria helped propel a price move above the $50 mark. Emerging market equities and currencies fell in tandem, but both remained higher on the year. All in all, May proved to be a relatively calm and unexciting month as investors appeared content to stay in wait-and-see mode ahead of some highly anticipated events – including the Brexit referendum and potentially “live” Fed meetings – later this summer.

THE DOLLAR REVIVAL
After bottoming out 6% lower than it ended 2015, the U.S. dollar took a sharp turn this month. A pickup in U.S. economic growth momentum, against a calmer global backdrop, spurred the dollar higher as markets warmed to the possibility of a summer rate increase by the Fed. The DXY – a popular measure of the dollar’s value against a basket of developed-market currencies – surged 3% in May as the dollar strengthened against virtually all counterparts. The rally provided much-needed respite for the eurozone and Japan, which have seen their currencies strengthen considerably this year despite central bank actions to the contrary. Emerging market currencies also fell in the month, dampening the recent rally in EM assets, although most remained higher on the year.

DEVELOPED MARKET DEBT
With global financial conditions relatively stable, developed market yields were driven more by fundamentals and central bank communications than the broad risk-on/risk-off sentiment that dominated market moves earlier this year. In the U.S., the FOMC’s indication that a June or July rate hike may be appropriate drove front-end rates higher as the market-implied probability of a summer hike increased dramatically. The yield spread between U.S. 2- and 10-year rates decreased 8 bps as the curve flattened. In the eurozone, yields shifted lower as inflation expectations remained depressed and uncertainty over the approaching June Brexit referendum grew. Ten-year Bund yields declined 15 bps over the month, while peripherals also saw a rally aided by the announcement of Greece’s €10bn debt-relief deal. Similarly in Australia, weak core inflation data drove the Reserve Bank of Australia (RBA) to cut rates to a new low of 1.75%.

CREDIT
The rally of the last two and a half months abated somewhat in May and contributed to muted risk sentiment, as global investment grade credit¹spreads widened 3 bps, due in part to the combination of a lack of easing from the BOJ and hawkish comments from the Fed. Yet, retail flows into investment grade mutual funds remained robust, signaling continued strong investor demand for stable income from corporate bonds.

Although global high yield bond² performance decelerated from the torrid pace set in the previous two months, a fresh high for oil prices amid supply constraints benefited the energy sector, which carried over into most other high yield sectors. Spreads and yields dropped by about 15 basis points over the month and global high yield bonds, as a whole, were up 0.63% in May.

EQUITIES
Developed market equities³ ended the month slightly up, returning 0.6% amid signs of a recovering global economy. U.S. equities⁴ advanced 1.8% as investors reacted positively to the expectation of a summer rate hike. In Europe,⁵ equities returned 2.4% as positive sentiment drove stocks higher despite political uncertainty and deflationary pressure. Japanese equities⁶rose 3.4%, following reports of a large fiscal stimulus package and a delay in the consumption tax increase. In emerging markets,⁷ stocks fell 3.7% as hawkish comments from the U.S. Fed weighed on returns. Chinese equities⁸fell 0.6%, though it did recover from a steeper decline early in the month. In Brazil,⁹ stocks fell 10.1% amid a reversal in optimistic sentiment driven by weak corporate earnings and a renewed focus on political corruption. Indian equities ¹⁰ rose 4.3%, following corporate profits that beat expectations.

MORTGAGE-BACKED SECURITES
Agency MBS¹¹ outperformed like-duration Treasuries by 17 bps, as rates remained range bound and gross Fed purchases increased amid heightened reinvestment activity, following the previous increases in prepayment speeds. Higher coupons outperformed lower coupons, and the 4.5% conventional coupon was the best performer. 15-year MBS underperformed, while Ginnie Mae MBS performance was largely in line with conventional MBS. Gross issuance of agency fixed rate pools totaled $112 billion and prepayment speeds for 30-year Fannie Mae MBS declined modestly by 5%. Non-agency MBS spreads tightened modestly, with bonds backed by higher beta collateral generally outperforming. Market technicals remain favorable, fundamentals were in line with expectations and nationwide home prices continued to increase.

INFLATION-LINKED DEBT
Global inflation-linked bond (ILB) market performance was overall positive in May. U.S. was the main outlier in terms of absolute performance as TIPS posted losses; in addition, TIPS were outpaced by nominal Treasuries over the month. Despite a continued rally in oil markets and another firm CPI reading for April, recent upward momentum in U.S. inflation expectations faded and breakeven inflation (BEI) levels ended the month lower across maturities. European linker markets fared better, posting overall gains and outpacing nominal sovereigns across countries. Outperformance came in the face of heavy ILB issuance over the month, with a positive turn in inflation accruals helping to offset any supply-related weakness. In the U.K., ILBs rallied alongside nominal ILBs as referendum uncertainty led to dovish messaging from the BoE.

MUNICIPAL BONDS
For the 11th consecutive month, municipal bonds posted positive returns and outperformed Treasuries as the curve continued to flatten. Performance was supported by market technicals as consistent inflows into municipal mutual funds absorbed elevated new issue supply. High yield municipals continued to rally despite another Puerto Rico default. The commonwealth missed the majority of a $422 million payment due to Government Development Bank at the beginning of May. Puerto Rico’s next large debt service payment is scheduled for July 1, when $1.9 billion is due across different entities, including general obligation. The U.S. Congress continues to work on a bill that would establish a federal oversight board to manage the island’s fiscal and legislative affairs as well as any debt restructurings.

EMERGING MARKET DEBT
The rally in emerging market (EM) debt assets that began at the end of January ground to a halt in May. The steady increase in commodity prices and a dovish U.S. Fed had helped buoy EM debt performance in recent months but provided fewer tailwinds in the month. Spread widening over U.S. Treasuries led to external debt losses, while higher EM local yields (in contrast to generally lower developed market yields) and weaker currencies drove local debt declines. Idiosyncratic political uncertainty also contributed to sharp declines in South Africa, where a confrontation between the president and finance minister spooked markets, and in Turkey, following the abrupt resignation of the prime minister.

COMMODITIES
Commodity sectors saw mixed performance for the month, with energy and agriculture posting gains and metals selling off. In energy, crude oil continued its upwards trajectory from April, supported by a number of developments on the supply side including production disruptions in Canada, Libya and Nigeria. Natural gas was down marginally due, in part, to the weather. In agriculture, sugar, soybeans and corn carried overall sector gains. Sugar outperformed the rest, supported by prospects of Indian import demand and rains in Brazil. Soybeans and corn saw gains following USDA stock forecasts that came in below expectations. In metals, gold faced headwinds during the month given market expectations of a June rate hike. Industrial metals were also down amid declining growth in Chinese PMI and weak Chinese trade data.

CURRENCIES
The U.S. dollar strengthened against the majority of its developed and emerging market counterparts as hawkish minutes from the Fed boosted expectations of a rate hike this summer. Beyond broad dollar strength, the sterling rallied as markets priced a higher likelihood that the U.K. will vote to remain in the EU ahead of the Brexit referendum. Among other G10 currencies, the Australian dollar weakened the most, following a surprise rate cut by the RBA. Currencies for EM commodity exporters generally weakened in May due to declining commodity prices, while political instability in South Africa and Turkey served to weaken the rand and the lira. In Asia, the Chinese yuan was weaker in anticipation of dollar buying on hawkish Fed comments and as economic data showed some signs of moderation after recent spikes.

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, our 2016 forecasts for global growth and inflation remain lower in light of weaker economic momentum as well as the tightening in financial conditions that occurred 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 steadier crude oil prices, 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 continued recovery in oil prices would help to end the current recession.

IN SIGHT: AS BRAZIL TURNS
Following months of political discord, political risk in Brazil appeared to reset after the Senate voted to continue the impeachment process of Dilma Rousseff and installed Vice President Michel Temer as the interim president. The Senate now has six months to try Rousseff for crimes against the Fiscal Responsibility Law, under which she was impeached. In her place, interim President Temer and his newly assembled team of ministers face important challenges on both political and economic fronts. Brazil remains mired in a deep recession, with an urgent need to reintroduce fiscal discipline and make headway on structural reforms in politically sensitive areas such as social security, pension reform and price-fixing. The breadth and complexity of the reform agenda is daunting, and Temer’s window of opportunity is small as presidential elections are scheduled for October 2018. Meanwhile, the threat of further investigations into the “Car Wash” bribery scandal continues to pose risks for both him and his allies in the government, making the success of the reform agenda far from certain.