As the month concludes, the PM steps down and we prepare for a declining pound.
Further negative comments with respect to the US/China trading relationship have continued to weigh on risk assets in the past week, as prospects for a trade deal dim and tit-for-tat measures point to a protracted stalemate, which may weigh on Chinese growth prospects and global trade more broadly.
Moves to stop firms from supplying Huawei go beyond steps seeking to limit the access of the Chinese telecoms player in the roll-out of 5G infrastructure and speak more clearly towards a narrative of a new ‘cold war’ type of relationship, related to technology and the battle for economic supremacy.
East/West power balance seesaws
It appears that Beijing misjudged Washington’s resolve to redress the balance, which has been tilted in China’s favour over the past several years. Having backtracked on an agreement, it is hard to see China returning to the table after more robust commentary on both sides of the Pacific.
In assessing the implications of this, we would principally observe that downside risks are more skewed towards the Chinese economy. However, it seems highly likely that the authorities will continue to ease domestic policy in order to cushion the negative of higher tariffs and slower external demand. Chinese easing has been a theme for several months and this has already helped to stabilise the economy after it slowed in 2018.
It seems that further monetary and fiscal easing measures may now be enacted, albeit we think it is unlikely that Beijing will allow the renminbi to weaken though CNH7.00 versus USD, as this would probably do more harm than good to the Chinese economy.
Meanwhile, we continue to take a sanguine view in terms of what China trade issues mean for US growth. At the margin, we continue to see jobs and investment moving back to North America and with respect to tariffs, we see these having only a small negative impact on GDP and an equal and offsetting positive impact on prices, such that nominal GDP is relatively unaffected.
A more widespread global slowdown could be an elevated risk – as was the concern in Q4 last year – but with policymakers in Asia and Europe set to ease policy to support growth, we are doubtful that policy action from the US will be warranted. We would only see grounds for a possible rate cut were we to see a sustained move lasting several months, in which GDP growth slipped below 1%, inflation stayed below 1.5% or equity prices fell with the S&P < 2,600, registering a loss for the calendar year.
Each of these outcomes are, in our view, unlikely at this time, and although tail risks will always be present, we would choose to emphasise the strength of the US consumer, accelerating housing, rising investment and accommodative fiscal and monetary policy as all helping to sustain above-trend economic growth. Moreover, the US backdrop remains materially stronger now than at the start of 2019 and we believe there is every reason for the Federal Reserve to retain its patience when setting policy in ‘wait-and-see’ mode.
We will be visiting policymakers in Washington again next week, but for now remain highly sceptical regarding any stories of impending economic demise and see the US continuing to look in robust health – a reason, perhaps, why Trump has little incentive to yield ground to China in the current round of talks.
Further tools in Europe’s toolbox
In Europe, PMI surveys underwhelmed once again, with the malaise in German manufacturing continuing to point to a gloomy outlook, even if real economy data remains rather more healthy.
As we head towards the next ECB meeting, we look for Draghi to emphasise a dovish bias. We look for a possible move to implement deposit tiering, as any forward guidance will, in practice, mean the ECB sees unchanged rates for the next five years and so taxing banks through negative rates on reserves, which they cannot pass onto their customers, seems like an increasingly self-defeating policy.
We also believe that Draghi will hint at other possible measures in the ECB tool kit, which the committee could stand ready to deploy. This could pertain to a re-starting of asset purchases – possibly also to include bank securities. A move towards Japanese-style yield curve control can also not be ruled out – after all, the ECB has been pretty adept at following the BoJ playbook over the past few years.
As we reflect on the creeping ‘Japanification’ of European markets, we would observe that this tends to mean flatter curves and tighter spreads. This should be good news for the eurozone periphery and after recent weakness in spreads in the run-up to EU elections and the noisy rhetoric surrounding the vote, we feel that convergence is set to be a renewed theme over the course of the summer.
May’s declining spiral
Elsewhere, the UK has continued to be overshadowed by the sorry state of the government and the shambolic last few days of Theresa May in the office of prime minister, where she stubbornly tried to cling to power, impervious to logic suggesting that the time had come to stand aside and make way for a new leader.
With May set to depart on 7 June, we feel that remaining hopes for a negotiated EU Withdrawal Agreement are starting to disappear with her. We see no appetite from Brussels to re-negotiate with a more hard-line Brexiteer, and so moves towards a hard Brexit are likely to gather momentum in the weeks ahead. This may see the pound come under further pressure and we continue to believe that it will weaken towards its post-Brexit referendum lows.
However, our analysis of the current composition of Parliament suggests that any new prime minister might struggle to deliver a hard Brexit through Parliament with the Tory majority non-existent and a number of Conservatives still firmly committed EU remainers. Consequently, we continue to look for election risks with a new prime minister seeking a stronger mandate. Should this occur, this in turn points to a material chance that there will be a Corbyn Labour coalition government in place before the end of the year.
In the same way risks seem skewed to a weaker pound, so we would see risks skewed to much higher Gilt yields with such an outcome and so continue to maintain short positions in both – even if little has really happened to either UK rates or FX since the 2016 referendum in the grand scheme of things. The Brexit endgame will be in sight before the end of the year and we therefore feel the moment where these views may play out is just around the corner.
As we survey the investment landscape, it is clear that May has been a choppy and, at times, challenging month. However, we doubt that trade escalation will be an unbroken theme during the summer and we remain hopeful for a relative ceasefire in hostilities. Downside risks are present, but we feel that risk assets (such as the S&P) remain supported.
Eurozone periphery holds promise
Conditions in some emerging markets remain challenged, with Turkey continuing to slip into a relative abyss with CDS spreads moving above 500bps as economic and financial woes worsen. Corporate credit spreads remain fully priced and might also struggle to rally – though in a world where recession risk remains low and financing conditions are easy, it is hard to see an acceleration in default rates away from specific sectors such as retail, which are challenged by ongoing technological change.
In this context, the European periphery appears the most attractive place to own yield in an environment where US Treasuries and core euro fixed income yields less than cash, at a time when hunger for yield should remain a dominant theme for asset allocators. Hard work lies ahead but at least May is now coming to an end.