Risks start to rise as inflation remains absent, the US/China trade feud rumbles on and there’s still no resolution in sight for Brexit.
US Treasury yields have continued to drive lower in the past week as the flight to quality intensifies, with downside risks from trade seen as a potential catalyst for the Federal Reserve (Fed) to cut rates.
During research meetings with policymakers in Washington this week, there was a clear view that the China/US relationship is unlikely to be resolved any time soon and that we are likely to see further escalation on both sides with 25% tariffs applied across the board over time, albeit with exceptions and exemptions.
That said, this seems to matter little to US economic growth prospects in a direct sense – with the question more one of how this may impact sentiment, and therefore business investment, on a forward-looking basis.
GDP growth is seen above 2% in this quarter and over the second half of the year and those we met were sceptical of an early Fed cut, thinking that more tangible evidence of economic slowing would be needed for the Fed to act – say in September.
The Powell factor
The view from those close to the Fed chairman is that his preference would be to maintain rates on hold until the 2020 election, though were equities to drop below 2,600 on the S&P, or were growth to go to 1%, inflation to drop below 1.5% or the dollar to rally to EUR 1.05, then this may force Powell’s hand.
Separately, next week will see the Fed discussing potential changes in approach with respect to its monetary policy framework, with some pushing for changes to adopt price-level targeting or an average inflation objective.
This debate may last several quarters, if not years – but it is clear that many at the Fed have been surprised at the absence of inflation and are asking why booming growth and massive fiscal easing has done seemingly nothing to prices.
Arguably if there is no inflation now, when will it ever show up? In addition, there is the question of the US becoming the next logical victim to fall under the disinflationary curse, which blights Japan and the eurozone.
It seems these are questions that won’t be answered quickly yet could skew some of the influential thinkers, such as Williams, Evans, Clarida and Brainard, in a more dovish direction.
At the upcoming June FOMC, it is expected that the Fed will remove further tightening from its dots. It is unlikely to infer cuts, as if this were the case the criticism from Trump and elsewhere would centre on what is the point of delay.
Upbeat views from on the ground
All this said, our research meetings continue to paint a picture which is upbeat on growth, with recession risk through 2020 remaining very low. The consumer remains very strong, as shown by highs in consumer confidence data this week.
Therefore, with a cut already largely discounted in markets for September, and with three cuts priced into the end of next year, we see rates markets as pricing in far too much downside risk.
For now, we continue to look for rates unchanged in 2019 and this supports a short duration bias – even if more general fears relating to equity markets and further flight to quality have caused us to reduce active risk positions somewhat in the past week.
Fallout on trade seems likely to impact Chinese growth more substantially and it seems that momentum in Q2 may also be stalling after rebounding in Q1. Further Chinese easing will be required, but we feel that Beijing won’t want to allow its currency to weaken quickly through 7.00 versus the dollar, having made this something of a line in the sand for fear of wider dislocation.
There may be a sense that China is left waiting things out, hoping for a change in the White House. Yet it is notable how, with respect to China, that Trump is more at the dovish end of the spectrum within the administration, having been the arch hawk in respect of the NAFTA discussions.
More generally, this backdrop could present a challenging environment in emerging markets, yet there is probably more to be made on a relative-value basis in identifying winners with sound fundamentals versus those which remain weak and exposed.
Turning to Europe: Election tactics
EU election results have seen Italy under pressure as it may embolden Salvini to be confrontational in his approach to the EU, with Lega Nord eyeing up the prospect of an Italian election later this year. However, we would observe that Salvini doesn’t want spreads wider, not does the EU want another headache. Hence, we continue to see it as unlikely that the EU will provoke the situation by issuing fines on Italy under excessive deficit procedure, as some have speculated.
Meanwhile, upcoming elections in Greece can be seen in a credit positive context, with New Democracy leading in the polls.
Greek government bond spreads have rallied during the week and, more generally, a world in which rates remain low and the ECB remains dovish is seen as constructive for EU sovereign spreads at a time when EU break-up risks remain low.
We remain bullish on Greece and Italy with relatively high conviction on a medium-term view.
Hard Brexit vs referendum 2.0
In the UK, the Conservative Party leadership contest looks wide open, yet it seems highly likely that a hard Brexiteer will be endorsed by Tory members – be it Johnson, Raab or someone similar.
Yet we would observe that committed ‘Remainers’ within Conservative ranks could see individuals such as Philip Hammond and others refuse to endorse such a choice, meaning that an election seems increasingly likely, in our view.
A narrative that tips towards a hard Tory Brexit, or another referendum and no Brexit under a Labour coalition, seems likely and, in this respect, it seems that Labour is now close to endorsing such a position after a resounding beating in last week’s polls.
We remain bearish on UK Gilts and the pound based on this thinking, even if it is requiring patience as we continue to wait for the final Brexit outcome.
Our research meetings in the US have caused us to reflect on a more cautious global outlook. Although we remain constructive on US growth prospects, elsewhere the backdrop does not look as robust.
Reflecting on trade, it seems that further escalation is more likely than compromise, with US/China relations looking like they could move more towards a Cold War type of footing.
We are concerned that this narrative could upset equity markets, where the consensus continues to look for a trade compromise, which we don’t see as likely to be forthcoming.
Downside risks in equities have led us to reduce risk in short rates positions. We remain cautious in corporate credit and emerging markets, with the strongest conviction remaining in European spreads in Italy and Greece.
It seems many have been surprised that trade tensions have moved up a notch and it is notable how many seasoned policymakers we meet are unnerved at the direction things are now moving in without an obvious path to back down or change course.
As one pities the plight of climbers on Everest battling the queues from a failure in planning and foresight, so it may seem that in the coming days, some market participants may find themselves exposed to forces that may seemingly be beyond their control.