8 February 2019
Rates: Risk-on can’t mean cuts

We have identified a change in rates market psychology; it shows that rates are peering down, but we’d prefer to bet against this as a tactical view. Structurally there will indeed be rate cuts at some point down the line

Take a look at the chart and large arrow below. It’s an update of what we showed last month, but is worthy of a repeat as it illustrates that the market has steered towards valuations that are not out of sync with interest rate cuts. Why? Typically when the 5-year trades more than 20 basis points rich to the curve, the Fed is often cutting rates (or engaging in QE).

Japan: No bounce

Things in Japan aren't looking as promising as we anticipated, with net trade the biggest scope for disappointment. This isn't too surprising in light of the weak global trade backdrop, though even without a trade war escalation we reckon the picture is still bleak for Japan's trade sector

For some time, we have been running with a more upbeat view on the economy than the Bank of Japan, who we felt were trying to talk the yen down.

But as we approach the release of the fourth quarter GDP release for 2018, we have to admit that things are not looking as good as we had hoped. 3Q18 was a terrible quarter for growth. But there were good reasons for that, namely terrible weather in the shape of Typhoon Jebi, the most powerful storm on earth in 2018.

Typically, when something of this nature happens, storm, flood, earthquake, volcano etc, we see a fairly dramatic drop in growth in that quarter, but then bounce back in subsequent quarters, and the GDP effect is often, thanks to rebuilding and replacement, better than the prevailing pre-crisis trend.

FX: Non-dollar opportunities

The Fed pause and the US: China trade truce has improved the external environment and allowed under-valued currencies to recover. As long as the trade truce holds, we expect this positive environment to continue and the dollar to stay gently offered. However, a serious risk event this month is the threat of US tariffs on auto imports

We cautiously expect the rotation out of defensive positions to continue

It has been a positive start to the year for risk-sensitive currencies, especially those backed by the commodity cycle. Despite much talk of slowing global trade volumes amidst weak growth in China and Europe, a common theme in the FX world has been of investors rotating out of defensive positions in the US dollar and into undervalued currencies – especially in emerging markets. We cautiously expect this theme to continue over coming months, but accept that Washington trade policy could easily pull the rug from under what has otherwise been a good year for risk assets.

A Star Wars analogy - if readers will allow it. Turbo-charged US growth last year saw the US play the role of the all-powerful Death Star in our galaxy. The relatively high returns offered in US – helped in part by Fed tightening – saw the tractor beam of US financial markets suck in global portfolio flows at the expense of most other economies. This supported the dollar across the board and left emerging markets – especially those in need of external financing – vulnerable.

This year it is perhaps Fed Chair, Jay Powell, who has taken the role of Obi-Wan Kenobi and switched that US tractor beam off.  The surprising switch to a neutral Fed stance in January – taking further tightening off the table – has allowed breathing room to emerge for other asset classes outside of the US and for portfolio flows to drift away from defensive positions in USD cash. Of course the temporary US-China trade truce has helped here as well.

UK: The impasse continues…

The Brexit impasse in the UK shows no signs of breaking. The EU is refusing to budge on the Irish backstop, while Prime Minister May is still reluctant to push for a cross-party solution. One way or another, an extension to the Article 50 negotiating period looks increasingly inevitable, which would prolong uncertainty for businesses

May has gone back to Brussels (again), but unsurprisingly the EU isn't budging

It’s been a particularly noisy few weeks for Brexit, but the quest for a solution that can unite the British parliament remains as challenging as ever. To recap, Prime Minister Theresa May’s Brexit deal was defeated in parliament by a heavy margin in January, and to turn things around, she’ll need to convince around 115-120 lawmakers to get behind a new plan. That broadly leaves three main options – adjust the current deal to win Conservative votes, re-write the deal to get opposition MPs on board, or put the choice back to the voters in a second referendum.

Despite the initial talk of cross-party cooperation on Brexit, Theresa May has stuck closely to ‘Plan A’ in a bid to win over pro-Brexit Conservatives, and thereby hold her heavily divided party together. Emboldened by a victory in the House of Commons, where a majority of MPs voted in favour of renegotiating the Irish Backstop, May has returned to Brussels to seek meaningful changes to her deal.

Unsurprisingly though, Brussels is still refusing to budge. As it has said many times, adding a legally binding time limit on the Irish backstop would prevent it from being an ‘all-weather’ insurance policy against a hard border. There is also deep scepticism any ‘alternative arrangement’ involving technology would be enough to emulate customs and regulatory checks on the Irish border – or that it could be developed in time.

China: The trade war is not over

The Chinese economy is weakening on several fronts and not just because of the US-China trade war. In response, the government is looking for ways to boost consumption. Tax cuts may not be enough to avoid a softening in the labour market...

At the end of January 2019 there were two major events in China that caught our attention. The first was the trade negotiations with the US, which ended without a major breakthrough. The second was the announcement of a Targeted Medium Term Liquidity (TMLF) by the People’s Bank of China. Under this facility, the central bank will lend to commercial banks at a lower interest rate, provided the commercial banks increase lending to smaller private firms. These two events highlight that the Chinese economy continues to face uncertainty from the trade war, and the government will continue to support the economy through this period.

Chinese vice premier and lead trade negotiator Liu He returned from Washington with some progress made, but without a final deal with the US. Negotiators have agreed some concessions on agricultural exports, but not resolved the key issues around intellectual property rights, the transfer of technology, and the role of state-owned enterprises. As outlined in the global trade section we do not think that the trade war will end by 1 March 2019.

Eurozone: Don’t mention the ‘r-word’ just yet

A reversal of some one-offs could bring slightly higher growth to the Eurozone in the second quarter, but the risks of US tariffs on European cars, as well as Brexit could yet be another brake on activity. With inflation unlikely to pick up much, there’s little need for monetary tightening from the ECB

The recession-word is back in vogue

With Italy having seen two consecutive quarters of negative growth and Germany just narrowly escaping it, the recession-word is coming back into vogue. While some temporary factors have held growth back, it is fair to say that the underlying trend points to a further growth slowdown with the risks tilted to the downside. However, it remains too soon to pencil in a recession in the Eurozone.

With 0.2% quarter on quarter growth in the fourth quarter, the same growth rate as in the third, the Eurozone seems stuck in a lower gear. While the Italian economy has probably been hit by tighter financing conditions on the back of the spreads widening on the bond market, the weak German growth in the second half of 2018 was probably a one-off, related to productions delays in the car manufacturing sector. When things get back to normal in Germany, we should see some growth acceleration.

The big question is whether things will really get back to normal. Some (temporary) improvement in the growth figures is still likely, but at the same time, a number of downside risks remain. The Brexit saga will continue to create uncertainty (with a potential hard Brexit likely to be a big drag on growth for a quarter or two). On top of that, the trade negotiations between the US and the EU seem to be going nowhere, raising the likelihood of higher import tariffs on European cars (see page 2). Also taking into account the negative sentiment effect, this could shave off 0.2 percentage points of Eurozone growth.

US: Biding its time

Trade policy remains critical to the outlook. If the US strike deals with the EU and China the Fed will hike interest rates again. But if it fails, the story could be very different… 

The US data flow is looking good

Markets are in a much more positive mood than they were at the beginning of the year. Equity indices having clawed back much of the losses seen through the final quarter of last year and high yield bond markets have surged with money clearly being put to work.

This is perfectly understandable given the news over the past four weeks. For a start, the government shutdown has ended and the 800,000 government workers directly impacted are being paid once again. There is a significant backlog of government work, but the data flow we have been seeing suggest no major adverse implications for the broader US economy. After all, the economy created 304,000 jobs in January and the ISM manufacturing index bounced back, fuelled by a surge in new orders.

Global Trade: Downs and ups?

February could be the turning point in the ongoing trade war if the US and China cut a deal and if the US administration decides against hiking tariffs on cars. Unfortunately, we’re increasingly inclined to think trade tensions will get worse before they get better

The risk of fresh US tariffs being imposed on China is rising

The ceasefire between the US and China meant that the scheduled 1st January 2019  implementation of an additional 15 percentage point hike of tariffs on US imports from China, worth USD 200 billion, has been on hold. It could disappear indefinitely if a trade deal is struck but in our view, the American wish list is too demanding for China to get a deal before the 1 March 2019 deadline.

Although an extension of the deadline is possible, we are inclined to think President Trump will look to increase the pressure by hiking tariffs on the USD 200 billion package to 25% in 2Q and threaten to impose further tariffs. We believe this will incentivise the Chinese to compromise just enough to make President Trump willing to compromise as well and cut a deal. After all, elections are coming up in 2020, and the US President needs to show that he has lived up to his promise of getting better terms of trade for the US. Moreover, retaliatory tariffs by China on soya beans and many other American products hurt US exports and the business of his voter base, so we expect a deal, but given the complexity of the negotiation agenda, nothing before 4Q this year.

Reading time around 10 minutes

February Economic Update: Stick or twist?

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