8 March 2019
US: A test of ‘patience’

'Cross-currents' have led the Federal Reserve to adopt a more 'patient', data dependent approach to monetary policy for 2019. While the market is pricing in an eventual cut as the next Fed move, we continue to look for one last 25 basis point hike in the summer

The next move on rates

With the government shutdown over, we are receiving the backlog of data from the end of 2018. Most notably, 4Q GDP slowed by less than feared to 2.6% annualised, which left full year 2018 growth at 2.9%. The aggressive tax cuts at the beginning of 2018 put the US economy on a strong footing, with momentum being well maintained despite escalating trade tensions and the financial market turmoil seen in the latter part of the year.

It was for these reasons that the Federal Reserve adopted a more cautious position in January. Earlier this week, Fed Chair Jerome Powell repeated comments that economic and financial market 'crosscurrents and conflicting signals' have created uncertainty. While officials continue to believe the US economy is broadly in good shape, the fact that inflation pressures are perceived to be 'muted' means the Fed can afford to be 'patient' with regards to decisions on future policy changes.

At present, markets believe that the Fed’s neutral stance will eventually give way to policy easing with Fed funds futures contracts pricing in a 25 basis point rate cut by the summer of 2021. However, we continue to believe that the next move is more likely to be an interest rate increase.

We continue to believe that the next move from the Fed is more likely to be an interest rate increase

Indeed, the economic tensions appear to have eased since the start of the year. The US-China trade truce that was called in early December delayed the imposition of additional tariffs on imports from China. President Trump continues to seek a concrete deal that will result in a lower bi-lateral deficit together with Chinese concessions on intellectual property and technology transfer. 

The hope is that a late-March summit can seal the deal with a 150-page document reportedly being finalised. Meanwhile, risk appetite has returned with equity markets recovering all of the losses seen since the beginning of October. Interestingly, gasoline prices have not rebounded to anywhere near the same extent, so household spending power continues to benefit.

Trade: A turn for the better

 A trade deal between the US and China is looking closer than ever, but the next few weeks will be far from easy for the negotiators on either side. But even if we get something soon, this won't really be the end – as President Trump recently confirmed our interpretation of his strategy – he can only secure new trade deals by imposing and threatening tariffs

Reports suggest a Trump-Xi summit could take place soon

A deal between the US and China is closer than ever and this was reason enough for President Trump to postpone imposing 25% tariffs on USD 200 billion worth of imports from China, which was due to happen on 2 March.

We have tweaked our base case and no longer expect an additional tariff hike on USD 200 billion of Chinese imports to occur

Given the ambitious demands from the US, it’s certainly not a done deal yet, but given press reports on the progress made so far and the optimism that President Trump and Xi demonstrate, we are inclined to expect that a deal will be struck. There is no new deadline, but reports suggest that a Trump-Xi summit could take place at the end of March. The public optimism of both presidents about the progress in negotiations has led us to tweak our base case. We no longer expect an additional tariff hike on USD 200 billion of Chinese imports to occur.

Eurozone: A sense of stabilisation

Sentiment indicators, which had been falling since the start of 2018 are finally stabilising, but with growth expectations scaled back and inflation still not going anywhere, the ECB has had to finally adjust to the Eurozone's new reality of elevated uncertainty. So overall, expect a low-interest rate environment to remain in place for some time to come

The stock market rally over the first months of the year has brought some welcome relief. Sentiment indicators, which had been falling since the start of 2018, are finally stabilising, though we shouldn’t overdo the potential for a strong recovery over coming months.

The European Commission’s sentiment indicator fell again in February, but the drop was very small, with several sectors actually improving. The weakness seems to be mainly concentrated in the manufacturing sector on the back of a weaker global economy and increased volatility. 

The uncertainty surrounding Brexit and the danger of higher tariffs on European cars in the US are still important and might lead to some hesitation as far as business investment is concerned. Research from the ECB shows that heightened uncertainty is indeed likely to weigh on investment decisions. Loan growth to non-financial corporates dropped from 3.9% to just 3.3% year-on-year on an adjusted basis in January. Still positive, but clearly decelerating. The European Commission’s sentiment indicator fell again in February, but the drop was very small, with several sectors actually improving. The weakness seems to be mainly concentrated in the manufacturing sector on the back of a weaker global economy and increased volatility.

UK: Will May’s deal pass after all?

The UK Prime Minister faces an uphill struggle to get her deal approved by Parliament. That means an extension to the Article 50 negotiating period now looks inevitable, but if this delay is kept relatively short, the threat of ‘no deal’ will remain. This would further reduce the chance of a rate hike this year

The next week in Westminster may well prove to be the most important in the Brexit process so far, which is saying something. In a series of votes, we’ll discover whether Parliament has changed its mind on Prime Minister Theresa May’s deal, and if not, whether lawmakers would prefer ‘no deal’ instead. If the answer to both of those questions is “no” – which seems likely – then MPs will finally get a vote on whether the UK should return to Brussels and ask for extra time. So how will things pan out?

China: State sees headwinds

China’s government has provided a set of targets for 2019, and it appears the government is relying a lot more on fiscal stimulus rather than monetary easing. A repeat of previous guidance on the exchange rate mechanism may mean the yuan will continue to follow the dollar index

China’s ‘Two sessions’ – the annual meetings of the national legislature and top political advisors- haven’t been as exciting as last year when the government was celebrating the 40th anniversary of its reform and opening up policy. While we’ve had a new set of targets, they’re almost as expected and details are missing when it comes to reforms.

The GDP growth target is now set at 6.0% to 6.5% for 2019, lowered from ‘around 6.5%’ in 2018. This lower growth target was expected by the market, and therefore didn’t create many ripples.

While the tax cut may save jobs, it doesn't necessarily mean the private sector will boost economic activity in general

The more surprising policy was an aggressive fiscal stimulus. Tax and fee cuts amount to CNY 2 trillion, including a 3% cut in value-added tax for manufacturing industries. This policy will give some breathing room to private companies by lowering expenses, which should help keep businesses and jobs alive. Without it, we would have seen more private firms closing down, which would result in job losses and a fall in consumption.

However, even with a smaller cost burden, private firms will still be keeping a watchful eye on the uncertainties surrounding the trade war/ truce, and may be reluctant to boost capital spending. So while the tax cut may save jobs and means the private sector won’t slow further, it doesn’t necessarily mean the private sector will boost economic activity in general.

FX: Dollar against the low yielders

We continue to look for the US dollar to outperform the low-yielding G10 currencies in the coming months. We expect the Federal Reserve to deliver a hike, while the European Central Bank and Bank of Japan will remain dovish/neutral. For sterling, it's all about Brexit

Further USD outperformance

Solid US economic data and a likely market-friendly resolution of the US-China trade talks should eventually translate into an additional Federal Reserve rate hike in the third quarter, in our view. With the market pricing in close to zero probability of a hike this year, any tightening should help to support the dollar against the low yielding G10 FX, where soft activity data has made tightening a low probability event. In essence, we continue to look for further USD outperformance vs the low yielding G10 FX in the months ahead.

Japan: Old style

Fourth-quarter growth was a bit of a 'dead-cat' bounce. Consumption is struggling to grow, despite better wage growth and inflation isn't going anywhere. This is spurring some talk of action at the Bank of Japan

As we feared, 4Q18 GDP failed to bounce back as strongly as we had initially hoped. After a 2.6% annualised decline in 3Q18, the 1.4% bounce in 4Q18 was of the distinct ‘dead-cat’ variety. Certainly not the ‘sharp bounce’ one business TV channel reported on the day. And since then, the data hasn’t got much better.

4Q18 GDP failed to bounce back as strongly as we had initially hoped

One of the biggest disappointments for Prime Minister Shinzo Abe, we imagine, must be that after convincing businesses to be more generous with wages, which they are now with wage growth honing in on 2.0% year-on-year, household spending still remains virtually flat. The idea that paying people more through scheduled cash earnings and not through one-off bonuses would lead to a smaller percentage being saved, has simply not been borne out by reality.

Rates: Ultra-low Bund yield rationalised by angst

The 10-year German yield at a mere c.20 basis points bears no reflection whatsoever on the Germany economy. So how can we make sense of this? Plain and simple, it is a combination of both macro and existential fear

Making sense of the German Bund

The 10-year German yield at a mere c.20bp bears no reflection whatsoever on the Germany economy. With nominal growth running in excess of 2.5%, such a low yield implies a negative real rate in excess of 2%, which under normal circumstances would imply significant macro angst. And while there has been a slowdown, it is nowhere near as sinister as that discount suggests. So how can we make sense of this?

The ultra-low 10yr German yield does not reflect the performance of the German economy

Plain and simple, the 20 basis point 10-year German yield is a measure of fear. And the closer we get to zero the more aggravated that fear becomes. That fear is a combination of two elements. First, there is an element of macro fear - that the current slowdown could become more severe. But the more significant element is the fear underlying the European project, and not enough attention is being paid to this.

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