A sense of gloom has been hanging over markets for the past few months, reflecting trade tensions, softer activity data and political strife. However, the situation may already be starting to improve with progress on US-China trade talks and tentative signs of stronger activity from major economies. Nonetheless, politics are never far away, with European parliamentary elections and Brexit creating uncertainty. We are also waiting for President Trump’s decision on possible auto tariffs. So while we are becoming a little more optimistic, market caution is likely to linger for a little while longer.
The US yield curve inverted and interest rate cuts are being priced in from the Federal Reserve as fears of an economic slowdown gripped financial markets. This largely reflects some mixed domestic data and worries about demand from China and Asia. However, we are more upbeat, with clear signs that 1Q GDP growth may be significantly stronger than initially feared, while a robust labour market should underpin consumer sentiment and spending.
We would also argue that the yield curve is not as powerful recession predictor as it has been in the past. Moreover, if we see a positive resolution to US-China trade tensions this may lift more of the gloom and lead to a re-pricing of the path for interest rates.
While first-quarter Eurozone growth was weak, March data seems to suggest a rebound is in the offing. With improving consumer sentiment and international trade off lows, the second quarter could come a bit stronger, provided that a ‘hard Brexit’ is avoided. Inflation continues to surprise to the downside, justifying continuing monetary stimulus. Reports of the European Central Bank contemplating a two-tier system for excess liquidity, thereby helping the banks, are perhaps a bit premature. We believe this scheme will only be put in place if an additional rate cut would be considered.
Nobody knows for sure where Brexit will take us over coming days, but talk of a long extension to the Article 50 period is growing. That would continue to put pressure on investment, not just because of the uncertainty, but also because firms may have to restart their contingency planning. The chances of a 2019 UK rate increase are fading, but don’t rule one out completely if a Brexit deal can be approved by MPs relatively soon.
China’s fiscal stimulus has begun to work. Manufacturing PMI showed activity expanded in March. We believe this is in large part thanks to the fiscal measures taken over recent months. Continued support from fiscal policy will likely be required to maintain activity even if a trade agreement with the US is reached.
Japan’s economy continues to disappoint on both growth and inflation, though the latter presents few genuine problems except presentational for the Bank of Japan, and a debate about the logic of continued negative rates and money printing is beginning to gather volume. We have dropped out the consumption tax hike from our forecast.
The markets see a US rate cut as probable. If the next move in the Fed funds rate is down, then history also shows that the 10yr can trade 25-50bp through in anticipation. At the same time, we believe the pessimism about growth is a tad overdone.
Unless Eurozone growth can prompt a re-rating of European equities or longer-tenor debt spreads move substantially against the dollar, it is hard to see EUR/USD breaking out of a 1.10-15 range in the next 3-6 months. We are thus downgrading our end 2019 and 2020 forecasts to 1.18 and 1.25 respectively.