September Economic Update: Getting real on “no deal”

The US consumer continues to spend, but the near-term outlook for the corporate sector is weakening. Manufacturing is in recession and with US-China tensions showing no signs of abating, this may drag other sectors down with it. The Federal Reserve has started to cut interest rates but argues that monetary policy can only do so much to offset the trade war damage. Further yield curve inversion looks probable which, in itself, adds to downside risks for growth.

President Trump continues to believe that ratcheting up tensions with China will deliver the concessions he desires, provide a long-term boost to the US economy and create a wave of euphoria that will get him re-elected. However, China is showing little sign of climbing down and President Trump may well need to backtrack to prevent an economic downturn from derailing his election chances. As it is, we have revised down our US 2020 growth forecast to 1.3% - a level well below the market consensus.

We believe that China has changed its strategy when it comes to the trade war, and that could lead to further market volatility. In terms of economic growth, it seems the strategy of boosting infrastructure projects is also working.

The eurozone economy is slowing down and with Brexit and the trade war continuing to weigh on confidence, especially in Germany, a further deceleration looks likely. If a hard Brexit were to materialise and Europe were targeted in the evolving trade war, it would be hard to avoid a technical recession. The European Central Bank is likely to act on its words with additional stimulus in September, keeping bond yields in negative territory for some time to come.

The UK appears to be heading for an election – the only real question is when. The chances of a ‘no-deal’ Brexit on 31 October appear to be receding, following legislative efforts to force a further Brexit delay. That doesn’t mean ‘no deal’ is off the table completely though, particularly if the Conservative Party can gain a majority in an election. In reality though, the results of a UK election are almost impossible to predict.

If we are to believe the rates market discount, these are the worst of times. Plus, things are discounted to remain bad, or even get considerably worse, for an extended number of years. A snapshot of current curves rings many alarm bells. The hold-out hope has been the US, but with the 30-year now below 2%, that hope is waning fast. We don’t like it, but the path of least resistance is still for lower market rates.

The cyclical slowdown continues to drive global FX trends. Unless we see some material improvement in trade relations, expect pro-cyclical currencies, including the euro, staying under pressure. Barring a much more aggressive Fed easing cycle, we fear EUR/USD could drop into a new 1.05-1.10 trading range into year-end.