The Global CIO Office Weekly Monday, 10 June 2019
Here We Go Again "A deepening of ongoing trade disputes or an abrupt reversal of the recent ebullient financial market conditions represent material risks to the US economy" IMF June 2019
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Central Bankers come to the rescue of the markets
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Fed and ECB appear on track to supporting their respective economies
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Weaker than expected US employment data may prompt the Fed to cut as early as July
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Risk assets should enjoy the easier monetary conditions
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Emerging markets could be primed for better performance as long as trade wars abate
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IMF reminds the US of its structural problems
At the first sign of trouble, central banks are dusting down their policies-for-trouble books. Both the Fed and ECB last week pointed to their ability to loosen monetary conditions. Markets have reverted to a positive tack in the hope that easier monetary policy will offset the current malaise in the global economy. We sense that the financial markets will take on trust that another round of rate cuts, and potentially quantitative easing will provide a significant boost to asset markets. After all, the last round of action led to a 10-year bull market. However, as the IMF pointed out last week in their report about the US economy, governments are not dealing with their structural problems – this can only lead to the ongoing rise of populism and trouble for markets at some time in the future. The IMF stated it very clearly last week trade wars significantly challenge the global economy. IMF Chair Christine Lagarde noted that the aggregate impact of US-China tariffs could be to reduce global GDP by 0.5% by 2020. This amounts to $455 billion the size of the South African economy.
Fed spokesmen ride to the rescue James Bullard, the president of the St Louis Fed, was the first to signal that the Fed would be open to a rate cut should the current malaise in the US economy and lower than expected inflation to persist. By the middle of last week, the Fed Chairman Jerome Powell was speaking the same language. By the end of the week after two poor employment reports, the market was salivating at an the prospect of a rate cut may be by as early as July.
Signs of a weaker US labour market The current malaise in the US economy is clearly creating some weakness in the labour market. US private employers added only 27,000 jobs in May, according to the ADP Employment report, against market forecasts of 180,000. The decline in jobs growth was led by cyclical sectors, manufacturing, construction and mining, as well as small businesses (which shed 52,000 jobs in May). The low monthly add was off the charts for the past nine years and akin to the slowdown we saw in 2008. The main employment report also showed a marked weakness in the jobs market. Only 75,000 jobs were added against 185,000 expected by the market. Employment data for March and April were also revised down by 75,000. Other than in the professional, hospitality and healthcare sectors, employment was weak across the board with employment falling in the government and retail sectors. Wage growth remains perennially poor. Year-on-year wage growth fell from 3.2% to 3.1%. Weak employment data caps a few months of weaker than expected data out of the United States, something that the market can't brush away. Undoubtedly President Trump's dysfunctional trade wars are taking a toll on even the US economy. The economic surprise index showing the degree to which economic data is coming in above or below expectations recently dropped to -68 on an index of +100 to -100 and only recently recovered to -47. ECB rekindles thoughts of a stimulus in the wake of growth and disinflation threats It's not just the Fed rethinking interest rate policy. At the ECB, they appear to be travelling in the direction of easing but are not quite there yet. Given the stuttering weak economic expansion and persistent undershooting of inflation targets, the markets had expected the ECB to shift its stance at the Governing Council meeting held in Vilnius last week. In the end, the ECB maintained its accommodative stance but seemed to leave the door to more dramatic action for later in the year. Mario Draghi said that the Council' would use all instruments at its disposal' including a rate cut if necessary. Many market pundits sense he wants to leave any aggressive policy moves to his successor. Mr Draghi is due to step down as ECB President in October. Other commentators disagree and perceive that Mr Draghi is setting the stage for a new bond purchasing programme before he leaves office. On quantitative easing, the ECB Council decided to continue reinvesting, the principal payments from maturing securities purchased under the asset purchase programme for an extended period. It maintained its targeted longerterm financing operations aimed at providing cheap, longer maturity liquidity to the banking system, thereby providing ongoing favourable lending conditions. President Draghi has frequently mentioned the Council's deepening worry over the impact of Sino-US trade tensions on growth both in the short and longer term. The modest tariffs already imposed by the US in 2018 (and China's response) were an adverse shock and have been magnified for specific countries' (e.g. Germany) in bilateral trade flows reflecting complex integrated supply chains. Added to this is the escalating alarm regarding this year's impasse in negotiations between the EU and the US, which is undermining long term cross-border capital flows, as well as international trade in goods and services. The latter, as a share of global GDP, has already shrunk from a historic high of 68% in 2008 to around 50%. The eurozone with structurally limited domestic demand growth is very vulnerable to weakening trade activity.
We believe there is a rising probability of a more dramatic easing in ECB policy in September. There is no real conviction from the ECB that the eurozone economy will sustain the GDP growth enjoyed in the first quarter (0.4% quarter-on-quarter) given the recent weakness of business surveys. Domestic demand growth helped by higher wages is a prop but cannot be relied upon to lift an inflation rate, which is still well below the ECB policy target of 2%. As we noted in our weekly last week other central banks are already on the move. The Reserve Bank of India cut interest rates last week by 25 basis points to 5.75% the lowest rate since late 2010. However, the country's financial sector is still a very inefficient transmission system to get lower rates into the right hands. Banks with poor balance sheets are having to raise funds using very high deposit rates. Hence, they are reluctant to pass on the lower interest rates to their borrowers. That said the cut might be followed by more particularly given the better behaviour of inflation of late. Risk assets to enjoy looser monetary policy The general support from more relaxed monetary policy across the world should provide a positive backdrop to risk assets such as equities and higher yielding bonds. Global equities rose 4.0% on the week. The US equity market will have insight its previous high a further 2.5% higher than Friday's close. We suspect that if the actions of central banks prolong any equity rally, then eventually emerging markets should do well. However, how broad a rally in emerging markets might ensue will depend critically on how trade talks develop. A topping out of the strength of the dollar should also help emerging markets. That has already been evident in recent months, as the market came round to the conclusion that the Fed would be minded to cutting interest rates this year. Tactically the US 10-year Treasury looks vulnerable to near-term losses with the yield down to just 2.12% the lows of 2017. For now, we doubt that yields would sink to the 2016 low of 1.36% hence yields are more likely to rebound towards the 2.30% level. The prospect of lower short rates has a two-way pull. It will tend to drag the yield curve lower, but at the longer end, there will be some expectation that growth will lift; hence a steeper yield curve and modestly higher long-term interest rates could ensue. Lower short-term interest rates will take some pressure off the high yield corporate debt. The asset class has struggled of late with higher spreads offsetting much of the benefit of lower government bond yields. US high yield corporate bond spreads (407bps) are currently around the average of the past few quarters. We could see them narrow to the lows of the year of around 300bps. A last thought – don’t forget the structural challenges While we see support for the markets in the near term doesn't mean we have lost sight of the long-term challenges for markets. The below reflects the views of the IMF published last week. The IMF's annual Article IV consultation said the US economy had shown extraordinary resilience, noting that unemployment was at its lowest in 50 years, but that "the benefits from this decade-long expansion have not been widely shared". It singled out: • The impact of rising suicides and drug overdoses on falling life expectancy, now one of the lowest in the G7. • A rise of just 2.2% in inflation-adjusted incomes for the median US household since the end of the 1990s, even though per capita incomes have risen by 23%. • A decrease in wealth among the poorest 40% of the population since 1983. • The fact that 45 million Americans live in poverty.
• An erosion of social mobility so that half of today's young American adults earn less than their parents did at a similar age. Forty years ago, the figure was 10%. • Poor education outcomes by international standards despite devoting a bigger slice of national income to schools and colleges. "Addressing the growing divergences between the aggregate fortunes of the real economy and the standard of living for the bulk of the US population is complex and will require action on many fronts," the IMF said.
Gary Dugan Bill O’Neill (Consultant)
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