Tough trade talks between the US and China drag on, prompting a slowdown in global trade and activity in the world's leading exporting countries, notably China and Germany. In Germany, GDP shrank by 0.1% in Q2 while August's published export figures were down 8% year-on-year.
In China, stimulus measures have failed to fully counteract the negative effects of this situation. Growth in China has not collapsed but activity indicators are falling short of expectations: industrial output grew 4,8% yoy rather than 6% expected, retail sales advanced 7.6% yoy compared to a 8,6% consensus forecast and investment rose 5,7% yoy while analysts were expecting 5,8%. Caution prevails among economic agents in China and this is also holding back growth.
Some investors are starting to question whether central banks can get on top of the situation, viewing an extension of accommodative monetary policy as posing serious risks.
The siren calls for protectionism in America, the end of China’s decades-long growth boom and central banks’ venturing into unknown territory are new factors stoking uncertainty in the markets. The effect has been to drive down yields on the US and German 10Y bonds to 1.5% and -0,67%, respectively. Given the threat of a severe recession and deep market correction, these yields are looking almost attractive to some in the financial community. The global economy needs to find a new equilibrium and for some among them the transition will prove painful.
A slump may be possible, but is it the central scenario? It seems to us that the bond market is massively overrating the risk of recession. We think it highly likely that the growth phase of the global cycle will continue. Inversions of the yield curves are a sign of negative sentiment rather than a leading indicator of a sharp slowdown to come. What factors underlie this constructive outlook?
First, remember that US economic data remain satisfactory: non-manufacturing ISM 53,7, manufacturing ISM 51,2, continuing strong monthly job creation (193,000 and 164,000, respectively, in June and July), consumer confidence at highs and US Q2 corporate results coming in ahead of expectations (77% of S&P firms beat expectations and earnings per share growth averaged 1.7% year-on-year).
Also, the US and Chinese governments are still talking. Trump would like to go into the 2020 elections with a diplomatic success under his belt and China wants to sustain its growth. There are sound grounds to bet a deal will be done.
Regarding China's stimulus, it should be stepped up (via fiscal and monetary policy measures) and better targeted, notably at small companies and infrastructure.
Finally, we see more benefits than risks to ongoing accommodative monetary policy. For instance, the near certainty of an expansion of monetary easing in the euro zone is in our view a strong supporting factor for the European economy and markets. Persistently cheap finance is welcome in these doubtful times and European banks are adapting their models to what is now the new normal. This may be accompanied by a fiscal stimulus - now being called for by some sections of Germany business - even if we cannot yet take such a move for granted, given the reticence of German policy-makers on such measures.
In this context, equity markets retain some upside and long yields could rise as markets realise they have overdone the pessimism.
Article completed on 27 August 2019 by Florent Delorme, macro-analyst at M&G Investments.
Source of data: Bloomberg
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