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Monthly Macro Outlook: “Whatever it takes” magics

Macro 5 minutes to read
Christopher Dembik

Head of Macroeconomic Research

Summary:  Trade war and China's growth slightly less important for now, focus on the central banks.

Over the past month, the bullish narrative has been fueled by rate cuts expectations and a first glance at solid US earnings, especially in the financial and banking sector that will benefit from upcoming softer US regulation this Autumn. The main themes of the first part of the year – trade war and China’s economic situation – are playing a less important role in the stock market. Investors are betting on a mini insurance cut cycle in the United States, that will start at the end of the month, which explains higher risk appetite. In the forex market, since early July, market makers are less active, but volatility is still present on some pairs, especially the USDGBP and to a lesser extent the EURUSD. Contrary to what most market participants believed, the EUR/USD rally was short-lived mostly due to the surprising dovish tone of the ECB. There was little doubt that the ECB would follow the path of the Fed, but no one thought it would have happened so quickly. 

Trade war mess and weak domestic demand

The macroeconomic outlook in Asia and notably in China has not changed much over the past weeks. Stabilisation of the economy continues but it is not broad-based. Q2 GDP print was released at 6.2%, the lowest level in 27 years, but what is probably more interesting is that many sectors have shown strong signs of revival in June: industrial production was up 6.3% YoY, manufacturing production beat expectations at 6.2% YoY and fixed asset investment grew by a solid 5.8% in the first six months of 2019 compared to a year earlier. Like it has been the case since the beginning of the year, domestic demand is still weak, as pointed out by the latest import figures (June total imports dropped by 7.3% from year-ago levels) and by the pursued contraction of passenger car sales (the three-month moving average was out at minus 8.08% YoY in June). Further fiscal stimulus measures are certainly needed to support domestic demand in the coming months.
Despite some weak spots, all these data confirm that China’s economy is resilient to the impact of trade war. We consider that the trade truce between China and the United States will last at least until the end of the summer, but it is obvious that there is no final trade deal nowhere in sight. The Osaka agreement was a big misunderstanding. According to people close to Chinese officials, Beijing has never made any explicit commitment to buy US farm products and saw it as contingent on progress toward a deal. As long as both countries manage to mitigate the macroeconomic effect of the trade war, the likelihood of trade agreement is close to zero. The real question that any investors should ask himself is: who can sustain the trade war pain longer? The first country that will fail will be the one that will make concessions. As of today, it is impossible to know whether it will be China or the United States.

Rest of the world: A very mixed picture

In the United States, the latest June data were broadly better than expected which tends to indicate growth is strengthening: unemployment is near a 50-years low and way below NAIRU, inflation expectations are slowly rising, retail sales were strong for two months in a row, ISM manufacturing was out at 51.7, with production and employment growing. The weakest spot is industrial production which has moved lower again in June, at 1.3% YoY, as a consequence of the gloomy global trade outlook. One risk that investors will need to monitor in the coming months is linked to rising inflation that could negatively impact US households’ purchasing power in a context of low wage increase. To assess it, we like to look at unconventional indicators in order to detect very early signals of inflationary pressures. We are a fan of Disney Parks attendance growth, which has been a reliable tracker of economic activity in the past. Based on preliminary data, it could be one of the slowest summers at US Disney Parks in over a decade. It is bright clear that price hikes are finally having an effect on guest attendance. This is also one explanation behind the fact that one-fourth of Americans canceled vacation plans this summer. We fear that it might be an early indicator that inflation starts to be at pain level and will require more attention from the Fed in coming months if it lasts. 
In Europe, the outlook is more worrying, mostly because of Germany’s depressed economy. The euro area economic surprise index is still in negative territory, standing at minus 8.8 and there is no sign of improvement coming. Sentix expectations for the eurozone are down at minus 13 in July and for Germany, it is even worse at minus 16. We are halfway into the year and there is still no indication that the German manufacturing sector is about to rebound. On the contrary, the latest data, including the ZEW climate index, point out the increasing risk of recession in H2 2019. The only hope for Germany is that the service sector will keep following its positive momentum helped by resilient domestic demand.

All eyes on central banks in the coming weeks

Looking ahead, we all know that the main market focus will be on central bank meetings at the end of the month. It will be the confirmation we are in a completely new monetary and economic paradigm where unconventional tools used after 2008 are becoming conventional tools in a world of very low neutral rates.
 
What is quite unique this time is that both the Fed and the ECB are ready to pull the trigger to act pre-emptively. Though there are more fundamental reasons for the ECB to act (risk of recession in Germany and subdued inflation), it is more questionable for the Fed. The macro case for rate cuts in the United States is debatable, especially if we consider that the Fed is first and foremost “data dependent”. The economy is in a rather good shape, but it seems that the Fed’s goal to loosen monetary policy is motivated by other considerations:

  • In his speech early this week, Powell implicitly confirmed that the Fed has certainly overtightened this cycle and is now looking to reverse the December hike which looks increasingly like as a monetary policy error.
  • The Fed has always taken into consideration the global context, but it seems this time it is playing a dominant role. In his short testimony to Congress, Powell used the words uncertainties and risk many times, putting very special attention on global factors, which constitutes a change compared to previous cycles.
At the time of writing, the Fed funds futures price a 70% chance of a 25bp cut and a 30% chance of a 50bp cut on July 31st.  Our view is that the Fed will cut rates by 25bp this month and, if needed, will act again in September. We have received a lot of questions from clients regarding the impact of the expected rate cut. The conventional wisdom is that the first rate cut is bullish for the stock market, but it has not always been true, especially taking into consideration the last two first Fed cuts. In addition, there are two factors playing against a strong rally: the 25 bp cut has already been priced in and, more importantly, in a QE world, it is probably useless to predict market reaction based on pre-QE history. 

Finally, as it was the case many times over the past decade, it is likely that the Fed and the ECB will try to avoid monetary policy divergence that could have a negative impact on exchange rates while we are on the breach of a currency war triggered by the Trump administration. The latest ECB minutes mentioned a “broad agreement” among the Governing Council to be ready to ease monetary policy again, referring to “strengthening forward guidance, resuming net asset purchases and decreasing policy rates”. We see a policy move more likely on September 12th than on the next policy meeting on July 25th. It could be officially motivated by subdued inflation, but the primary concern will be the deteriorated economic outlook in Germany. At first, we expect a slight adjustment in interest rates, by moving the deposit rate further into negative territory. However, as it is unlikely to have a significant impact, the ECB will need to apply more drastic measures, especially exiting limits of its QE program by rising the ownership ceiling for bond issues to 50% from the current 33%%. This is the era of QE infinity. 

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