Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
Trump tariffs comment spark risk-off
Peter Garnry
Chief Investment Strategist
Summary: Equities are retreating today on Trump's comments as the US-China trade deal again seems uncertain. In today's equity update we also focus on the OECD leading indicators released yesterday showing the global economy's growth momentum eased for the 20-straight month with most worryingly no signs of stabilising in the US leading indicators. Finally we take a look at China's broken credit channel and Italy seemingly being the big winner of ECB's new tiering system on excess reserves in the euro area.
Global equities are downhill today as the US president at the Economic Club of New York said that tariffs on China would be “raised very substantially” if the “phase one” US-China trade deal did not go through. It’s clear that behind the glossy comments in October about a tentative agreement from both sides that things are not progressing as well as initially thought. In addition, the protesters in Hong Kong are becoming more and more violent adding to risk-off sentiment. The STOXX 600 Index in Europe is down 0.8% and safe-haven assets such as JPY and JGBs are bid overnight. This seems to be the never-ending story of US-China trade deal.
The ongoing tensions between the two largest economies are beginning to have a serious impact on businesses’ willingness to invest. A recent study released yesterday by the German Chamber of Commerce in China indicates that 25% of German companies operating in China are planning to source production elsewhere. This follows the same trend from US companies putting more on the Chinese economy. Yesterday, the OECD also released its global leading indicators (CLI) and they showed that growth momentum eased for the 20-straight month in August. While the global leading indicators show sign of stabilizing the US leading indicators are worsening with no imminent sign of stabilizing. This highlights that the current macro environment remains extremely fragile and sensitive to the slightest shocks.
China issues are not only related to the US-China trade war but also a seemingly broken credit channel. The Q3 earnings releases from Chinese banks have allowed us to update our market cap to total assets ratio for the four largest commercial banks in China. The ratio hit a new all-time low of 5.8 in Q3 driven total assets growing annualized 8% in Q3 while market cap of the four banks declined. Our interpretation is that Chinese investors are not valuing these new assets as high quality and the most likely dynamic in China right now is that the current credit expansion is just offsetting the rise in bad loans. The net effect is zero credit transmission to the real economy in China constraining economic growth.
There are also positive stories most notably in Italy where the FTSE MIB Index has been very strong lately as evidence shows that the ECB’s new tiering system for excess deposits is doing considerable redistribution inside the euro area. Italian banks are benefitting the most with banks moving excess reserves from Germany, Belgium and the Netherlands as excess reserves above the limit staying in those countries would be penalized relative to move them to Italy. Italian banks deposits with the ECB have increased by €37bn to €138bn and thus reduced the net claims inside the euro area. In addition, recent data from Bank of Italy showed that non-performing loans are declining in Italy improving balance sheets and credit quality. On top of these good news for Italian banks several Italian companies including Enel have delivered better than expected earnings. Italian equities are up 33% year-to-date making them one of the best performing equities globally this year. Adding to the attractiveness of Italian equities is the fact that they are valued at a 40% discount to global equities. The risks in Italian equities are heavy debt financed companies, low profitability and a constant uncertain political situation.
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