Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Are equities ready to rally?
Peter Garnry
Chief Investment Strategist
Summary: The Fed has stepped in with what the market considers policy support while the key risk event remains the upcoming G20 summit in Buenos Aires this weekend.
Whether it was Fed chair Jerome Powell’s October 3 comments that started the subsequent equities sell-off or not, it took less than two months for Powell to change his assessment of the US economy. In a speech yesterday at the Economic Club of New York, the Fed chair sounded upbeat on the economy while indicating that the Fed Funds Rate was probably just below the neutral rate.
The reaction was immediately up 0.9% in S&P 500 index futures with momentum extending after the cash market closed; S&P 500 Index futures were up 2% in yesterday’s session. In our Equity Update webinar on Tuesday we did indeed argue that the Fed blinked and that rate hikes would likely end by Q1'19.
The economy is clearly late stage and several sectors are showing weakness, including housing. At this point it is probably more by the Fed to observe financial markets more than the economic data which by their very nature is lagging. If not, the Fed risks overshooting on rates.
The reaction was immediately up 0.9% in S&P 500 index futures with momentum extending after the cash market closed; S&P 500 Index futures were up 2% in yesterday’s session. In our Equity Update webinar on Tuesday we did indeed argue that the Fed blinked and that rate hikes would likely end by Q1'19.
The economy is clearly late stage and several sectors are showing weakness, including housing. At this point it is probably more by the Fed to observe financial markets more than the economic data which by their very nature is lagging. If not, the Fed risks overshooting on rates.
The below statements are the official wordings by the Fed chair over the two events.
October 3: “We may go past neutral. But we’re a long way from neutral at this point, probably”
November 28: “Funds rate is just below the broad range of estimates of the level that would be neutral for the economy”
A lower interest rate trajectory is short-term positive for equities and based on yesterday’s speech we are revising up equity returns post- the G20 by two percentage points across all three scenarios. The Fed’s new stance will also likely strengthen the US' negotiation hand in case the G20 leads to nothing.
Three rate hikes discounted in financial markets on top of the tariffs hike to 25% from 10% on the latest $200bn would have been toxic to equities. It would have given the Chinese a good hand against Trump in Q1 as their stimulus is working through the economy with likely effect in Q1. We are not changing the probabilities for the G20 outcome and still believe a no deal is the most likely scenario.
While we remain constructive on China’s ability to engineer a rebound in Q1, we must also recognise the things that argue against this view. Our biggest worry is whether the credit transmission has weakened to a point where the banking sector is no longer able to effectively channel stimulus to the real economy. The chart below shows the market value to total assets of the four largest Chinese banks. The ratio has been falling consistently since the Great Financial Crisis. Rising loans have not been able to lift market values one-for-one, which is essentially investors mistrusting the creditworthiness of the last years of credit extension.
While yesterday’s event was significant and important, the real risk to markets is still this weekend’s G20 meeting and the important Trump-Xi meeting. Stay safe out there.
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