Combating Recession Risks

Following a volatile last week market attention will remain on trade tensions, measures to combat the risks of recession and will turn to the Jackson Hole central bankers’ symposium at the end of the week. The inversion of the US yield curve has led to growing expectations that the US is heading into recession and has spurred inflows into bonds. As a result US Treasury yields continue to fall and the stockpile of negative yielding debt has risen to well over $16 trillion. While economic data in the US remains relatively firm, the picture in the rest of the world has deteriorated sharply as reflected in weakening German and Chinese trade, against the background of a weak trade backdrop.

There have been some mixed headlines on trade over the weekend – Larry Kudlow, Director of the National Economic Council under President Trump, said yesterday that recent phone calls between US and Chinese trade negotiators had been “positive”, with more teleconference meetings planned over the next 10 days.  Separately US media reported that the US commerce department was preparing to extend a temporary license for companies to do business with Huawei for 90 days. However, Trump poured cold water on this by stating that “Huawei is a company that we may not do business with at all”.  A decision will be made today.

In the wake of growing expectations of recession, attention is turning on what will be done by governments and central banks to combat such risks.  The Jackson Hole meeting on Thursday will be particularly important to gauge what major central bankers are thinking and in particular whether and to what degree Federal Reserve Chairman Powell is planning on cutting US rates further.  We will be able to garner further evidence of Fed deliberations, with the release of the Fed FOMC July meeting minutes on Wednesday.

While central bankers look at potential monetary policy steps governments are likely to look at ways of providing further fiscal stimulus.  Kudlow stated that the US administration was “looking at” the prospects of tax cuts, while pressure on the German government to loosen is purse strings has also grown.  Even in the UK where a hard Brexit looms, the government is reportedly readying itself with a fiscal package to support growth in the aftermath.   Such news will come as a relief to markets, but recession worries are not likely to dissipate quickly, which will likely keep volatility elevated, and maintain the bias towards safe haven assets in the weeks ahead.

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A Host Of Global Risks

Last week was a tumultuous one to say the least.  It’s been a long time since so many risk factors have come together at the same time.  The list is a long one and includes the escalation of the US-China trade war, which last week saw President Trump announce further tariffs on the remaining $300bn of Chinese exports to the US that do not already have tariffs levied on them, a break of USDCNY 7.00 and the US officially naming China as a currency manipulator.

The list of risk factors afflicting sentiment also includes intensifying Japan-Korea trade tensions, growing potential for a no-deal Brexit, demonstrations in Hong Kong, risks of a fresh election in Italy, growing fears of another Argentina default, ongoing tensions with Iran and escalating tensions between India and Pakistan over Kashmir.

All of this is taking place against the background of weakening global growth, with officials globally cutting their growth forecasts and sharply lower yields in G10 bond markets.  The latest country to miss its growth estimates is Singapore, a highly trade driven economy and bellwether of global trade, which today slashed its GDP forecasts.

Central banks are reacting by easing policy.  Last week, the New Zealand’s RBNZ, cut its policy rate by a bigger than expected 50 basis points, India cut its policy rate by a bigger than expected 35 basis points and Thailand surprisingly cutting by 25 basis points.  More rate cuts/policy easing is in the pipeline globally in the weeks and months ahead, with all eyes on the next moves by the Fed.  Moving into focus in this respect will be the Jackson Hole central bankers’ symposium on 22/23 August and Fed FOMC minutes on 21 August.

After the abrupt and sharp depreciation in China’s currency CNY, last week and break of USDCNY 7.00 there is evidence that China wants to control/slow the pace of depreciation to avoid a repeat, even as the overall path of the currency remains a weaker one. Firstly, CNY fixings have been generally stronger than expected over recent days and secondly, the spread between CNY and CNH has widened sharply, with the former stronger than the latter by a wider margin than usual.  Thirdly, comments from Chinese officials suggest that they are no keen on sharp pace of depreciation.

Markets will remain on tenterhooks given all the factors above and it finally seems that equity markets are succumbing to pressure, with stocks broadly lower over the last month, even as gains for the year remain relatively healthy.  The US dollar has remained a beneficiary of higher risk aversion though safe havens including Japanese yen and Swiss Franc are the main gainers in line with the move into safe assets globally.  Unfortunately there is little chance of any turnaround anytime soon given the potential for any one or more of the above risk factors to worsen.

What To Watch This Week

Market expectations for Fed FOMC interest rate cuts have gyrated back and forth following a recent speech by NY Fed President Williams, one of the key decision makers within the Fed FOMC. He appeared to support a 50bps rate cut at the meeting at the end of the month, but unusually this was clarified later.  If anything, as the clarification may suggest, the bigger probability is that the Fed eases policy by 25bps in an insurance cut.

There will be no Fed speakers in the days ahead but the Fed will assess developments this week in helping to determine the magnitude of easing. Attention will continue to centre on US earnings, with more than a quarter of S&P 500 companies reporting Q2 earnings this week.   On the data front, US Q2 GDP and July durable goods orders will command most attention.  The consensus looks for a slowing in GDP growth to 1.8% q/q in Q1 from 3.1% q/q in Q1 while durable goods orders are expected to increase by 0.7% m/m.

A major central bank in action this week is the European Central Bank on Thursday. While policy easing is unlikely at this meeting, the ECB is likely to set to set the market up for an easing in deposit rates at the September meeting.  ECB President Draghi could do this by strengthening his forward guidance, but as a lot of this is priced in by the market, a dovish sounding Draghi is unlikely to weigh too much on the EUR.

In the UK this week it’s all about politics. Boris Johnson is widely expected to be announced as the new Prime Minister.  GBPUSD has clung onto the 1.25 handle, as worries about a no deal Brexit continue to impact sentiment towards the currency.  Once Johnson is sworn in he and the government could face a no confidence motion, which could gain support should it be seen as an alternative to the UK crashing out of the EU.

National elections in Japan yesterday resulted in a victory according to Japanese press for Shinzo Abe’s coalition, its sixth straight victory, with the governing LDP winning over half the 124 seats. The results were no surprise, and unlikely to have a significant market impact, but notably Abe suffered a setback by not gaining a supermajority. He therefore cannot change the country’s pacifist constitution.

In emerging markets, both Russia and Turkey are likely to cut interest rates this week, with Russia predicted to cut its key rate by 25bp and Turkey to cut by at least 200bps if not more.  Elsewhere geopolitical tensions will remain a major focus for markets, as tensions between the UK and Iran intensify.

Fed’s Powell & China trade data in focus

US jobs data released at the end of last week will diminish hopes of more aggressive policy rate cuts from the Fed FOMC at its policy meeting at the end of the month. Non-farm payrolls rose by 224,000 last month, beating market forecasts, a sharp improvement from the disappointing 72,000 increase in the previous month.

Despite the stronger than expected reading in June, the Fed is still likely to cut interest rates by 25 basis points amid concerns about a loss of growth momentum, trade tensions against the background of low inflation.  Soft US June CPI releases on Thursday this week will likely confirm the subdued inflationary backdrop.

Markets will be able to garner more clues during Fed Chair Powell’s testimony to Congress on Wednesday and Thursday while Fed FOMC minutes from the last meeting will also provide greater detail on Fed thinking.  Both are likely to help confirm expectations of a 25 basis point cut in rates at the next FOMC meeting.

The USD has recovered some if recent losses, helped at the end of last week but the US jobs report.  Further gains are likely to be limited (with the USD index likely to struggle to break 98.0) though much will depend on Powell’s testimony this week.

Also in focus this week will be China’s June trade data.  This data will be scrutinised in particular, for the trade surplus with the US and whether there are any signs of this surplus beginning to narrow.  The data will also give some indications of the health of China’s economy, with another weak print for imports, likely to show further softening in China’s growth momentum. Similarly weaker exports will highlight the softening in demand from key trading partners such as Korea.

Further evidence on the outlook for China’s economy will be seen in the release of monetary aggregates including new loan growth and aggregate financing. Meanwhile, China’s currency continues to remain stable amid the trade truce with the US.

 

Waiting For US Jobs Data

Ahead of the US jobs report later today and following a lack of leads from US markets after the 4th July Independence Day holiday, markets are likely to tread water, at least until the employment report is released.  However, there are plenty of factors lurking in the background including the ongoing US-China trade war, US-Iran geopolitical tensions, and growing trade spat between Korea and Japan.

Markets continue to be supported by expectations of monetary easing globally.  This week, bond markets have continued to rally, helped by President Trump’s nomination of July Shelton and Christopher Waller for the Board of Governors of the Federal Reserve, both of which are considered dovish.  Separately, markets applauded the backing of Christine Lagarde to lead the European Central Bank after weeks of wrangling by European leaders.

Immediate attention will be on the US June jobs data.  Market expectations are for a 160,000 increase in non-farm payrolls, unemployment rate at 3.6% and average earnings growth of 0.3% compared to the previous month, 3.2% compared to the year earlier.  Anything much worse, for example an outcome below 100k would likely lead to an intensification of expectations that the Fed FOMC will cut by as much as 50 basis points later this month.  An outcome around consensus would likely result in a 25bp easing by the Fed FOMC.

Separately trade tensions between Japan and Korea have intensified. Japan is implementing restrictions on exports to Korea of chemicals essential for chip making. Japan is Korea’s fourth largest export market. The new approval process required by Japanese exporters of three semiconductor industry chemicals will hit Korea’s tech industry at a time when it is already suffering.  The trade spat could also have widespread implications given the wide range of products that South Korean chips are used in, impacting supply chains globally.

G20, Fed and Iran

Market attention this week will focus on Fed speakers, the G20 meeting and tensions between the US and Iran.  Here are my thoughts on all three:

Federal Reserve Chairman Powell and Vice Chair Williams are both scheduled to speak tomorrow.  Investors will be looking for any further clues on the path, timing and magnitude of Fed interest rates in the months ahead and whether they validate market expectations of easing at the July FOMC meeting.   Markets are already pricing in several cuts and a result the USD has weakened sharply over recent months, suggesting that the bar to an even more dovish stance is high.  Nonetheless, the Fed is at least likely to deliver a 25bp rate cut at the July meeting followed by at least one or two further hikes this year.

The main event this week (Fri-Sat) is the G20 meeting in Japan and in particular the potential meeting between Presidents Trump and Xi on the sidelines.  Expectations/optimism towards some form of progress on trade talks appears high.  Markets are set to remain upbeat heading into the G20, suggesting that risk assets will maintain their rally this week, which will bode well for equities. However, the reality is that the gap between both sides remain wide and there may be some positive noises emanating from the G20 on trade, concrete progress is likely to be limited.

Trump and Xi are likely to discuss a range of issues, with trade teams from both sides preparing the topics for discussion, after talks broke down last month.  It is likely that both Trump and Xi will agree to continue more formal talks, with both leaders sounding positive in the run up to the G20.  However, the threat of additional 25% US tariffs on the remaining $300bn of Chinese exports to the US, remains in place and it is unlikely that this will be taken off the table without some major concessions from China.  As I’ve previously stated it could take months before a concrete deal is agreed upon.  In the meantime global trade will continue to deteriorate.

Elsewhere geopolitical tensions remain in focus as President Trump threatens Iran with additional sanctions in an effort to force Iran to renegotiate the 2015 nuclear accord, as early as today. This follows Trump’s decision to call off planned air strikes in response to Iran’s shooting down of an unmanned drone.  Iranian oil exports have plunged as a result of sanctions and oil prices continue to react, rallying by around 8.7% in just under a week.  Markets will remain nervous over the risks of any further escalation, leaving oil prices susceptible to a further push higher.

 

Dovish Fed Hits The US Dollar

The US Federal Reserve shifted towards a dovish stance yesterday and asset markets applauded.   Against the background of signs of slowing growth, intensifying trade tensions and growing “uncertainties” about the economic outlook, the Fed removed the previous “patient” stance and instead noted that “act as appropriate to sustain the expansion”.   The bottom line is that the Fed is priming the market for easing as early as July, though the market had already primed itself by moving sharply in terms of pricing in rate cuts over recent weeks.   The market is now pricing in three rate cuts this year and at least one next year, which seems reasonable.

Clearly there are a huge number of uncertainties ahead, making the Fed’s job particularly difficult and the picture could look quite different should the upcoming G20 meeting in Japan (28-29 June) deliver some form of trade agreement between the US and China.  This would likely result in less need for Fed easing.  As I have noted previously there are still a huge number of challenges and obstacles to any such agreement, suggesting that market hopes of an agreement stand a good risk of being dashed.   Until then, risk assets will remain upbeat, with equity markets rallying in the wake of the Fed decision even as bond yields moved lower and gold prices reached a 5-year high.

The USD remains under pressure and took another blow in the wake of the FOMC meeting.  The USD has now lost ground against almost all G10 currencies except GBP amid Brexit concerns over the last month.  This has extended today and the currency looks set to remain under pressure in the short term as markets continue to price in Fed rate cuts.  The tension between President Trump and Fed Chairman Powell is not doing the USD any good either.  The USD index (DXY) is now threatening to break below its 200-day moving average (96.710) though this has proven to provide strong support in the past.  A sustained break below this level could see the USD extend losses against major and many emerging market currencies.

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