– changes in the structure of the global economy
– conclusions from the analysis of the US yield curve and projection of its shape
– political risks and obstacles on the world map 2019
– elections to the European Parliament: Parliament’s structure and its implications
– Brexit: what’s next
– market overview: perspectives and significant risks
Market report May 2019
In our opinion, the global economy may be remodeled in the coming months, which will be determined by three main factors:
USA – China, change in the world producer of growth
One of the macroeconomic scenarios (optimistic) forecasts a decline in GDP growth in the US from 2.9% in 2018 to 2.2% in 2019 and 1.6% in 2020. China’s economic growth is expected to remain relatively resilient (+ 6.4 %), mainly due to the proactive stimulus package (4.15 trn CNY, 5% of GDP). As a result, we expect China to replace the US as the main source of global growth in 2019 and 2020.
Making monetary policy more flexible for central banks
After the tightening phase, falling inflation prompts major central banks to re-examine expansive moves. The majority of central banks, including the FED and the ECB, changed their position on communication towards more accommodative orientations.
Searching for commercial risk de-escalation
The agreement on the US-China line, according to our assessment, is currently difficult to achieve. This is not due to cultural differences, but more to the priorities of both countries and the various development phases in which the US and China are located. We expect discussions to play a stabilizing role in global trade and growth, which we believe can be achieved in 2020. China will continue its policy, seeking new markets for its products (Russia, Asia, South America), the US as part of a created curtain smokers will seek to change the balance of power in the Middle East.
In February, the FED favored “patience” in the normalization of monetary policy and declared that a return to pre-crisis level to the size of its balance sheet is not possible. This reorientation took place in the face of uncertainty in world trade, government shutdown (the longest in US economic history). In March, Jerome Powell said that it is unlikely that the interest rate increase would take place in 2019. The FED also confirmed that the rate of reduction of its assets portfolio would be reduced.
At the March meeting, the ECB decided to “overtake” the yield curve with policy announcements. Based on a sharp reduction in macroeconomic forecasts, in particular the forecast for 2019, the ECB revised its forecasts, with key interest rates currently suspended for at least the remainder of 2019. Another round of TLTRO funding was announced (Targeted Longer- Term Refinancing Operations) aimed at counteracting all bottlenecks in the terms of granting loans to commercial banks financing lending to companies and individual consumers in order to ensure the proper functioning of the monetary policy transmission channel and to control inflation.
Chart showing the structure of global GDP growth in 2013-QI 2019, taking into account the shares of individual countries:
US Yield curve – warning signals from the US interest rate market
In March 2019, the spread between the long and short end of the US yield curve entered the negative territory, causing fears of an economic slowdown. Over the past 60 years, every economic downturn in the United States has been preceded by a reversal of the yield curve.
The current shape of the yield curve is likely to take longer. The short-end anchoring of the curve by the Federal Reserve at 2.5%, as well as the hidden stickiness of the long end of the curve, valued at 2.5%, indicate the possibility of a further reversal of the yield curve. Warning signs resulting from the current and future shape of the yield curve suggest that the economic slowdown in the US is likely.
Shape of the yield curve of the US for the years 2016-2019
The table presents particular years in which the “reverse” yield curve appeared, the current interpretation of the market situation and what the market actually showed:
Reversal of the curve is explained by the banks buying long-term Treasuries instead of financing the real estate market
The short recession of the American economy lasts from June 1990 to March 1991, rising interest rates and oil prices caused by the invasion of Iraq on Kuwait and the First Gulf War, the sell-off of the S&P 500 -25%
The budget surplus of the Clinton administration does not need to be financed by long-term instruments
Recession in March-November 2001, dotcom bubble burst, WTC September 11, S&P 500 index sell-off -20%
The global transfer of savings causes a reduction in the profitability of long-term securities
Recession in December 2007-June 2009, global financial crisis, sell-off of the S&P 500 -51%
Real image distortion caused by the FED loosening program, increased market financing through the issue of short-term securities (below 1 year) and low level of interest rates
Source: Financial Times
To perform the projection of the yield curve structure, the behavior of the short and long end of the curve is analyzed separately. As for the short end of the curve, the latest federal economic forecasts show forecasts for the central trend of 2019 at the level of 2.4-2.6%, and its long-term forecast value is 2.5-3.0%, which means that the curve at its short end will remain anchored at around 2.5% in 2019 and 2020. Similarly, economists predict that the short end of the curve will remain at 2.50% in 2019 and in 2020 (Bloomberg).
Going to the long end of the curve (represented by 10Y US Treasury yields), the Bloomberg survey shows that most economists expect a slight increase in long-term yields, with 10Y Treasuries at 2.75% by the end of 2019. And 2, 87% by the end of 2020. In our view, the long end of the yield curve is close to the internal fair value of ~ 2.5%. The elasticity of the “fair value” of US 10-year Treasuries is low, suggesting that the long end of the curve appears to be quite sticky and is unlikely to shift in any direction.
Considering both the short and the long end of the curve, the US yield curve is likely to remain flat at best in the near future. Based on this premise, another round of the yield curve inversion is possible. Considering the uncertainty caused by the reversal of the yield curve, the downside risk strategy is justified in order to protect the portfolios and realize the likely economic downturn over time.
Political risks and obstacles on the world map
Elections to the European Parliament
What does the fragmented European Parliament mean for EU priorities
Over the next few months, the most important people in the European Union will change positions: the President of the European Council; President and Commissioners of the European Commission and President of the European Central Bank. These nominations will be influenced by the results of the European elections in May 2019, as a result of which, for the first time in 40 years, a grand coalition was formed – including the European People’s Party (PPE), the Progressive Alliance of Socialists and Democrats (S & D). The Alliance needs a Alliance of Liberals and Democrats for Europe and the Renaissance (ALDE & R) to be able to create a majority capable of governing. Eurosceptic parties lost the blocking minority (33.33%). The strength of the Greens (almost 10% of seats) suggests that they can be the driving force of Parliament. They could work with mainstream parties to have a bigger voice in the EU’s reform agenda. Considering that the majority of Green voters are under 30, mainstream parties may also be willing to compromise, which may lead to a ruling coalition of over two-thirds.
We expect the newly created Commission to focus on purchasing power and social policy, security, defense and climate change over the next five years. The tripartite program can be supported by non-traditional parties.
♦ Identified by us as “easy topics”, which should receive broad support in the first half of the five-year term, reform of the European Stability Mechanism (ESM), higher infrastructure spending, enhanced migration control, stronger European security and defense policy, climate change mitigation reforms and ratification of the Brexit agreement (yes, we decided to put Brexit in the category of “easy topics”).
♦ “Mixed topics” that are not yet on the agenda, but the rivalry and growing populism between the US and China can help set priorities and get support in the second half of the five-year term. These are the Common Industrial Policy (CIP), including the European Purchase Act, the reinsurance program for the unemployed, and proceedings against EU countries that diverge from European democratic values.
♦ “Difficult topics”: the European Deposit Insurance Scheme (EDIS) to finalize the Banking Union; Capital Markets Union (CMU) and less financial regulations; new Free Trade Agreements (FTAs); central budget for the euro area with a dedicated joint minister of finance and further enlargement of the EU.
The table illustrates the current balance of power in the European Parliament vs the balance of power after the vote of 2014:
May’s departure did not solve anything.
The resignation of Premier May did not bring anything new. The prime minister has been widely condemned for handling the Brexit process, but this is not the main reason why the negotiations so far have been unsuccessful. The biggest obstacles were the lack of agreement of key stakeholders on the compromise – the wings of the Conservative Party, Labor MPs and EU parliamenters on the hard “Brexit”, as well as the failure to find a solution for Irish border security.
The Conservative Party must choose a new leader, a process that will probably take between six and eight weeks. Boris Johnson, one of the leaders of the Brexit campaign, is currently the favorite to win this vote and become the next Prime Minister of the United Kingdom – although Tory leader competitions have a long history of delivering unexpected results (May, John Major and even Margaret Thatcher). The winning candidate will most likely take a more aggressive stance on the Brexit case than in May.
Secondly, the new prime minister will face some huge restrictions:
Parliamentary arithmetic has not changed. The government has a working majority of just six places. The departure of a handful of Tory deputies would lead to the collapse of the government.
The growing support for the Brexit Party means that it will be too risky for the new prime minister to try to hold parliamentary elections before the end of Brexit.
Despite growing support for the second referendum, there is still no majority in the Parliament.
There is no guarantee that supporters of staying in the Union will win a second referendum (it is not even clear what the question will be). The EU is unlikely to reopen the exit agreement. Position on the further extension of art. 50 probably worsened.
The risks associated with the cycle are still valid
We believe that the likelihood of a prolonged recession is low. We see warning signals, but the lack of recession symptoms that would lead us to move into an underweight position in equity allows us to adopt a neutral position (in the market report of April 2019, we recommended an underweighting of equity).
We are waiting for next data from the second half of the year, in our opinion the key will be IVQ 2019 – IQ 2020. Good current data may be the result of a dispersed economy, low inflation – the result of lowering product prices (attempt to liquidate accumulated stocks) and lower oil prices.
We carefully monitor the risks associated with the cycle, in particular the areas of excess caused by many-year low interest rates around the world. These include an increase in the level of debt in the world, with the level of general government debt being higher than in 2008, and high-yield credit markets, especially in the US, look alarming. Leveraged loans are a special area of interest – the Bank of England estimates this market at USD 2.2 trillion – a potential risk to financial stability. As long as rates remain low and support growth, this risk remains limited.
Better growth can also be a threat to asset prices.
Stronger than expected growth in the US may cause the Fed to return to a more hawkish stance and resume tightening monetary policy earlier than expected by the market. Higher interest rates can put pressure on equity markets.
Low inflation sounds good. But if it continues, it can block the economy in the deflationary spiral with falling prices, slowing demand and growing unemployment. An example is the experience of Japan from the last few decades. The FED will most likely allow the economy to warm up long enough to increase inflation, even if economic growth remains robust.
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The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all RCieSolution management teams. Are subject to revision over time.