The first half of 2019 was a pretty unique period for financial markets. And so much for a ‘quiet summer’ – August volatility was the equivalent of a perfect storm… What’s in store for markets and investors over the months ahead?
Despite a general further weakening of the global economy during the first half of 2019, every asset class saw positive returns: equities, fixed income, credit and commodities. The reason, of course, is that central banks have shifted dramatically toward more dovish stances.
A fresh wave of monetary easing and political uncertainty
We are now at the start of a new wave of monetary easing from most major central banks, including the Federal Reserve, the European Central Bank (ECB) and the Bank of England (BoE). And we are already seeing a string of rate cuts by smaller G10 and emerging market central banks.
Four core macro themes for the rest of 2019
As we think about how to navigate the coming months there are four core macro themes that are sure to play a role in asset prices.
- Risk assets: Priced to perfection
- UK: Back on the radar but for all the wrong reasons
- Europe: The need for fiscal policy
- US dollar: The next big move is likely down
Risk assets: Priced to perfection
One striking feature of risk-asset pricing is how much they have diverged from the global manufacturing cycle. Chart 1 below shows the global manufacturing Purchasing Managers Index (PMI) against the NatWest Markets’ growth-linked asset basket. The growth-linked asset basket is a collection of assets whose value very closely tied to global economic growth – their prices rise as growth increases.
The gap is an indicator of sentiment – the larger the gap, the further sentiment is from actual growth. The blue and purple lines run quite closely together for most of the chart until very recently. As indicated by the red circle, today shows the largest gap in more than a decade. So this chart clearly demonstrates how successful central banks have been in boosting market confidence despite very weak manufacturing growth.
Going forward, it will be increasingly difficult to sustain this gap indefinitely. Unfortunately, we think that the underperformance of risk assets is more likely than an improvement in global manufacturing.
 G10 countries are Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the UK and the US.  Risk assets are defined as those which are by their nature, not risk free such as equities, high yield bonds or derivatives
Chart 1: Global manufacturing PMI and a basket of growth-linked assets
Factors behind the weakness in global industry
There are many factors behind the weakness in global industry, but likely the biggest is the escalation in trade tensions over the past 18 months. A surge in exporter anxieties led the downturn in global manufacturing, and we don’t see much reason to expect an improvement in the coming months (see Chart 2). At time of print, tensions between the US and China have re-escalated, with a new tranche of tariffs expected to go into force in September. Meanwhile, the threat of tariffs on European goods remains a clear and present danger. The key point is that the US Administration’s unpredictable use of tariffs is providing a shock to the global trading system – the economic implications are hard to measure, but almost certainly negative and very likely persistent.
Chart 2: Global manufacturing PMI and export orders
UK: Back on the radar but for all the wrong reasons
For much of the past 18 months, Brexit uncertainty has been the main driver of UK assets prices and the pound. After a period of quiet, we are set for a new wave of political uncertainty into the end of the year.
The 31 October date looms large and it is as uncertain as ever where things are headed. It is certainly plausible that a new deal is agreed before the date, but we wouldn’t place a very high probability on it. This leaves us with a few very different outcome - a ‘no deal’ Brexit, a new delay or a revocation of Article 50. In any outcome, general elections risk loom large, most likely in October or November. Markets will not like the inherent uncertainty around a new UK election.
Alongside political uncertainty, the UK economy is experiencing an acute period of weakness. Some of this weakness looks due to a reversal of inventory stockpiling ahead the original March Brexit. But the weakness is widespread and looks at least partly driven by the extended period of Brexit uncertainty. For much of the past few years the Bank of England has maintained a tightening bias. This needs to change. Our view is that rate cuts are coming, not rate hikes. Expect more sterling weakness as well.
Europe: The need for fiscal policy
It looks nearly certain that the European Central Bank (ECB) will launch a new phase of monetary easing at its September meeting. We expect a package of easing which includes a:
- 0.1% cut in interest rates (10 basis points)
- Some firm of rate tiering to ease pressure on banks
- Restart of quantitative easing
- Relaxation on issue/issuer limits
This would go some way in convincing markets that the ECB has not quite run out of ammunition, at least not yet.
But ECB easing is at best the third most interesting story in Europe today. Ahead of it are two key transitions, both of which point to an easing of fiscal policy in 2020: The first transition is in Germany’s economy and second is ECB leadership transition.
Transition one: Germany economy
For the first time in almost 15 years, German industry is the weak link in the euro area. It is likely to persist. Germany’s economic model is built on the premise of a globalised trading network, which is now under threat from a significant rise in protectionism. It doesn’t help that the global auto sector is experiencing both cyclical and structural headwinds. As in Chart 3 below, you can see that there is a big difference between the structural budget balance for Germany versus the US (as indicated by the red circle).
Chart 3: Structure budget balances for Germany and US
Transition two: ECB leadership
The second transition is at the ECB. This autumn, Mario Draghi will step down and be replaced by Christine Lagarde. This change is significant. Draghi’s was the right person for the past 10 years – he was able to steer the euro area out of crisis by breaking down institutional boundaries and find ways to add monetary stimulus and shore up the banking system.
Now, with much of the monetary ammunition spent, the ECB needs a leader that can argue for more balance between monetary and fiscal policy. Christine Lagarde looks to us the right person for this next challenge. She has astute political skills and has already been a big proponent of more fiscal stimulus as head of the International Monetary Fund.
European outlook: All eyes on Germany
So for now, the focus for Europe is about what form the next monetary stimulus will take. Before long however, the debate will heat up about how to strike a better balance between monetary and fiscal stimulus.
All eyes will be on Germany. Its industrial sector is experiencing acute stress. And unlike most other major economies, Germany has a huge amount of fiscal ammunition to deploy, if it wants to use it of course.
US dollar: Expect a downward shift
For the past few years, the dollar has had a lot going for it. Cyclical supportive factors have certainly helped, namely:
- Strong growth
- Attractive returns
- Better performing stock and bond markets
And this has certainly been more than enough to offset an overvalued currency and a large twin deficit (fiscal deficit and current account deficit combined).
Looking ahead however, there is evidence to suggest that these supports will fade. US growth looks to be peaking, if slowly. The US stock market looks stretched, given steep valuations and a fading earnings cycle. Meanwhile, the yield pick-up on US bonds is diminishing rapidly as the US Federal Reserve (the Fed) has started cutting rates.
When will dollar weakness begin?
It is difficult to say with certainty what the timing and catalyst will be for next phase of broad-based dollar weakness, if it comes at all. What is clear, is that US policy is becoming an obstacle to more dollar strength.
The latest budget deal sets the stage for more over-spending at a time when the deficit is at its largest in 50 years. Meanwhile, the outlook for Fed policy is now finely balanced. If the Fed over-delivers, it will put downside pressure on the US dollar. Whereas, if the Federal Open Market Committee (FOMC) under delivers, the risk is two-fold: a sharp dollar rally and potential intervention from the US treasury as the Trump administration grows tired of persistent dollar strength.
And as we can see in Chart 4, the US dollar bubble (indicated by the red square) is very small compared to most other G10 currencies. This bubble captures nicely the combination of the dollar’s long-running over-valuation and its large and rising twin deficits – not a good mix for a currency.
In our view, the path of least resistance for the US dollar in the coming months is down. Either way, recent record low levels of foreign exchange volatility looks wrong in the backdrop we are heading into.
Chart 4: G10 currencies bubble chart
Navigating this new policy phase looks set to be tricky
It is hard to say with certainty what the rest of 2019 will bring. One thing is clear: the stage of policy execution we are entering will be much trickier than the period of policy promise we just exited. This is especially true now, with markets expecting a fairly aggressive cycle of monetary easing in the coming month. We look forwarding to seeing how things play out.