A dangerous mix of circumstances
Today's news headlines:
- ‘India joins New Zealand with bigger-than-forecast rate cut’. The central banks in India and New Zealand have both cut interest rates following last week’s Federal Reserve rate cut. The escalation of the US-China trade war is increasing pressure on policymakers across the globe to accommodate downside risks to economic growth.
- ‘EU stands firm as UK heads for no-deal Brexit’. The EU recognises a no-deal Brexit is becoming more likely as it refuses Boris Johnson’s demand for a renegotiation of the withdrawal agreement. The prospect of bespoke ‘mini-deals’ on the side is proving controversial within the bloc, with many officials refusing to back such deals.
The new 10% tariffs on China change the global growth story in a way previous tariffs haven't. Ever since the trade tensions began, the lack of certainty has hamstrung business investment—global supply chains aren't easily or quickly reshuffled—but the consumer was still in a good place because of the record-low levels of unemployment. This type of risk-off dynamic tends to feed more conservative asset allocation, contributing to US Dollar, Swiss Franc, and Japanese Yen appreciation. The prolonged nature of the low interest rate and weak growth environment has driven both fixed income and equities classes higher in unison. This is somewhat more surprising; in past economic cycles, flights to safety would tend to drive investors into bonds and out of equities. Uniformly high asset prices have, in turn, driven investors to ever-riskier assets in the search for return, a phenomenon called 'reach for yield'. Our view has been that central banks have used most of their proverbial monetary policy ammunition and, at some point in the near future, the lack of economic growth would undermine disproportionately high prices.
The reason these new tariffs change the story is because they directly impact the consumer. With trade tensions holding back business investment—budget constraints and political polarisation preventing government investment—the consumer is driving the current modest economic growth. Bearing in mind, of course, that the average consumer hasn't seen a meaningful pay rise in nearly a decade, a tax on a broad range of consumer goods is likely to land at a time of consumer price sensitivity. The market's expectation of continued central bank support is also perhaps optimistic (read our weekly) so the asset prices reflecting this growing expectation are only stretching prices further beyond economic reality. That is a dangerous mix of circumstances.
Bottom line: Only a week ago, the Dollar seemed to have topped-out, but this latest hit to global growth expectations and accompanying expectation of central bank easing is likely to extend the asset rally further and preserve/extend Dollar strength for some time yet. Our concern is that a consumer-led slowdown is likely to hit leveraged loan and high yield markets rather acutely in the back of the year. Then again, with Donald Trump, nothing is for certain, and the tariffs may never materialise.
Commodity prices are affirming the rising US and China trade tensions are hitting global growth. Due to its safe-haven status, Gold Futures have benefitted to the tune of almost 18% since May and reached the key $1500 per troy ounce level last seen in April 2013. The People's Bank of China embarked upon a bullion-buying spree long before the recent trade war escalation, and official data (released today) could indicate that China's gold reserves grew for an eighth consecutive month. Long considered a hedge against inflation, it's more accurate to characterise gold as a hedge against economic uncertainty. The large-scale central bank purchases of gold reserves, on some level, reflect diminishing confidence in economic health.
Oil prices are a quintessential proxy for global economic activity since oil is a key input into so many parts of the economy: manufacturing, transportation, petrochemical plastics, etc. The global benchmark, Brent crude, has tumbled more than 20% since a late-April peak, meeting the traditional definition of a 'bear market'. Bart Melek, Head of Global Commodity Strategy at TD Securities, said that the impact of a full-blown trade war could mean markets significantly overestimated demand growth for oil—a sign of continued downward price pressure. The deteriorating relationship between the two economic behemoths has also spurred speculation that China will avoid buying US oil in expectation of Beijing imposing tariffs.
Bottom line: We learned back in April that oil prices above the $74 per barrel were a drag on global growth, and self-imposed OPEC+ production cuts had supported Brent above $60 per barrel. The breach of this natural trading range below $60 per barrel highlights the severity of the current turn of events in the US/China trade dispute. This measure will be watched particularly closely to see if the downward pressure continues, a prediction of an economic slowdown.
A reduction in Brexit related news has caused the pair to trade in a tight range this month with support at 1.21. The Sterling Index remains anchored to all-time lows while the Dollar Index continues its rebound following last week’s rate cut from the Fed.
With little development in the Brexit story, the anchored Sterling Index and a rallying Euro pushed the pair to two-year lows in yesterday’s session. The 200-daily moving average may be a key support level for the Euro, suggesting lows for the pair may easily be tested again in the short-term.
After breaking above the 200-daily moving average earlier this week, the Euro Index is trading marginally above the key level this morning. The Euro appears to be the lesser-of-all-evils right now as the pair trades around the 1.12 region.