Bedrock’s Newsletter for Friday 22nd of March, 2019

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 Friday, 22nd of March 2019

“Forecasts create the mirage that the future is knowable.”

– Peter L. Bernstein

 

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Equity markets have continued to rally this past week, buoyed by dovish Central Banks on both sides of the Atlantic and despite weaker Eurozone data and all the political machinations over Brexit. On Wednesday, the Fed confirmed that it was unlikely to raise rates again this year while its balance sheet reduction (dubbed QT by some) would now end in September, three months sooner than expected. This is quite a climb down for the Fed Governor, whose bullish optimism and hawkish guidance in early December did much to precipitate the subsequent sell-off – and earn Trump’s wrath. The Fed’s base case (and ours) remains for the US to grow strongly this year, with healthy labour markets and inflation close to 2%. But with slower growth abroad, they will need to lend a hand to make this happen.

The Fed’s dovish turn has prompted big moves in global rate markets with sovereign bond yields falling around the world and across the curve. The yield on US 10Y Treasuries is now under 2.5%, a full 70bps below last year’s peak, while the yield on 10Y German Bunds has returned to zero, a level not seen since 2016. More ominously, the spread between 2Y and 10Y Treasury yields is today within a hairsbreadth of turning negative. Should that happen in a ‘yield curve inversion’, many investors would take it as a signal to begin counting down to a US recession. The pricing of futures currently implies that investors see a 40% chance that the Fed’s next move will be to cut interest rates. If the 2Y-10Y spread turns negative, we expect that probability to shoot up. Indeed, to avoid a prolonged inversion and the potential impact on confidence, lending activity and aggregate demand, the Fed may be forced to act even if other economic fundamentals suggest a recession is unlikely. Rate cuts or even a return to QE would be highly supportive for equities, providing a liquidity injection unencumbered by any dispositive change to the outlook, as well as reducing the return available on less risky investments. Moreover, even if the Fed decides merely to keep the rate hiking cycle on hold, equities should benefit: there is simply no alternative when the yield on safer assets is so paltry. In the short-term, markets may have got a bit ‘over their skis’ given the strength of the rally this year. But any correction should be seen in this context and as an opportunity to deploy cash held in reserve.

The most likely trigger for a sell-off can be found on the other side of the pond, where the probability of a ‘no deal’ Brexit is rising once more. Without warning, the Speaker of the UK House of Commons decided to block a third meaningful vote on the Withdrawal Agreement. He cited a convention from 1604 that Parliament should not have to vote on substantially the same bill more than once in each session. A technical fix is likely to be found, so this move seems designed purely to irritate the PM. Moreover, its principal beneficiaries are those who hope to make ‘no-deal’ happen by default. Although Brexit was meant to take place next Friday, the UK is now set to accept an EU offer for a short Article 50 extension. This delay will be until May 22, just before the European Parliament elections, but only if the UK Parliament passes the Withdrawal Agreement next week. If not, the extension will only last until April 12, by which time the UK must come up with an alternative plan or leave without one. To make matters worse, the PM has made strategic blunders in recent days that make a ‘no deal’ Brexit more likely. Firstly, by ruling out a long extension she reduced the pressure on those MPs who fear a protracted delay leading to a softer Brexit. She then alienated the rest of Parliament by blaming them for the mess she caused by having a handful of civil servants, not politicians, lead Brexit negotiations. At present, it is hard to see how the Withdrawal Agreement can pass next week given the political arithmetic. Therefore, a ‘no deal’ Brexit in April cannot be ruled out. But a fourth ‘meaningful vote’ in the last moments of extra time cannot be ruled out either.

Regardless of what happens with Brexit, European data looks grim. Preliminary PMI surveys suggest that France’s economy will shrink in March, with both services and manufacturing down. If this decline becomes a trend, the country could end up joining Italy in recession just as the gilet jaunes return to the streets. Meanwhile, weak Chinese demand is taking a heavy toll on German manufacturing. The preliminary PMI reading of 44.7 is well below the 50.0 level representing zero growth and suggests that the sector will contract sharply this month. On previous occasions, we have spoken at length about Germany’s unique vulnerability to de-globalisation and slower growth in China given the huge contribution of exports to the country’s economy. This seems to be showing up in the data. Although the US-China trade war has harmed the latter, and its resolution would give the economy a needed boost, China’s most intractable problems are all chronic. Afterall, the massive excess capacity in their bloated over-leveraged ‘old’ industries won’t disappear overnight. De-leveraging and restructuring could constrain Chinese growth for years and may even precipitate a crisis before the transition is complete. In this context, Germany’s reliance on foreign demand looks increasingly like an Achilles’ heel. In addition, once the US moves beyond the current trade spat with China, our bet is that Europe and Germany will be to where Trump next turns his attention.