The intensification of the trade discussions between the US and China as well as the increasing probability of a global economic slowdown has once again forced central banks across major economies to revise their policy path indicating a more dovish response throughout the rest of the year.
The US Federal Reserve (‘Fed’) stole the limelight at the end of December and again in January. Fed chairman Jerome Powell communicated a complete policy U-turn by pausing interest rate hikes in the near term, while also indicating the possibility of slowing down the rate of shrinking its balance sheet. This would be achieved by decelerating the run-off of security holdings acquired during their quantitative easing programme.
The US economy is running on strong labour market momentum and improving productivity as inflation remains relatively muted. Growth rates are expected to be lower compared to last year; however projections are still targeting a respectable expansion of between two to 2.5 per cent for 2019. The policy reaction by the Fed is not mainly driven by expectations of a deteriorating US economy, in fact the probability of a significant economic slowdown or recession is very low, but it is intended to cushion potential spill-over effects from weakness in other major economies.
Europe is expected to experience a deeper slowdown than previously anticipated. The European Commission recently revised its growth forecasts for the euro area down from 1.9 per cent to 1.3 per cent in 2019. All euro area economies are expected to grow this year, however the deterioration in growth is mainly expected to stem from the largest euro area economies, namely Germany, France, Italy and Belgium.
The revision in growth outlook is mainly attributed to external factors that have increased global uncertainty, mainly the trade tensions, a slowdown in China as well as the possibility of a disruptive Brexit outcome.
The Fed’s dovish tone has been echoed by the European Central Bank (‘ECB’) during its January policy meeting when it pushed outwards the expectations of a first rate increase by the end of 2019. Moreover, the ECB has reiterated its position to maintain the current accommodative stance for a prolonged period of time.
The US economy is running on strong labour market momentum and improving productivity as inflation remains relatively muted
Despite this commitment, Europe is already in a negative interest rate regime and we have only just seen the termination of quantitative easing. In the current situation, the ability of further policy response from the ECB to a worsening environment seems to be limited. This could lead to concerns on policy impotence.
On the fiscal front, euro area sovereigns are bound by deficit and debt criteria which limit their ability to launch the fiscal stimulus needed to curb periods of weak (or negative) economic growth. In fact we have not seen any significant pro-growth fiscal initiatives across the euro-area since 2011. This pro-cyclical fiscal formula combined with limited monetary capacity present significant challenges for the European economy to overcome the structural impediments that are in-built into the economy and to effectively tackle the external factors that are overshadowing the progress achieved so far.
With this backdrop, the divergence between the US and the rest of the world is expected to resume. On balance, US equities are expected to deliver a stronger performance compared to European or emerging market equities. This is mainly underpinned by stronger earnings growth expectations in the US while discount rates are likely to remain subdued.
Secondly, the expected economic differential between the US and Europe is skewing the balance of risks in favour of a stronger US dollar versus the euro, despite the parallelism in the recent central bank communiqué.
Thirdly, the positive economic growth in the US combined with a dovish Fed is likely to calm potential increases in default probabilities in US credit. This should provide a fertile ground for US bonds to also outperform euro-denominated paper.
Lastly, the spread between the 10-year US treasury yield and the German bund yield is likely to re-widen. However, any steepening in the US yield curve is likely to be dampened by foreign buying.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.
Matthias Busuttil is senior portfolio and investment manager at Curmi and Partners Ltd.