Global Weekly: Cavalry (or the Fed) to the rescue

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Last Friday, US President Donald Trump spooked the markets once again with a tweet. He said that the US will impose a 5% tariff on all goods coming from Mexico until illegal immigration from its southern neighbour stops. As if this was not enough bad news, investor sentiment was hurt further by developments in China. Beijing is readying a plan to restrict exports of rare earths to the US. Bad news always comes in threes, and this time is no different. Recent data shows that China’s manufacturing sector slowed more than expected in May.

As a result of all this negative news, equities tumbled and US Treasuries surged. Meanwhile, Wall Street’s biggest banks lined up to warn investors of growing recession risks from the escalating trade war between the US and China. JPMorgan, for example, increased their forecast regarding the probability of a US recession in the second half of this year to 40% from 25% a month ago.

Fortunately we can count on the cavalry in the form of the US Federal Reserve to come to the rescue. On Tuesday, Fed Chairman Jerome Powell signalled an openness to cut rates if necessary, pledging to keep a close watch on fallout from a deepening set of disputes between the US and its largest trading partners. This message was reinforced by the Fed’s Vice Chairman Richard Clarida. He told CNBC that the Fed would “put in place policies that not only achieve, but sustain, price stability and maximum employment, and we’ll do that if we need to.” This was clearly what markets wanted to hear, the prospect of an easier monetary policy started to fuel a stock market rebound.

Our neutral stance toward stocks remains unchanged. We see earnings growth moderating and geopolitical uncertainties weighing on markets. We favour the US over Europe because of its better growth outlook, more exposure to secular growth trends and more defensive characteristics. Based on this view, our equity sector preferences are in areas of secular growth, such as the communication services and IT sectors.

Trade tensions rising

Ongoing trade tensions between the US and China keeps uncertainty high in capital markets. In addition, new tariffs on Mexican imports, which were not expected by any market participants, accelerated the flight to quality assets. As a consequence, both US Treasuries and German government bonds rallied strongly, even forcing central banks to become more vigilant concerning the impact of the current trade war on global growth.

A global trade war could trigger a cascade of economic and financial reactions that would tip the global economy into a growth recession, which is not our base case. In moments of uncertainty, fixed assets which promise steady cash flows are the preferred option. We expect that the G-20 summit in Japan at the end of June could bring relief, owing to a planned meeting between US President Donald Trump and China President Xi Jinping.

In this more bearish context, US Treasuries saw yields tightening along with the rest of the investment-grade asset class, while other riskier investments suffered from risk-off sentiment. Emerging-markets sovereign and corporate debt, which we prefer, behaved better than global corporate high yield, given the higher correlation of high yield with equities.

Italy’s unstable coalition government and Germany’s disappointing recent economic data gives us to believe that the dovish stance by the European Central Bank is a safe bet. In a press conference on Thursday, ECB President Mario Draghi mentioned he will not shy away from action to support the euro-area economy, as growth weakens, keeping rates at record lows. It is therefore a case of increasing uncertainty on the one hand, but central bank support on the other hand.