Inverse yield curve
- Due to the uncertainty surrounding inflation and economic growth, bond investors are typically looking for higher yields on longer maturities. In recent days, the yield curve (interest rate level relative to maturity) has received a lot of attention in the US. Indeed, in the run-up to a recession, the US yield curve has always been inverted in the past, i.e. the 10-year rate was lower than the two year rate. Today, however, the difference is not negative, but – at 0.13% – it's very close.
- In historical terms, we note that this sharp slowdown in growth follows 10 months, at the earliest, after the inversion and on average takes 21 months to manifest itself. A downturn in growth is therefore not imminent. Economists also wonder whether the yield curve is still a good predictor of a recession. Due to bonds being bought by the central banks, the long-term rate is lower than normal, while ageing and the continued low level of inflation are also putting pressure on rates.
Slowdown in growth?
- The US economy is 'pumping on all cylinders', with virtually all the economic lights on green and the leading indicators pointing to economic activity gaining more momentum. Unemployment there is at an all-time low, which is boosting consumption. The fear of recession, which is being fuelled by the flat yield curve, therefore seems to be exaggerated, to put it mildly.
- China – the second largest economy in the world – is indeed growing at a somewhat slower rate of 6%. However, if we look at the most recent data, such as producer confidence, the picture is reassuring. Confidence has risen again, indicating stable and fairly strong growth. So there is no sign of a hard landing in China.
- In Europe, however, there has been a marked slowdown since the turn of the year. What's more, the weak third quarter was worse than expected, though that seems to be due mainly to temporary factors (such as new measures in the important automotive sector). Economic activity should therefore recover somewhat in the fourth quarter, especially in Germany, where the automotive sector is getting to grips with these measures.
- Furthermore, the lower oil price is a shot in the arm for both companies and consumers.
- Key rates were raised, mainly in the US, which is a positive sign as they go hand in hand with a strong economy.
- However, additional rate hikes by the Federal Reserve (Fed) are raising fears of 'an interest rate hike too far', with President Trump criticising the Fed last month and saying it had gone ‘loco’. However, Fed chairman Powell has indicated that he will not turn a blind eye to a potential slump in economic data. He can therefore put the brakes on – what has until now been – the very rigid pace of rate hikes. This is something he also indicated by saying that the short-term rate is now very close to its neutral level (at which the economy is neither being stimulated nor deflated).
- In Europe, none of the above applies and policy remains fairly flexible. Persistently low core inflation and the lower price of oil indicate that a sharp rise in interest rates is not on the horizon. Although the crisis policy will stop at the end of this year, the ECB's huge balance sheet is still being reinvested. In other words, the economy does not have to fear significantly higher interest rates.
The trade conflict
This remains the number one problem for the markets. Any communication about it – whether positive or negative – always leads to sizeable (even exaggerated) reactions on the stock markets. However, it remains a mixed bag:
- In North America, the UMSCA is a replacement for the NAFTA accord that had been maligned by Trump.
- Negotiations between the EU and the US continue, but no major breakthrough has been made since the deal between Trump and Juncker. Therefore, there are still latent fears of higher tariffs, especially on cars.
- The biggest dispute continues to be the Sino-American trade relationship. A breakthrough was expected at the G20 summit in Argentina. The 'ceasefire' agreement between Trump and Xi Jinping was initially positively received by the markets, but the sentiment reversed the more it was interpreted as a non-deal.
- We expect tensions between America and China to persist. They clearly have an impact and weigh on the prospects for growth, but are not such as to trigger a global recession.
- Brexit: the main consequence of this long-running issue has so far been the drop in sterling. Prime Minister May, who was heading for a heavy defeat, cancelled the crucial vote on the agreement reached earlier with Europe. The biggest stumbling block remains the solution for the border between Northern Ireland and the Republic of Ireland. However, May's hope of obtaining better terms from Europe would appear to be unrealistic now that EU Council President Tusk has indicated that he is not open to renegotiating the agreement. So, all-in-all, another episode of uncertainty in the Brexit saga. Stay tuned…
- German-French tandem hit by wear and tear: both countries had to work together to blow new life into the European project. In Germany, however, Merkel announced her departure and the elections resulted in a more fragmented political landscape. French President Macron, whose popularity had been in decline for some time, is in an even worse situation. In addition, there is a high budget deficit, now that France is abolishing tax increases (on energy). This not only undermines France's credibility on the climate issue (it had organised the Paris climate summit earlier this year), but also its ability to meet the Maastricht criteria (budget deficit of below 3%). In fact, its deficit has been larger than Italy's for years now.
- Italy has been on a collision course with Europe regarding budget and migration matters since the new government took office. There doesn't seem to be an immediate solution to the budgetary conflict given the low level of growth, high level of debt and the lack of political will to push through reforms. The conflict may take a back seat until after the European elections, but Italy will remain the weak relation even after they have been held. The risk premium that investors assign Italy will therefore remain high in the months ahead.
- Moreover, issues such as the Migration Pact reveal a division in Europe between Western and Central European states.
To sum up, the global economy continues to be strong, which for the time being is still the most important indicator for the stock markets. The US is by far the strongest growing region, with fears of a recession fuelled by the flat yield curve appearing to be unfounded in the light of the economic data. However, we need to continue paying very close attention to developments in the trade conflict. The turnaround in sentiment prompted a very sharp correction on the stock markets. Combine the above with what are still very robust operating results, and the stock markets still look quite attractive. The positive fundamentals, therefore, enable us to see through the problems in Europe and the trade conflict and lead us to a rather positive view of shares, with the emphasis on Europe.
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