BlueBay: Draghi keeps his weapons in reserve for now

7 jun 2019

Comments from the Federal Reserve speakers at their Chicago conference cited that the FOMC will be looking at downside risks to the economy as it meets in the months ahead and will stand ready to ease policy if this is deemed necessary.

Notwithstanding this, our dialogue with and understanding of central bankers suggests that any action will require further evidence – in the case of the Fed, either coming from a marked slowing in growth (towards 1%), a sustained move in inflation below 1.5%, or a sharp drop in asset prices with the S&P below 2,600. 

Downside risks from trade could lead to such evidence materialising and resultant disruption to supply chains and investment due to action on Mexico. This could prove more problematic for the US economy than tariffs on China.

However, for now, the US economy retains strong momentum, with ISM services data beating survey estimates during the past week at 56.9 – emphasising that away from some softness in manufacturing, aggregate demand remains robust.

Some commentators have wondered whether the FOMC could ease rates, as was seen in 1995 or in 1998 – though in both instances there had been a much more substantial slowing in growth before the Fed acted, with ISM surveys printing several months below 50, so in contrast there seems little evidence of contraction today and it may be that growth only slows from an above-trend rate towards trend – and that in itself would not require policy intervention.

Future unlikely to be seen in the dots

As we head towards the Fed meeting later in the month, we believe that the FOMC may adopt an easing bias but won’t communicate an intention to cut rates in the dot plot, rather citing a readiness to act should downside risks manifest. We also sense that Powell may want to lean against market expectations, which price in multiple cuts in rates in quarters to come, and will be eager to cite the relative strength of economic momentum.

Of course, it is possible that Trump suddenly changes tack on Mexico tariffs (after all, it seems a thinly disguised effort to get the ‘Mexicans to build a wall and make them pay for it’), noting that on Mexico, Trump is acting as the arch-hawk within the administration – whereas on China he has less room to pivot because many others are keen to adopt a much more hard line stance than the president himself.

Perhaps with such unpredictability in the White House, the Fed will only be able to react to what it sees and it could appear foolish if it ends up forming its own policy decisions based on Trump’s tweets, eschewing an approach firmly planted in the analysis of data trends.

Multi-tool approach from the ECB

In the eurozone, Draghi delivered a broadly dovish message at the ECB meeting this week, in line with our expectations. Inflation and growth expectations have been shifted marginally lower for 2020 and in line with that the staff projections, which shifted their forward guidance to mid 2020 for the first hike.

When asked if he thinks the next move is a hike, Draghi pushed back, highlighting that the governing council has plenty of tools available and discussed rate cuts, as well as a re-engagement in bond purchases if the outlook deteriorates while downside risks to inflation prevails.

The ECB also delivered on more favourable TLTRO3 terms, with rates as low as -30bps, which should support front-end periphery spreads.

Elsewhere, performance in EM has been mixed with South Africa and Mexico enduring a difficult week, while Brazil, Turkey and some others rally on more constructive domestic news flow.

Meanwhile, oil prices have continued to move lower, putting pressure on high yield energy spreads as breakeven rates for certain shale fields come under pressure.

Equity rally lifts corporates, aided by earnings growth

Corporate bonds have continued to take their lead from equity markets. Stocks have held up well in the past week, with the S&P rallying as yields have fallen and hopes for rate cuts have come to the fore.

In part, the assessment of lower long-term neutral rates may mean higher equilibrium P/E multiples due to a lower discount rate – yet beyond this there does seems to be a growing dichotomy between fixed income and equity pricing, with equity markets seemingly happy that earnings growth should remain in the mid-to-high single-digit range, whereas rates markets seem to suggest a much more significant downturn, which would be consistent with an earnings recession.

We have been flattening FX risk in a climate of some uncertainty and continue to express the highest level of confidence in risk in the eurozone periphery as we see low levels of EU break-up risk and with eurozone rate anchored at ultra-low levels for a long period of time. We see Greece and Italy offering clear value to fixed income investors.

Looking ahead, despite accommodative central banks globally, volatility in markets is likely to stay elevated until we have better visibility on tariffs and their impacts on global growth.

Violent swings in investor sentiment and conviction continue to lead to excessive asset price volatility. In our opinion, to generate alpha in this environment it is important to focus on investing based off our fundamentally researched alpha convictions, and not falling into the trap of trading off each and every tweet.

Negotiating markets in recent weeks has felt like a challenge. However, in the words of King George VI on D-Day 1944 “what is demanded from us all is something more than courage and endurance; we need a revival of spirit; a new unconquerable resolve.”

Mind you these sorts of moments can often be viewed in hindsight as major turning points and, in this context, it may be that the recent rally in rates has now run its course.