Last week was a good one for risk assets, with the major equity markets and oil prices steadily advancing on the perception that the global economic downturn might not be as bad as feared.
The week started with the publication of the Chinese PMI data for March, which increased above the contraction-expansion break even level of 50. In conjunction with a recent increase in Chinese industrial production and retail sales growth, investors saw this as evidence that recent monetary and fiscal stimulus steps are starting to work.
US ISM manufacturing activity was firmer, rising to 55.3 last month, while the UK manufacturing PMI rose to 55.1, a 13-month high and a strong rebound from February. China’s service sector PMI also improved and eurozone services PMI data were revised up.
US-China trade talks are continuing and even though President Donald Trump said that it might take more time before a deal is agreed, there is nothing to suggest that the talks will break down. On Brexit too there were signs that a “softer” exit might be on its way, which reassured sterling even though Friday’s deadline for a decision is again ominously close.
A constructive resolution to the US-China trade dispute would remove a key downside risk for global growth that has been in place for more than a year now at a time when world trade has slowed and export growth – especially for some Asian economies — has fallen into negative territory. Last week the IMF’s Christine Lagarde warned about a “delicate moment” for the global economy, and the World Trade Organisation, in its latest outlook, marked down its forecast for world trade growth.
Removing the US-China risk would provide a boost to economic activity and business confidence, helping both the US and Chinese economies and reopening global supply chains and export links to the benefit of other parts of the world.
Because of investor optimism, the bond markets eased up on their previous message of deflation and impending recession, with the yield curve steepening. US two-year and 10-year Treasury yields are now both above the lows posted in March and the effective Fed funds rate.
The US non-farm payrolls employment report added further to this optimism as jobs bounced back by 196,000 last month from a revised 33,000 increase in February, but still without much sign of wage inflation, with the annual growth rate of average hourly earnings falling back to 3.2 per cent.
In that sense it was a “Goldilocks” employment report, being not too hot and not too cold, strong enough to allay fears of a recession but not one that would necessitate a return to monetary policy tightening.
For the Fed to return to tightening mode, many conditions must be met, but this is unlikely to happen in the near term, keeping interest rates unchanged for the foreseeable future. In fact, the next “fly in the ointment” may not be the risk of a return to monetary tightening but a premature move to monetary easing if Mr Trump gets his way.
The probability of an earlier-than-expected rate cut by the Fed may have resulted in a modest reduction as a result of the payroll figures, but pressure from the White House is unlikely to go away. Both Fed nominee Stephen Moore and Larry Kudlow at the National Economic Council have called for an immediate 50bp cut in the Fed funds rate, and Mr Trump is now pushing for another political loyalist, Herman Cain, to be appointed to the Fed’s open market committee, while also calling for a resumption of quantitative easing.
The Fed’s adoption of a more patient outlook since the start of the year, which appears to have been the result of a nudge from Mr Trump, was broadly welcomed by the markets. However, any step into actual easing territory is likely to be viewed with suspicion, especially if it occurs when the economy appears in good shape.
The 2020 election may seem a long time away, but the independence of the Fed already looks like it will become a significant issue during the campaign.
Tim Fox is Chief Economist & Head of Research at Emirates NBD