Equity markets have been gradually improving since the start of the year, recovering most of the losses seen in December. With markets having largely priced in the key macro themes of slower global growth, and the US-China trade dispute at the end of last year, the surprise factors in 2019 have been how accommodative the Fed appears to be and some signs of optimism over trade. The end of the US government shutdown was also a pleasant surprise. Risks have not gone away, however, and most of these are currently hovering over the eurozone and China.
Markets were relatively quiet last week as Chinese New Year holidays kept investors sidelined, combined with a relative dearth of economic data. Underpinning sentiment the most, however, was the message from the Fed a fortnight ago that it will remain ‘patient’ and hinting that its tightening cycle might be coming to an end.
Other central banks have also suggested more dovish outlooks, including the Bank of England, the Reserve Bank of Australia and the Reserve Bank of India which last week cut interest rates by 25 basis points. Combined with downward revisions to growth estimates in many parts of the world, the perception is growing that monetary policy normalisation is being postponed.
A positive end to the US-China trade dispute later this month could also add to recent positive sentiment. Investors appear hopeful that the current ‘ceasefire’ in the trade war can be extended beyond the March 1 deadline when US tariffs on $200 billion of Chinese imports are due to be increased to 25 per cent from 10 per cent. Trade talks between the two sides will resume in Beijing this week, less than three weeks before the current ‘truce’ expires, but ominously the White House’s chief economic adviser Larry Kudlow has indicated that there is still “a pretty sizeable distance” between the two sides.
With the Chinese Purchasing Manager’s data pointing towards recession the markets need to see a resolution to this issue to prevent a more dramatic decline in business confidence. In the short term they probably also need to see a successful outcome from the US bi-partisan Congressional committee talks on border security, in order that another US government shutdown can be avoided.
The temporary funding deal is due to expire on Friday of this week and the outcome will depend on whether President Trump will accept the recommendations of the committee. The Democrats are unlikely to agree to fund Mr Trump’s border wall which, given his recent comments would suggest a new shutdown could still be on its way.
Beyond these longstanding issues, of increasing concern to markets, however, is the eurozone where risks are building on a number of fronts. On the macro side the publication of forecasts by the European Commission last week certainly caught the markets wrong-footed.
The EC slashed its euro-zone gross domestic product growth forecast for 2019 from 1.9 per cent in November to 1.3 per cent. Among the biggest changes Italy’s growth projection was cut from 1.2 per cent to 0.2 per cent and Germany’s from 1.8 per cent to 1.1 per cent.
The coming week will see if Germany avoided slipping into outright recession at the end of last year, with publication of its fourth quarter GDP data on Thursday. German yields fell sharply on the news of the Commission’s forecasts, with the spread between Germany and Italy widening to its highest level since mid-December. This will put renewed pressure on the European Central Bank to restart quantitative easing, or roll out fresh targeted longer-term refinancing operations - a liquidity programme for banks. Most of all it should force it to delay its plan to raise interest rates later this year.
But this is not Europe’s only problem. Political tensions are also mounting between key members of the eurozone, with France recalling its ambassador from Italy last week in protest at ‘interference’ in its domestic politics following comments made by the Italian government.
Finally awareness is also growing that a ‘no-deal Brexit’ - which may result from the EU Commission’s intransigent negotiating position with the UK - could make the eurozone much worse off given the region’s sizeable trade surplus with Britain. If the markets can get beyond US-China trade, and avoid another US government shutdown, it will be in the eurozone where volatility is next likely to come from.
Tim Fox is chief economist and head of research at Emirates NBD