New article from Tatton Investment Management: Battle of the ‘doves’

24 June 2019

There were relatively few economic data or corporate announcements this week. The US came within a hair’s breadth of clearly carrying out an act of war against Iran.

And the global stocks rose 2.25% during this week, with the US S&P500 index finishing Thursday back at its all-time high.

Markets have regained a form of optimism; the combination of low growth expectations but a renewed confidence that the central bank gods will act and that their powers are undimmed.

Markets took a turn for the better on Tuesday when Mario Draghi gave his keynote address at the European Central Bank Conference in Sintra, Portugal. It was another version of the “whatever it takes” speech;

For the markets, his key words were:

  • “The (European) Treaty requires that our actions are both necessary and proportionate to fulfil our mandate and achieve our objective, which implies that the limits we establish on our tools are specific to the contingencies we face.
  • If the crisis has shown anything, it is that we will use all the flexibility within our mandate to fulfil our mandate — and we will do so again to answer any challenges to price stability in the future”
  • “In the absence of improvement, such that the sustained return of inflation to our aim is threatened, additional stimulus will be required”
  • “In the coming weeks, the (council) will deliberate how our instruments can be adapted commensurate to the severity of the risk to price stability”
  • “Our medium-term policy aim: an inflation rate below, but close to, 2%. That aim is symmetric, which means that, if we are to deliver that value of inflation in the medium term, inflation has to be above that level at some time in the future.”
It appears that Draghi may be trying to bounce the ECB’s governing council into making a conditional commitment to easing policy further – including a resumption of asset purchases – based on the inflation outlook. That decision (whether that condition is met and any subsequent action) could easily fall to his successor, who is due to arrive later this year.

Also, comments (sourced from other ECB members immediately after the speech) suggested that his tone was significantly more forceful than had been signalled at the ECB meeting a week ago, where their debate took place.

Nonetheless, if they felt they were being bounced into an uncomfortable position, the push-back was muted. Markets did not see Draghi as acting out-of-turn; European equities rallied hard while bond yields went to further extremely low yields.

The Euro reacted as well, falling over a percent. The comments about easy monetary policy were enough to draw a Trump tweet about currency devaluation.

The BoJ also signalled a willingness to remain easy in their meeting and yields fell, although the equity markets received less support as the Yen remained strong.

  • Wednesday brought us the Federal Open Markets Committee verdict. JP Morgan put it thus (in a precis):
  • “Today's Fed meeting delivered on our expectations for stable policy rate while also signalling for a near-term cut. The statement removed the notion of “patience,” noted deteriorating inflation compensation, highlighted increased uncertainty, and suggested it would act if needed based on incoming data. Dissent came from President Bullard, who voted for a cut.
  • Powell, in his briefing, noted that there is not enough in the data to warrant a cut currently and the new uncertainties on the scene (read: trade war) are too recent to know how it will play out. The Summary of Economic Projections revealed little change on the median growth outlook but roughly 1/4%-point lower headline and core inflation this year and a touch lower next year.
  • The Fed dots moved down as expected and now the average looks for a full cut by next year and a hike in 2021. However, the distribution shifted by more, with seven members looking for two cuts this year, policy on hold through next year (and five members expecting this to last through 2021). This is a now large dovish minority. We have pulled forward our call for cuts and now see a 25bp cut in July and another in September.”
In the “dot-plot”, there was another clue about how the Fed currently see their long-term policy in relation to the economy’s growth. They moved the long-term rate expectations down without moving the long-term growth expectations – a signal that they see stability being achieved by making bond returns even less attractive.

On the other hand, there was no counterpart to Draghi’s implication regarding asset purchases. Markets behaved as if the Fed had committed to buying more bonds but that was nowhere to be seen in any comments.

Like in Europe, bond yields fell sharply, equities rallied, and the US Dollar fell (pushing the Euro back up).

The major central banks are being about as dovish as the current circumstances allow (with the exception of the UK, as we mentioned last week). As mentioned earlier in relation to the ECB members, with policy expectations at the truly dovish end of things, the hawks may start screeching especially if there is a positive tinge to economic data in the next few weeks.

And there’s good reason to think that the data is not going to get worse. Indeed, the dive in inflation expectations reversed sharply this week (as priced by bond markets), as did hard and soft commodities.
 
The economic data in Europe showed some positivity, with the “flash” business surveys being stable overall (Germany continued weak, France continued its bounce, the periphery remained quite buoyant). US home sales showed strength in line with the fall in mortgage rates.

The US and Chinese helped on Tuesday, announcing that preparations are underway for Trump and Xi to meet at the Osaka G20 meeting next week. With Xi meeting Kim Jung-Un this week, the sense that the trade issue may also be resolved certainly added to the jollity. Even the flaring of Middle-Eastern trouble failed to concern markets, since it will have relatively little immediate impact on global trade.

To repeat: markets have regained optimism amid low growth expectations due to a confidence that the gods of money and politics will act quickly and that their powers are undimmed.

There is probably a limit to how far markets can go in the next week ahead of the G20.The run of important economic data begins at the start of July, as does the H1 earnings data. There may be some quarter-end repositioning, but it feels as if the bearish investment community (according the May Bank of America institutional investor survey, as bearish as in 2016) has been forced into quite a sharp rebalancing already.

Another support for markets is the relative positivity in emerging markets, helped particularly by a weakening dollar.

The easing from developed markets has pushed credit yields down sharply, a huge benefit to funding rates for emerging market nations, allowing them also to respond by lowering local currency rates without fearing capital flowing away from them.

So, market sentiment has swung from bearish to bullish, in itself a help to the global economy. Everything else being equal, that will help global growth. But before we get ahead of ourselves, let’s remember that one of the issues has been the increasing volatility in the economies. Underlying base level aggregate demand is anaemic, and high debt levels continue to encourage a mild pay-down of that debt which reduces further medium-term growth. That means that profit growth will also be anaemic especially if margins are under pressure from a pick-up in input costs. 

And then there’s the unremitting confrontational approach taken by the US administration. While we may be about to get some respite in respect of China, the Trump approach to 2020 election requires external and internal enemies. Europe could well be the next target – viz the Trump tweet about Draghi’s “unfair” speech on Tuesday. 
 

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