The first half of 2019 was, on an initial reading, unusual in that it was characterised by a strong rally which encompassed both risk-on and risk-off assets. However, this is very reminiscent of QE at its height, as the material driver of the cross-asset rally was central banks turning dovish, in response to slowing economic growth.
Indeed, in the absence of an inflationary threat, central banks are interpreting their primary role as to extend the economic expansion, now the longest since 1854 in the US. In the more financialised economies, such as the US and the UK, this has material implications for asset markets, as central banks are acutely aware that any extended dislocation in financial markets will have a negative and material impact on the real economy. That’s not to say that central banks are explicitly supporting asset markets but, in reality, they are.
Closely related to this dynamic, and one of the fundamental questions for markets in the second half, is whether the US economy, and probably therefore the global economy, experiences a reflationary period or moves towards a recession. For us, there are too many unknowns to have much conviction just yet. First off, assessing the underlying data is muddied by the impact that the trade war has had. Putting that impact to one side, difficult as it is to isolate, it’s probably too early to say that global activity is bottoming out but, with little momentum in either direction, the question remains, where does the data go from here?
The trade war is the wildcard in this and, even though there has been some de-escalation of tensions between the US and China over the weekend, we expect little more than a fragile truce globally (see how the US quickly turned their focus to the EU, post the better news on China). As a result, sentiment around trade will likely remain fickle and so can quickly become a headwind or a tailwind.
One of the remaining pieces of the jigsaw is the Fed, who have rightly cited the trade war as a factor in their decision making. That is a new dynamic, as is the challenge to their independence from Trump. Furthermore, current consensus seems to be that dovish Fed policy can counter hawkish trade policy, though this feels somewhat simplistic. Certainly in more orthodox times, a trade war and a dovish Fed would both be considered as adding to inflationary pressures. Either way, the Fed appears ready to act to correct a weakening economy, and market perceptions are currently for a dovish Fed this year.
When are we going to get some answers to these questions? The Fed meets at the end of July, where a cut is priced as a 100% probability currently, but the press conference will be closely followed for gauging the second half, while the Q2 earnings season is getting underway, and guidance provided for the rest of the year will also be insightful.
If there is a single instrument that most closely reflects all of these factors, it is the US Treasury 10 year. In turn it has a material impact on other financial assets, like equity-bond proxies and banks (more specifically the steepness of the yield curve) at an equity sector level, gold, the US dollar and property, as well as the real economy itself, which can act in a circular self-correcting way, in theory at least. In the multi-asset space, it is the shape of the portfolio, more than anything else, that determines performance success, or not. In short, getting the equity sectors and bond duration right is key.
As with calling the US economy, we are not comfortable taking a conviction call yet on a change in market dynamics. Rather than do anything too dramatic at this stage, we have begun to reduce our long duration US Treasuries and our exposure to gold, and we have started to establish a US banks position. Where we go from here, as ever, depends on how the data unfolds.
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Source for information: Miton as at 02/07/2019 unless otherwise stated.
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