The recent spate of weak economic data reinforced our assessment that the flare-up of trade-related uncertainties since May will further weigh on the softening growth outlook.
In China, indicators of economic activity in July broadly missed expectations. Industrial production growth fell to 4.8% in July – the lowest in 17 years – versus 6.3% in June.
Data in Germany, the biggest economy in Europe, is exceptionally soft. 2Q 2019 GDP contracted 0.1% quarter-on-quarter, and business confidence in August slid to a seven year low.
While the US labor market and the consumer side of the economy is holding up, business sentiment continues to weaken. Trade-related uncertainties are mounting for business managers, and the risk is that they would significantly reduce the pace of investments and hiring. This could eventually spill over to the labor market and consumer spending.
Last week’s announcement of a three-month delay in some US tariffs on Chinese imports resulted in a short-lived rally. This tariff delay, however, provided only a reprieve and does not eliminate the tariffs’ eventual negative impact on business confidence and supply chains.
Notwithstanding the recent US decision to extend Huawei’s supply ban by another 90 days and also our view that the US is unlikely to hike tariffs further before 15 December, we are wary that there has been no meaningful progress since May between the US and China on core issues such as intellectual property protection, tech transfers, market access and industrial policies.
The remarkable movements in the bond market in August reflect similar long-term concerns as investors fled to safe assets and forward inflation expectations fell. The ten-year US Treasury yield fell as much as 20 basis points to a low of 1.47%, which drove a brief inversion of the two-year to ten-year segment of the US Treasury yield curve.
If we do see a sustained inversion of the yield curve ahead, it will be good reason for caution but not panic. Although an inversion of the yield curve has reliably preceded US recessions over the last 40 years, there are good reasons to question if this phenomenon has as much recession signaling power as it did in previous cycles.
Unprecedented monetary easing post the Great Financial Crisis has contributed to unusual factors in this cycle, such as negative term premiums, ultra-low rates in Europe and Japan, and a positive correlation between inflation expectations and risk asset prices, all of which act to flatten out the yield curve.
Although a cautious stance towards to the market seems sensible due to the mix of uncompelling valuations, persistent trade uncertainty and sliding business sentiment, our expectation is that the global economy will ultimately bend and not break. All considered, it is difficult for us to forecast a recession over the next 12 months as a base case. Integral to our set of baseline assumptions is that, if required, the Fed and other central banks will do more to support growth.
Later this week, the market will be focused on Fed Chair Jay Powell's speech in Jackson Hole, where we expect him to tee up another rate cut in September and potentially a third cut after, in addition to emphasizing that the Fed is fully attentive to downside risks. A dramatic dovish pivot at Jackson Hole, however, to something more than a small series of insurance cuts - or a "mid-cycle adjustment to policy" as Powell calls it - seems less likely.
Policy makers can and will do more to support the economic outlook if the need arises, but the threshold for more action will likely be tighter financial conditions and weaker economic data - in other words, there is the risk of more market pain before relief.Disclaimer applicable to recommendation
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