Insight weekly multi-asset update: week beginning 26 August, 2019

From

Adam Kibble

Market and economic review

Equity volatility falls and bond yields rise despite uninspiring global growth prints

Global equities were broadly mixed last week with most major indices climbing around 1% to 2%, which the exception of the US indices, which were down -1-2%. What was particularly noticeable was the fall in volatility, after two weeks of very choppy price action. Indeed, five-day realised volatility last week was 12%, a sharp fall from the level of 25%. The same was true for implied volatility with both the US and European volatility indices (VIX and V2X respectively) trading close to their August lows.

This dynamic held until Friday afternoon when China announced retaliatory tariffs on $75bn of US imports, although the initial reaction was relatively muted. Government bonds gave back a little of recent gains, with core 10-year yields rising 1-3bps, despite the provisional PMI data which showed a continued deterioration in global manufacturing. In currency markets, the dollar was broadly stronger, particularly against emerging market currencies. One exception was sterling, which increased 1% after Prime Minister Boris Johnson’s meetings with the French and German heads of state offering a little hope for potential on a Brexit deal. Credit spreads also performed well and Italian spreads tightened following Prime Minister Conte’s resignation.

Provisional PMI data shows global manufacturing output continuing to deteriorate

The data docket was very light in the first half of last week, but on Thursday we got the latest round of provisional PMIs for August. Regular readers will know the importance we place on PMIs as a useful indicator within our investment framework. Indeed the fact that global PMIs have now been in ‘contractionary’ territory for three months was an important factor in our recent reduction in directional exposure. The provisional August data this week does nothing to change this view, with global manufacturing output continuing to deteriorate.

In Germany, the manufacturing PMI did increase modestly to 43.6, from 43 last month, however this is still very deep in the contractionary (sub-50) zone. The details within the release were uninspiring, with ‘new orders’ at a six-year low and the majority of firms now expecting output to fall over the next 12 months. The services PMI (which effectively reflects the domestic economy) remains robust, printing at 54.4, so there is little evidence yet that the dire industrial backdrop in Germany is spreading to the rest of the economy, but this is something we’re monitoring closely. The PMIs in the US were also weak, with the manufacturing PMI just slipping into contractionary territory at 49.9 for the first time since 2009. Perhaps more worrying was the sharp drop in services from 53 to 50.9. This contrasts with the strong retail sales print that we discussed last week and given the importance of the US consumer to GDP growth, this is something we will have to watch closely.

China retaliates with tariffs on US Imports

We were looking forward to a weekly note with little mention of the ongoing US-China trade dispute, however the announcement from China of retaliatory tariffs on US imports on Friday afternoon spoiled that dream! The Chinese Ministry of Commerce stated that some of these countermeasures will take effect starting 1 September, while the rest will come into effect from 15 December, mirroring the timetable the US laid out for its 10% tariffs on nearly $300 billion of Chinese goods. An extra 5% tariff will be put on American soybeans and crude-oil imports starting next month while the suspended 25% duty on U.S. cars will resume 15 December. The response from President Trump (to further increase tariffs on Chinese goods) was fairly immediate, and we continue to expect tit-for-tat retaliation will drive short-term sentiment and hurt an already struggling global growth picture in the medium term.

There were also important political developments across the Atlantic with Italy being the biggest focus. Prime Minister Conte resigned on Tuesday, ending the increasingly strained coalition between anti-establishment Five Star and right-wing League. The market reaction for Italian bonds was positive on the news, due to both Conte and Italian’s President Sergio Mattarella stating that a new coalition is preferable to a snap election; however the situation remains highly uncertain.

In the UK, Boris Johnson travelled to meet French President Macron and German Chancellor Merkel. Merkel hinted that it may be possible to find a solution to the Brexit impasse within the next month while Macron cautioned it would have to be done without straying too far from the substance of the existing Brexit Accord. There was a modest move higher in sterling (+1%) on this news however this could just be a function of extended short positioning rather than any sign of meaningful market re-assessment on the probability of a no-deal Brexit.

Outlook

While there has been plenty of commentary around a potential 50bp interest rate cut in September, the Fed minutes released last Wednesday reduced market pricing for this to just a 10% probability. The minutes made it clear that the Fed viewed last month’s easing as an ‘insurance cut’ rather than the start of a sustained easing cycle. That being said, both economic data and trade relations have deteriorated since then and markets anticipate that this view may have changed.

After the China announcement on additional tariffs, risk sentiment in the week ahead will likely be dictated by the ongoing trade war rhetoric.

The process of forming a government in Italy will continue, with the Five Star Movement discussing a coalition government with the Democratic Party. Such a government formation would prevent an imminent election, for which polls currently predict a strong result for the Northern League party.

The other main European reading will be August’s inflation, which is expected to be 1.0%, the lowest since 2016. Given the European Central Bank (ECB) has a target of 2% or below for inflation, such a low reading could lift expectations of action at the next ECB meeting in less than three weeks’ time. From the US there will be the Conference Board’s consumer confidence reading, whose previous rebound to an eight-month high is expected to reverse along with durable goods orders data and another cut of Q2 GDP.

By Adam Kibble, Investment Specialist

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