Recession not imminent

clock • 6 min read

While the global economy continues to slow and trade tensions weigh on the outlook, we still believe that we are not on the brink of a US or global recession. At the moment, data is generally pointing towards trend growth, with some exceptions such as Germany, which contracted in the second quarter. Manufacturing remains weak, but services are holding up. In addition, consumers are broadly healthy and the US housing market should benefit from lower rates. US growth for Q2 came in at 2.1% in the preliminary estimate, and Chinese retail sales have pointed to stabilization.

The beginning of August has already seen a roller-coaster between the re-escalation of the trade war by President Trump, who announced new 10% tariffs on remaining 300bn imports set to begin on 1 September, and a reversal this week as many of these products will be exempt until 15 December, essentially calling another truce in the ongoing trade dispute. In the meantime, the Renminbi was allowed to weaken past the key psychological 7 level, but has stabilized since. We continue to believe that a swift resolution is unlikely, but we also believe that Mr. Trump needs to navigate his re-election year increasingly carefully and make sure the US economy holds up.

The Brexit saga continues, with neither the EU nor the UK showing any signs of compromise on their respective stances. As such, the market is pricing in a higher probability of a no-deal exit at the end of October. The market is also expecting a general election in the coming months, though not necessarily ahead of the deadline October. Our base case remains a soft Brexit, with a version of Mrs May's deal being approved. However, we only assign a slightly higher probability to this scenario than to the possibility new general elections. And finally, we still believe that while the no-deal risk has risen, it is a low probability scenario. In the meantime, headlines are likely to keep the pound under pressure.

Mr Salvini has broken off Italy's governing coalition, but hasn't yet managed to get new general elections, although this is the most likely outcome. Poll numbers in his favor are at a peak, implying he should manage a governing majority without Five Stars and without Mr. Berlusconi's party. Fears for the euro could rise, but Mr. Salvini has retreated from his rhetoric of exiting the EU. Nonetheless, he will most likely try to cut taxes and support growth, setting up a budget battle with Brussels.

The Federal Reserve cut rates as expected and ended its quantitative tightening program two months earlier than planned. Mr. Powell nonetheless signaled that this was not the start of a full easing cycle, but that further insurance cuts were likely. Given trade tensions, the September rate cut is guaranteed, and some in the market are even hoping for a 50bp move, which we view as unlikely. Markets are also expecting another a third cut during Q4. We expect the Fed to maintain a dovish tone for the coming months, but believe a third cut, while likely, isn't a foregone conclusion and remains data- and trade-dependent.

The European Central Bank prepared markets for additional easing at its September meeting, with hints towards a rate cut, possible "tiering" of the deposit rate to protect banks and even the re-start of its asset purchase program. With Mrs. Lagarde's dovish inclination, the transition should be a smooth continuation of these additional easing measures. In addition, Mrs. Lagarde is expected to continue to ask for fiscal support in addition to monetary support.

Oil has come under pressure from growth fears due to ongoing trade tensions, dropping sharply in recent weeks before recovering on the latest trade truce announcement. Oil is likely to remain under pressure from growth fears, but should continue to trade in a broad range. Gold continues to benefit from save haven demand and expectations for lower rates, breaking USD1500 per ounce, and the momentum is set to continue.

Market outlook

Equity markets have been see-sawing alongside trade headlines. They corrected sharply at the beginning of the month before rebounding on the latest trade truce announcement. We believe that any trade truce or improvement will continue to support markets, as will very dovish central banks around the world. Q2 earnings season brought positive surprises, albeit with slashed expectations, but decent earnings will also be needed to support upside performance. Overall though, higher volatility and bigger intra-day moves should be expected as the political and geopolitical picture remains complex and littered with risks.  

While we have some profit taking in the US on negative headlines, we expect the market to continue to perform well thanks to better growth and better earnings, and supported by Fed rate cuts. The threshold for an upside surprise in Europe remains low, but political headlines and ongoing Brexit uncertainty are likely to keep investors away, especially given German growth concerns and banking sector woes with the Argentina sell-off.

Sovereign yields continue to fall at alarming rates, painting an overly negative outlook in our view. Nonetheless, with little inflation and additional central bank easing, yields are unlikely to reverse sharply. Bunds are one of the culprits, where soft European growth and expectations for further ECB easing are pulling yields further into negative territory, dragging with it the rest of the world. While we believe yields are too low, we maintain exposure to core holding as protection from volatility, and because momentum in thin August trading can continue.

The US yield curve has now inverted between the 2-year and 10-year bonds, another ominous sign, although we continue to believe that data is not pointing to an imminent recession and that lower yields are due to dovish expectations and search for yield in the US, given over USD15 trillion of negative yielding debt, which now includes some pretty risky names. European worries are also dragging yields down with the Bund, which yields -0.65% for 10-years.

Credit spreads have stabilized in investment grade bonds, but have widened somewhat in the high yield space, as growth concerns persist. If a more negative scenario materializes, credit spreads will be at risk, but this isn't our base case scenario and we expect range-trading for now, though overall performance is likely to come mostly from carry.

With ongoing uncertainty and market sensitivity to headlines, we expect a challenging road ahead, and we continue to add absolute return, flexible strategies such as liquid alternatives for diversification. Indeed, as return expectations for traditional asset classes are challenged, alternatives can help fill gaps. We expect risk assets to grind higher and we maintain our exposure for now, but higher volatility and short-term corrections should be expected. It might not be time to add too much risk, but we don't think it's time to take it all off either.

 

Esty Dwek, is head of Global Market Strategy, Dynamic Solutions, Natixis Investment Managers