Growth outside the US slowed dramatically in 2018, hindered by the strong dollar, trade wars and Chinese deleveraging efforts. The US, aided by the stimulus, appeared immune and this spurred capital to flow and loosening financial conditions and forcing the Federal Reserve (Fed) to offset this through rate hikes – causing further pain outside the US.
The flip from the Fed came after US credit costs started to rise. The Fed finally acknowledged that it should take global conditions into account more, seeing a collapse in real yields, and this spurred a risk rally in 2019. This rally failed to kick on as the data in the rest of the world (RoW) hasn’t improved enough to encourage investors to reallocate into RoW risk.
With better China and European PMI data recently, however, along with the dramatically reduced chance of a no-deal Brexit and cooling Sino-US tensions, it can be argued the cycle looks like it could be slowly turning. Some hard data is still pretty bad — German factory orders in February dropped 8.4% YoY but is being regarded as old news. We like being short the US dollar, short rates and long the spread into this.
The biggest risk to this view in our mind is that the Fed pushes back against market expectations (63% chance of a cut this year), or some on the Fed Open Market Committee start talking about resuming the tightening cycle if we get some decent data. Against that we would argue that:
1. it seems far too soon for another flip-flop from the Fed and they would need much stronger growth to resume. The US data has been average of late.
2.Inflation pressure remains low with wage pressures not feeding through meaningfully into CPI, suggesting that companies may have to start absorbing into their margins given competition pressures.
3.The Fed should now realise that neutral rates are more nuanced than the standard definition of where savings=investment after the huge surge in outstanding corporate credit since the crisis. The speed of the transmission mechanism has quickened as we saw in Q4, and if the Fed turns hawkish again and widens spreads, the damage can happen quite quickly as US companies cut costs and reduce debt.
4.The Fed is fighting for its political future with Trump’s criticism on one side and advocates of Modern Monetary Theory on the Democrat side. The Fed will do its utmost to prevent a recession that could be pinned on its policy, and low inflation gives them plenty of cover to do so.