Today’s key points
- Rising risk of a market correction.
- Less support to risk sentiment as we are close to a peak in global PMIs and the risk of Trump disappointing the markets is increasing.
- Monetary policy set to stay accommodative in both the US and Europe.
- Changes to US economic policy are likely to come later and be smaller than previously expected.
- The risk of a US military conflict with North Korea is rising.
In Strategy: Three reasons why bond bears should be careful, 17 March, we warned there was a rising risk of a market correction. This week we saw the biggest one-day fall in S&P 500 since October 2016. Two main ingredients have driven stocks higher since the trough at the beginning of November. The first and, in our view, most important factor has been the turn in the global business cycle, as we are in the strongest synchronised economic recovery since 2009. The second factor has been expectations of more growthfriendly economic policy under President Donald Trump. While accelerating growth and expectations of more growth-friendly economic policy have supported risk sentiment over the past six months, we are now close to a peak in PMIs and we believe the risk of Trump disappointing the markets is increasing.
While our MacroScope short-term models remain strong across regions, our mediumand long-term models have weakened. This suggests we are close to the peak in global PMIs, after they increased sharply across regions over the past six months. This does not mean the economic recovery is set to pause but that growth is no longer accelerating. As we argued last week, whether or not growth is accelerating is the key driver for a bond bear market, not the level of growth. This week, the rally in US fixed income following the Fed meeting continued and US 10-year Treasury yields are now trading at 2.4%. While a peak in PMIs means less support for equities, we are still positive on stock markets in the medium to long term, as we expect global growth to pick up in 2018. A correction in the market would just lead to a pause in the longer term bull trend and we still like to buy on dips.
In recent months, headline CPI inflation has moved higher in both the US and Europe supported by the base effects of energy prices adding fuel to the reflation trade. The Brent oil price hit the bottom in January/February 2016 but recovered afterwards. This means the positive contribution to inflation from a higher oil price is fading (especially after the recent oil price fall from around USD55/bl to USD51/bl) unless the oil price moves higher again.
In our checklist for reflation, we mentioned four key factors for reflation, one of them being easy monetary policy (see also Strategy: The case for reflation – what it means and what to watch, 18 November). As we expect CPI inflation in the euro area to fall again to just above 1% in early 2018 and the ECB’s core inflation forecast is too optimistic (see also ECB’s core inflation forecast is still too optimistic, 14 March), we stick to our long-held view that the ECB will extend its QE purchases beyond December 2017. Although the Fed, as expected, moved on with its hiking cycle by increase the target range by 25bp to 0.75-1.00% last week, Fed Chair Janet Yellen indicated that it would be too early to remove accommodation completely. While the Fed still projects a total of three hikes this year, four hikes would be one too many, as it would make monetary policy neutral instead of accommodative, see FOMC Review: Fed says it is on track, not more hawkish, 15 March. With very low inflation expectations and core inflation still below the 2% target, the Fed has room to stay patient removing accommodation completely, especially as there are still indications of slack in the US labour market. If necessary, the Fed will postpone the next hike to avoid a repetition of what happened from 2014-16, when too-tight US monetary policy contributed to the fall in real GDP growth, commodity prices and inflation expectations.
Trumponomics postponed further
We have become more pessimistic on the outlook for Trumponomics in recent weeks, as we view the ‘repealing and replacing’ of Obamacare as a proxy for what to expect of Trumponomics. Changes to US economic policy are likely to come later and be smaller than previously expected due to the chaos within the Republican Party. Although replacing Obamacare has been very high on the agenda for both President Trump and the House Speaker Paul Ryan, the process has dragged on and it has begun to look like a crucial blow for the Republicans, as the moderate and more conservative Republicans are fighting each other about how to proceed. The vote in House of Representatives, which was supposed to be held yesterday, has been postponed to later today but may be postponed further if President Trump and House Speaker Paul Ryan do not have enough Republicans on board to win the vote. Even if the healthcare bill passes the House of Representatives, it may be dead on arrival in the Senate where the Republicans have a slimmer majority, see the article ‘House Obamacare repeal DOA in the Senate‘, from POLITICO, 22 March 2017. Due to the political process of passing a new healthcare plan in order to avoid being filibustered by the Democrats in the Senate, the Republicans cannot get going with tax reform before an agreement on healthcare has been reached. The technical explanation is that the healthcare plan is attached to the 2017 budget resolution, while the tax reform will be attached to the 2018 budget resolution and there cannot be two outstanding budget resolutions at the same time. Although we still think the debt limit will be raised or resuspended eventually (see Research US: Debt limit suspension expires tomorrow, 14 March), the chaotic situation within the Republican Party also questions how quickly they can reach a deal here.
This weekend White House budget director Mick Mulvaney said that Trump’s full budget will be released in mid-May, which, in our view, raises questions about whether the Treasury Secretary has enough time to reach a deal on a tax reform before Congress’s August recess. We have argued for a long time that it will take time to pass changes to economic policy, meaning that the biggest real growth impact would be in 2018 due to policy lags. With this new information, we think a deal on a tax reform is more likely to be reached in late Q3 17 or even Q4 17, meaning the real growth impact would be in Q2 18 at the earliest, in our view. That said, the Fed has clearly indicated that it wants to offset more expansionary fiscal policy, although it welcomes reforms that increase productivity growth.
North Korea raises US-China tensions
While markets seem less worried about European politics following the Dutch election and the (so far) strong performance by Emmanuel Macron in France, we are about to face the first test between President Trump and China, as the risk of a US military conflict with North Korea is rising. This week North Korea made its third missile launch test this year and, although it failed, North Korea is determined to develop an intercontinental ballistic missile, which would be able to reach the US. Although it is not there yet, it is getting closer. The North Korea issue is just one of many possible confrontations between the US and China and is likely to be a key issue at the meeting between President Trump and Chinese president Xi Jinping scheduled for 8-9 April. With China’s softer stance of going to the negotiation table with North Korea and President Trump’s increasing impatience, North Korea is another area of conflict bears are following closely (see also Research: North Korea raises US-China tensions, 10 March). The rising tension between the US and China also means we see a risk of a trade war between the two countries (see also Research: Don’t rule out a US-China trade war just yet, 21 February).
