The US yield curve is steepening: has the recession been postponed?
Financial markets faced rising bond yields, mixed indicators on economic growth, ongoing rhetoric from the US in particular about the trade war and an Italian budget proposal with a significantly larger deficit than expected. In our investment policy, we have kept our neutral outlook for equities unchanged. We still believe investors would do well to take higher inflation into account. However, we do feel reassured about our contrary outlook that emerging markets are being punished too severely.
Higher bond yields in the US, emerging markets being squeezed
The flattening of the yield curve in the US has kept analysts very busy this year. After all, a negative yield curve (in which 10-year bond yields are lower than 2-year bond yields) is normally a reliable precursor of a recession. In our outlook for 2019, we initially expect inflation in the US and perhaps a recession in 2020. The yield curve is not yet negative and moreover a period of time always elapses between a negative curve and the start of a recession. As Fed-chairman Powell phrased it in simple terms, “The economy looks very good”. Last month, confidence at service sector businesses increased to close to a record high. Unemployment fell to 3.7%. Such a low level of unemployment has not been seen since 1969. No wonder the Fed announced that it wished to raise interest rates further. And so 10-year bond yields in the US broke out of the bandwidth of about 3% that they had been in for the larger part of the year. Equities stayed in the red in particular in emerging markets. Incidentally, we believe that this is not so much down to US monetary policy or the higher bond yields. In the period 2004 to 2006, emerging market equities were highly resilient to yield increases in the US. And when emerging markets lagged behind between 2010 and 2016, this was not accompanied by higher 10-year bond yields in the US. A more expensive US dollar traditionally causes misery in emerging markets, but we do not foresee a further strong appreciation in the value of the US dollar. For this reason, we retain our positive outlook for emerging market equities.
“Economic indicators displayed a rather mixed picture. ”
Mixed economic indicators
Economic indicators displayed a rather mixed picture. On average, purchasing managers in industry were almost as positive in September as they had been in August. The GDP-weighted index declined from 53.0 to 52.9, which clearly still points to growth. The decrease in China to 50.0 was the subject of much discussion and the downward movement of the past few months also continued in the Eurozone. On the other hand, there were improvements in the US, Korea and a number of other emerging markets. In fact a sharp improvement was visible in the Chinese service sector purchasing managers’ index, but Brazil and South Africa fell further. In the Eurozone, a slight slowdown was also visible in real indicators, such as industrial production and retail sales. Yet a stimulatory fiscal policy in the US, a highly cautious ECB and a gradual increase in monetary stimulation in China mean that we see no need to structure our investment policy defensively.
Italy presents larger budget deficit
The previous Italian government aimed for a budget deficit of 0.8% of the GDP in 2019. Given that Italy analysts were counting on a deficit of below 2%, the proposed 2.4% was a lot worse than expected. Markets responded negatively to the news, spreads on Italian government bonds widened and equities, especially banking equities, plummeted. It is true that the deficit is lower than that of France and much lower than had been feared when the new government took office in May, but the assumptions relating to economic growth and tax revenue would seem excessively positive, meaning that the actual deficit could easily rise to 3%. This would not be enough to reduce Italy’s sky-high sovereign debt. Downgrades to credit ratings would therefore seem inevitable, although we do not expect Italy to drop to high yield in the short term. Differences of opinion between the Italian government and the European Commission could well continue to trigger volatility for some time. Referring to the historic words of ECB President Mario Draghi in 2012, Italian Minister of Finance Tria said: “Italy will do whatever is necessary to restore calm if market turbulence turns into a financial crisis. In the face of a financial crisis, the government will do what it must do, as Draghi did.” Yet this is certain to be fraught with difficulty.
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