Tilney Group's CIO discusses why Europe is not out of the woods yet.
'Whether Mario Draghi intentionally or unintentionally untethered bund yields in his speech in Sintra is a moot point. The data has suggested that extraordinary monetary policy needs to be dialled back for some time. However, the move up in interest rates is likely to be contained.
Our reasoning behind this dovish view starts on the other side of the world in China, where credit and fiscal expansion have helped the authorities hit their growth targets with boring precision.
Fiscal spending grew by 3.5% of GDP in 2016 and in the same time period, the change in broad credit creation moved up from -5% year-on-year in 2015 to +10% year-on-year by mid-2016. Combined, these changes catalysed a powerful stimulus to global growth toward the end of last year and into 2017.
With a lag of around eight months, this credit impulse drove a recovery in Chinese manufacturing, commodity prices and a broad rebound in global growth, particularly in emerging markets, hence the strong performance of emerging market equities.
Most observers probably credit the recovery in oil prices to the Opec output agreement November 2016. However, the low in the oil price actually occurred nine months before that meeting and almost exactly eight months after credit growth started to increase in China.
The data suggests rather surprisingly that the price of oil is dependent on policies set in Beijing rather than Riyadh. Since August 2016 the credit impulse in China has slowed materially. With the fiscal deficit increasing only fractionally in 2017, the peak in the current wave of global activity has possibly passed. Taking account of the lag effect, we can expect global GDP growth to slow in the second half of the year.
China is now the second largest economy in the world growing at probably twice the rate of the US. (Although the numbers are a little unreliable!) A change in Chinese growth today will impact the world economy and to misuse a meteorological metaphor, the wings of the Chinese butterfly are now flapping at a slower pace. The slowdown expected in China also coincides with a decline in loan and credit activity in the US, which again points to the potential of a negative growth surprise in the US over the next few months. Both indicators suggest an upward inflection in early 2018.
The second reason for our dovish view is that, apart from in the UK, central bankers targeting inflation have probably seen the headline numbers peak this year due to negative year over year commodity price comparisons. The green shoots of inflation have been music to the ears of the European Central Bank and Bank of Japan, but we fear that consistent inflation will elude them a little longer. As a result, while both may tighten marginally from current extremes, they are likely to remain extremely accommodative.
With this backdrop in mind it is possible that the Federal Reserve will make a policy mistake and raise rates into a temporary slowdown that emanates from China.
This loss of momentum could be viewed quite negatively by equity investors who are struggling already to find value in an expensive market. It is possible that the Republicans finally get something done on tax reform to ameliorate investor concerns, but in our view it is probably more likely that Janet Yellen will identify the risks and defer further increases in interest rates to the beginning of 2018 or at least the December 2017 meeting.
Mario Draghi may also feel confident enough to signal an end to the bond buying program in Europe fairly soon, but again, Europe is not out of the woods yet and the overall policy stance would remain supportive of growth and risk assets like equities.
We remain pragmatically neutral on equities, while in bonds we continue to avoid rate sensitivity, favouring short-dated credit risk and overseas exposure through selected fund managers.
Within equities we continue to have a preference for Europe amongst developed markets and also favour Asia Pacific and emerging markets.'
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