Strategy: The US is leaving the euro area behind

As it turned out, it was the ECB that managed to deliver the surprises in a very eventful week. At the meeting on Thursday, the ECB announced an end to asset purchases by the end of 2018 and a tapering of purchases from EUR30bn per month to EUR15bn per month in the period October to December. In addition, the ECB announced that policy rates will stay unchanged at least until summer 2019. The overall message was dovish, with the ECB downgrading its growth forecast and pointing to increased uncertainty. The market reaction was also quite clear: EUR weakened sharply and German bond yields fell. Based on the dovish message, we feel confident in our forecast of the first hike not coming until December 2019, so still 1.5 years away.

While the tone of the ECB was cautious, its counterpart on the other side of the Atlantic, the Federal Reserve, sent a clear signal of confidence at its meeting on Wednesday. The median expectation among FOMC members increased from three to four hikes this year and they see GDP growth at 2.8% in 2018 and 2.4% in 2019. However, at the same time, the Fed highlighted again that the 2% target is symmetrical, which sends a signal that even if inflation should move to somewhat above 2%, it would not cause a big concern. We have changed our forecast and in line with the Fed projections now look for four rate hikes from the Fed instead of three.

In 2019, the Fed projections point to another three hikes of 25bp, taking the Fed funds rate to 3.000-3.250%. This is actually above what the Fed sees as the long-term Fed funds rate of 2.875%, indicating the Fed sees a need to step on the brake a little to avoid overheating. The market is pricing in close to four hikes this year and just below two hikes in 2019, which seems fair, in our view, given the risks to the economic outlook, which we see as skewed to the downside.

The US is leaving the euro area behind

Taking stock of the economic developments, it is increasingly visible that the US is leaving the euro area behind. Over the past few weeks, we have seen very weak German industrial orders and industrial production and this week the ZEW investor survey fell to - 16.1, which is the lowest level since 2012. This indicates that, on top of the headwind from EUR strength, the current trade frictions with the US have created uncertainty and may be holding back some investments. We expect euro area PMIs and growth to stabilise soon around current levels but we see some downside risks related to Italy and the trade war (more on this below).

We do not see the same weak picture in the US, where confidence data continues to be robust and consumers keep spending. The NFIB small business optimism index for May rose to its highest level in 35 years and regional business surveys generally stayed strong in May. Retail sales for May also surprised on the upside following a soft patch in Q1. We see three main reasons for the better US performance: First, growth is underpinned by the big fiscal boost by the US administration. Second, the US is a more closed economy than the euro area countries and the fear of a trade war is thus smaller there. Third, US industry is still benefiting from the past two years of US dollar depreciation.

When it comes to China, the data are a bit mixed. On the one hand, PMIs for May were quite robust signalling still decent growth. On the other, data for industrial production, exports and retail sales have all been on the soft side in recent months, which is more in line with our scenario of a moderate slowdown of the Chinese economy this year.

As we outlined in The Big Picture – From boom to cruising speed, 7 June, we look for the global recovery to continue in coming years, albeit at a somewhat slower speed than we saw in late 2017 and early 2018. At the same time, we also see the risks increasingly skewed to the downside.

Trade war, Italy and emerging markets key risk factors to keep an eye on

We see three main risks to the outlook that bear close watching. The most important one in the short term is a trade war. We see a rising risk that new tariffs on China from Donald Trump could lead to a re-escalation of the trade conflict and trigger a tit-for-tat trade war. We should know more on this over the weekend as it becomes clear whether Trump will implement tariffs on China as he has signalled and we see how China responds to this.

Another risk factor that has resurfaced this year, is a return of the euro crisis with a new epicentre in Italy. Following the turmoil in late May, markets have calmed down again as the new Italian finance minister Giovanni Tria has struck a constructive tone towards the EU. However, it is too early to call off the risk and we see a high probability that it will come to a clash between the EU and Italy in the autumn, when Italy is set to submit a fiscal budget to the EU.

Finally, emerging markets have seen more volatility this year and fairly sharp selloffs in selected markets, not least Argentina and Turkey. While we do not expect it to escalate into a big new emerging markets crisis, the developments here bear watching.

Financial outlook: short-term equity volatility set to stay but we still see upside in the long term

Where does this murky picture leave the financial outlook? As long as we do not tip into an outright downturn or recession, we still see equities as the most attractive asset class on a 12-month horizon. We expect volatility to stay quite high though, as trade frictions and a possible clash between the EU and Italy over the next six months will keep the market jittery.

When it comes to the bond market, we look for core bond yields to rise only moderately over the next year. A decelerating global business cycle has historically tended to give a tailwind to fixed income. At the same time though, Fed hikes and the ECB eyeing the exit next year in combination with higher US and euro core inflation should keep some upward pressure on bond yields intact.

On EUR/USD, we recently adjusted the path lower and see more downside risk in the short term. However, we still look for the cross to move higher again in 12 months, when our target is 1.25. The main drivers for EUR/USD to move higher in the medium to long term are a reversal of bond flows (as we move closer to the first ECB rate hike) and a continued robust current account surplus.

 

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