Q2 outlook - Introduction: Inversion of US yield curve not to be ignored, but neither should US-China trade negotiations

After a drastic final three months in2018 and a dramatic flash crash to begin the new trading year, the first quarter of 2019 offered a welcome relief for equity investors.

Volatility declined by more than 40%, US and most European indices recorded double digit gains, and China became the best performing market, with the CSI300 Index rising above 28%. This performance can send its gratitude and thanks to major central banks pausing monetary monetization led by the Federal Reserve. The decision to abandon further tightening in monetary policy sent government debt with negative yields above $10 trillion, which is another reason why equities had a strong performance.

The post-economic crisis expansion has been a very long one according to historic norms, and whether it still has further room to run depends on what economic data has to say. Will it turn brighter or continue to head south? The inversion of the US yield curve, an environment in which long-term debt yield declines below the short-term ones has historically been an accurate predictor of economic recessions. This is why investors panicked when on March 22, the US 10-year Treasury Yield declined below the yields of three-month treasury bills for the first time since 2007.

Whether this inversion is going to be an exception to previous ones that led to an economic recession remains unknown, but it is certainly a warning signal.

Past yield curve inversions have tended to precede economic recessions by about 6 – 18 months. However, investors begin to sell risk assets well before a recession occurs. They don’t wait for a recession to hit. That’s why economic data releases in the first few weeks of the second quarter will play a significant role in determining whether to hold onto risk assets or begin liquidating positions. Equity investors may forgive a quarter or two of negative or slow earnings growth, but if it the trend resumes further, they might consider beginning to search for the exit doors. 

While much attention will be focused on turningto economic data, investors also need to keep an eye on US-China trade negotiations. Although tensions between the world’s two largest economies eased significantly in Q1, we howeverstill don’t have a signed deal yet. The biggest concern among investors is that negotiations might break down and we return into a new period of prolonged uncertainty.

Our view on equities is neutral in Q2 with risks tilted to the downside. Special attention needs to be provided to earnings, not just for Q1 but the forward guidance offered for Q2 and beyond. While lower interest rates will provide a boost to profits, higher wages and diminished growth expectations will have a negative impact. Hence, expect to see more volatility going forward.

In such an environment of potential volatility, the Yen may outperform its major peers as investors seek safety in their portfolios. The Dollar also has further upside potential, given that the US economy continues to be in a better shape in comparison to its developed counterparts. Sterling will be the most volatile currency as negotiations around Brexit resumes however any good deal with Europe will provide a strong push to the currency.

Here’s our outlook for the coming three months.