August traditionally tends to be particularly sensitive to wider geopolitical and macroeconomic news. This is because there is a lack of corporate news, together with lower than usual market liquidity, which is caused by much of Wall Street and the City being away on holiday. August 2019 is no different with geopolitics and macroeconomics driving markets lower.
Bond Yield Inversion
Over the last month, the key talking point for the markets has been a bond yield inversion in which the US Treasury 2 year bond yield was higher than the 10 year bond yield. Generally, long-term yields are higher than short-term yields as investors expect to receive a ‘term premium’ to reward them for locking up their capital for longer time periods. In the rare cases where this does not occur, bond yields invert. The big issue for the markets is that it signals short-term interest rates will be cut, which in broad term signals a weakening economy.
Historically there has been a correlation between an inverted yield curve and the next recession. The initial bond yield anomaly only lasted a few hours; however, the brief inversion has attracted a great deal of attention from market strategists. Historically it has successfully predicted a recession within ’36 months’.
Following the 2008/09 financial crisis, the US Federal Reserve (Fed) bought government bonds through their policy of Quantitative Easing (QE). This drove bond yields to record low levels, ‘distorting’ the bond market. Therefore, there are question marks as to whether an inverted yield curve is still an accurate indicator for a recession. Only time will tell.
US-China trade tensions
Trade tensions between the US and China remain a key risk to the global economy. This is because the US and China are the two great engines of the global economy and the market remains hypersensitive to perceived progress in trade talks. The Chinese government has said it would retaliate if the US raises trade tariffs, as expected, in September. Donald Trump is seeking re-election as US President in 2020; therefore, there is little incentive for him to act before autumn next year, although there may be some tough talk.
Importance of China to the US
Although the US-China trade dispute is a key risk for markets, it must be highlighted that China only represents about 7% of total US exports; whilst by contrast, about 12% of US exports go to Mexico, 14% to Canada and 23% to the European Union. However, China is a key location for production by US companies, although other countries are capable of picking-up much of the production, if required, including India, Vietnam and Mexico.
The US has announced it has reached an agreement in principle with Japan on a new trade deal that could be signed in September. Donald Trump has also indicated that he is seeking a US trade deal with post-Brexit UK.
Although the US economy is slowing there is still positive economic news. US retail sales rose 0.7%, month on month, which is the largest rise in 4 months. The US consumer is continuing to support the US economy. Despite the buoyant US consumer, the Fed is expected to loosen monetary policy, with lower interest rates.
Unlike the US, the UK economy is experiencing an economic contraction with Gross Domestic Product in the second quarter of 2019, declining 0.2%. This is the first time that the UK economy has contracted for seven years. Economists highlighted the reason for the decline as stockpiling activity and Brexit uncertainty.
Although the UK economy has slowed, wage and employment data remains positive. Wage growth in the UK has reached an 11-year high of 3.9%, in the year to June. The number of people employed is at its joint highest since 1971, with 32.81 million in employment, 425,000 more than a year earlier.
Similar to the UK, the Eurozone is showing signs of a move towards a recession. To start with, inflation in the Eurozone, as measured by the Consumer Price Index, slowed from 1.3%, on an annualised basis, in June, to 1% in July. A year earlier inflation was 2.2%. This decline takes the level of inflation further away from the European Central Bank’s (ECB) target of 2%. The decline makes it more likely that the ECB will extend QE.
Not only is inflation in the Eurozone subdued, there are question marks about the region’s largest economy, Germany. The German central bank, the Bundesbank, has warned that the country is heading towards a recession. German industrial production suffered its biggest annual decline in 9 years, falling 1.5% in June, month on month. The economy has been hit by an escalation from the threat of a US/China trade war, which, in the summer, has resulted in a sharp slowdown in exports. This trend is likely to continue into the autumn. Demand for cars and industrial equipment has been particularly weak. If the UK leaves the European Union with no deal, German exports to the UK may begin to suffer.
China and Hong Kong
Over the last month, over a million people attended protests in Hong Kong, which totals 20% of the total population. Hong Kong enjoys a disproportionately important place in the global economy, because of its role as a ‘super connector’ between China and the rest of the world. Hong Kong’s developed capital markets and legal infrastructure acts as a valve through which foreign capital can be funnelled into China (and vice versa). The political protests could not only damage the Hong Kong economy, but also China’s economy.
The global economy is in the process of slowing down and one or two major economies, particularly in Europe, are at or very near recession. The economies and markets are likely to continue to be supported by the developed countries’ central banks utilising loose monetary policy, which could result in additional QE. Some of the developed countries’ governments may also support their economies through expansionary fiscal policy. The key risks to the global economy remains global trade tensions and the uncertainty surrounding Brexit.