Bond markets: Government bond prices explode in Germany and the euro zone
The European bond markets surprised everyone in 2019 with exceptionally good performance, and the third quarter was no exception. According to JP Morgan indices, German government bonds recorded a gain of 2.2% in the third quarter and thus an overall gain of 6.5% since the beginning of the year. Government bonds from the euro zone even gained 3.8% in the third quarter and 10.1% since the beginning of the year. The price fireworks on the bond market were driven mainly by weak economic data, another surprising escalation of the US/Chinese trade conflict, and measures by the central banks. For example, the US Federal Reserve lowered the key interest rate twice in the third quarter (July and September) by 0.25 percentage points each to an interest rate range of 1.75% to 2.00%. The European Central Bank (ECB) also lowered its key interest rate from -0.4% to -0.5% in September and decided to revive its securities purchasing scheme. The prospect of an imminent resumption of the ECB's government bond purchases led to a significant decline in yields on Italian government bonds.
The ECB has hardly any room for interest rate cuts. In the current monetary system with negative interest rates, commercial banks are forced to pass rate cuts completely on to customers in order to avoid losses. This provides incentive for customers to withdraw their money from commercial banks and keep the cash. With new ECB President Lagarde, the ECB could cut the key interest rate in December to -0.6% at the most while still avoiding major cash withdrawals. This limits the ECB's scope for monetary policy measures and the overall interest rate level is likely to have bottomed out for the foreseeable future. Only a comprehensive restriction of cash withdrawals would open the door to further interest rate cuts. Let us hope that our baseline scenario of stabile growth by the first quarter of 2020 followed by recovery materializes, so that the ECB will not have to realign its monetary policy.
Equity markets: The flood of liquidity provided by central banks triumphs over disappointing economic data
In the third quarter of 2019, the global equity markets developed differently. The MSCI Europe and the MSCI World posted gains of 2.1% and 1.7% respectively, while the MSCI Emerging Markets index lost 1.9% (in local currency). The US Federal Reserve lowered its key interest rate in two steps over the quarter, and the Euro-pean Central Bank (ECB) also eased its monetary policy in September. The new flood of liquidity provided by the central banks in conjunction with falling yields on the bond markets acted as a key pillar for the equity markets in the developed economies. Liquidity thus triumphed in the third quarter over disappointing economic data that was obviously not weak enough to bring prices to their knees – especially since the US and China both adopted a more conciliatory tone after a surprising escalation in the trade conflict in early August.
We believe the global economy is currently in the grey area between recession and recovery. Both scenarios are therefore possible. However, we see a good chance that growth will stabilize at a low level in the fourth quarter because eased monetary policy is strengthening growth and US President Donald Trump is unlikely to take any more economic risks before next year's elections. In 2020, the global economy could even return to the growth path, but Brexit remains a major uncertainty factor. Overall in this climate, moderately falling or stagnating corporate profits are likely in the fourth quarter. In contrast to this, continued loose monetary policy and low yields on the bond markets could boost valuations (price/earnings ratios) on the equity markets in the fourth quarter, as investors have hardly any alternatives to equities in a "non-recessionary environment". Despite risks, the chances that the year will end on a positive note for the global equity markets are good.
Euro zone: Economic weakness seems to be limited to the European corporate sector
According to the ifo index and the purchasing managers' indices, economic conditions in Europe deteriorated noticeably in September, even though consumer confidence in the EU rose from -7.0 in August to -6.4 in September and thus remained well above the long-term average of -9.5. The purchasing manager indices improved in China in September and were mixed in the United States, so the economic weakness in Europe seems to be limited to the European corporate sector. One reason for this might be the heightened concerns about a hard Brexit, which perhaps prompted European companies to cut investment spending. There also seems to be a “buyers strike” for cars due to great uncertainty as to when e-cars will establish themselves in Europe and how high the residual value of fossil-fueled cars will be. The state of Europe’s economy is therefore very fragile. Europe would have only little ability to withstand a recession, as its monetary policy has already exhausted virtually all measures and fiscal stimulus would likely be difficult to coordinate. However, in our current baseline scenario, we assume that economic growth will stabilize at 0.5–1.0% by the first quarter of 2020 and recover somewhat after that. The purchasing managers' indices in the USA and China appear to be reliable leading indicators for the European economy with a delay of three to six months. In this climate, the sideways trend in euro zone core inflation of around 1.0% is likely to continue for now. Although unemployment in the euro zone dropped to 7.4% in August – only 0.1 percentage point above the trough of 7.3% in March of 2008 – wage growth has accelerated hardly at all so far. In the second quarter of 2019, wages and salaries rose by only about 2.1% while an increase of 3.3% was recorded in the second quarter of 2008. The often extensive labor market reforms in many European countries have probably contributed to the fact that the unemployment rate in the euro zone could decline even further without noticeably accelerating wage growth and inflation.
An upswing would thus have plenty of room to unfold. It cannot be ruled out that the ECB might lower the key interest rate to -0.6% in December and increase its securities purchasing scheme from EUR 20 billion to EUR 30 billion, but this would deliver hardly any impetus to the development of the real economy. It would be much more important to reduce the uncertainties connected with Brexit and the trade conflict, to launch a multi-year government investment scheme in Europe, and to noticeably reduce regulatory hurdles for private sector investing.
US economy: Solid growth likely to wane somewhat
The US economy recorded solid growth of 2.5% in the first half of the year. In the second half, growth is likely to slow to around 2.0%, but still be above or on par with the potential growth rate of 1.5–2.0% as estimated by most experts. Particularly the US Federal Reserve's key interest rate cuts in July and September could have made an important contribution to preventing a stronger decline in growth. In this climate, the unemployment rate should either remain stable at 3.7% for the foreseeable future or even fall somewhat. Interestingly, this could fundamentally change wage dynamics. From 2011 to 2017, the unemployment rate declined continuously from 9.1% to 4.1%, and wage growth accelerated only very slowly in those seven years from 1.8% to 2.6%. In the less than two years since then with the unemployment rate at or below 4%, wage growth has accelerated sharply from 2.6% to 3.2.%. An unemployment rate of 4.0% thus appears to be a critical level. Unemployment rates below this level mean the labor market is overheated, which generally goes hand in hand with accelerating wage growth. The longer the unemployment rate remains low, the faster wage growth accelerates. In line with this, inflation is also likely to trend upwards and will probably require key interest rate hikes again next year. However, it is highly questionable whether the Fed will be able to hike key interest rates at all in election year 2020 – especially since it currently has to provide considerable liquidity for the money market in order to keep interest rates stable. One possible interpretation of the recent turmoil on the money market is that the flood of new government bond issues can no longer be absorbed at the current interest rate level and therefore the Fed is providing liquidity as a form of indirect government financing. The Fed could thus experience a conflict of objectives in 2020 between the fight against inflation, the election campaign and government financing.
Asian economy: Uncertainty due to higher value added tax in Japan – China's economy surprisingly robust despite trade conflict
The VAT increase from 8% to 10% in October is a key issue in Japan. The Japanese government plans to use it to reduce the budget deficit from an expected 3.5% of gross domestic product (GDP) this year to below 3% next year. Looking back, however, VAT increases in April of 1997 and April of 2014 both turned out to be very negative, with consumer spending declining by -1.3% and -2.6% respectively. There is therefore great concern that Japan’s economy might suffer another recession due to reduced household purchasing power. In our opinion, however, the chances are good that there will only be a mild recession this time round. So far, there has been no consumption boom in the run-up to the VAT increase, which should soften the fall compared to 1997 and 2014. In addition, the Japanese government plans to lessen the negative impact of declining consumer spending on growth by increasing government spending. There is therefore a good chance the economy will bounce back by the end of the year.
Interestingly, it seems as if China feels like it holds the reins in the trade conflict with the USA. China’s economy has been surprisingly resilient to punitive tariffs. The domestic market has obviously already reached a critical mass, so there is only little dependence on exports. Moreover, China's industry continues to rank among the world’s market leaders in numerous areas and its products are virtually impossible to replace. Several local experts also believe that, helped by central government intervention, China has brought the real estate price bubble under control, so that the trade conflict with the USA has not triggered a crash in real estate prices. In addition, the trade conflict seems to have welded the Chinese together, making it easier to implement reform measures that were difficult before. The Chinese government recently curbed real estate speculation drastically, reformed the financial system causing bank profits to drop markedly and credit interest rates to decline, and massively expanded government investments in new technologies. It seems the big tech companies in China can already draw many US tech imports from domestic sources instead. The trade conflict is thus forcing the advancement of the tech sector at home. The market for semiconductors is the only sector where China is still almost entirely dependent on the USA. In addition to the measures mentioned above, the Chinese central bank and government have sufficient other possibilities to react to any signs of weak growth, but growth stability has admittedly been “bought” by granting the government a greater role in the economy. For China's future economic success, however, it will be crucial to strengthen the private sector. Overall, China is very confident it will survive the trade conflict with the USA and will only have to make a few concessions.
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