Bond markets: We expect euro zone yields to move sideways until the end of the year
After a very good first quarter, European bond markets performed strongly again in the second quarter. According to the JP Morgan indices, German Bunds recorded a gain of 2.0% while government bonds from the euro zone even gained 3.4%. A decline in yields was decisive for this positive performance. The yield on ten-year German Bunds dropped from -0.07% at the end of March to -0.34% at the end of June. The yield on ten-year Italian government bonds even dropped from 2.5% at the end of March to 2.1% at the end of June. These declining yields resulted from a sudden escalation in the US-Chinese trade war at the beginning of May which came as an economic shock to the global economy, thus intensifying the global downturn. The weak economic data combined with a persistently low inflation rate prompted financial market players to speculate that the ECB could soon lower the key interest rate again and reactivate its securities purchasing scheme. This was more or less confirmed by ECB President Draghi in his speech in Sintra, Portugal in mid-June.
The key question for the future is whether the European economy will succeed in stabilizing growth in the third quarter in order to create a basis for growth in the fourth quarter. If the trade war does not escalate any further, there is a good chance the European economy will bottom out. If this happens, yields on government bonds will have reached their trough – provided the ECB lowers the deposit rate to only -0.5%. However, there are voices already predicting a rate cut to -0.6% or even -0.7%. Based on our forecasts, we expect yields to move sideways until the end of the year and, due to economic recovery starting in the fourth quarter, we expect yields to rise in 2020. The rather one-sided expectations of financial market players also back up our forecast – they hardly expect yields to rise at all any more.
Equity markets: Scope for higher valuations in the third quarter
Despite the surprising escalation in the US/Chinese trade war at the beginning of May and weak economic data as a result, the global equity markets performed positively in the second quarter. The MSCI Europe closed the quarter with a gain of 4.5%, while the MSCI World gained 3.8% and the emerging markets MSCI Index gained 0.3%, all in local currency. The expectation of prompt monetary policy easing by the major central banks appears to have been sufficient to offset weak fundamentals. The "trade war ceasefire" agreed in Osaka at the end of June also helped to calm the waters and triggered expectations that there would be no further escalation any time soon.
According to our calculations, the noticeable decline in interest rates and low inflation rates open up some scope for a higher valuation of the equity markets in the third quarter. In addition, stabilizing economic momentum could bring a small rise in profits for companies represented on the equity markets. The combination of higher valuations and rising profits could also generate price gains on the global equity markets in the third quarter. However, there are also some risks, e.g. of another unexpected trade war escalation, a hard Brexit or other political events. There is also a small chance that central bank measures might come too late and the global industrial sector could drag the previously solidly growing services sector into recession.
Euro zone: Economic recovery strongly dependent on the course of the trade conflict
Economic growth in the euro zone was surprisingly robust in the first quarter (0.4%), although this was largely due to special factors. Basically, the growth trend of 2.0% in the euro zone seen between 2015 and 2018 does not appear to be sustainable. The economy is likely to grow by only about 1.0% in 2019 due to a high level of uncertainty about the global trade conflicts burdening the industrial sector and causing it to shrink. By contrast, growth in the service sector slowed only slightly. Core inflation has remained stable at around 1.0% in recent years – far from the ECB's inflation target of 2.0%. On June 17 in Sintra, ECB President Draghi reacted to the weak economic data and the persistently low inflation rate by announcing his intention to relax monetary policy again. Therefore, we expect a key interest rate cut to -0.5% in September, a resumption of the securities purchasing scheme, and an introduction of a tiered reserve system. Interestingly enough, Italian government bonds benefited the most from the announcement. At the beginning of June, yield on ten-year Italian government bonds was still 2.7%, but it dropped to 1.6% at the beginning of July. Should the yield on Italian government bonds settle at these levels, new financial leeway would open up for Italy's government budget in 2020 due to lower interest costs. Perhaps the marked rise in interest rates starting in May 2018 and the recent decline were a salutary shock for the government. A glance at recent history also shows that a decline in yields in Italy has often stimulated economic growth. Further developments in the trade conflict will be a decisive factor in determining whether the euro zone economy can recover somewhat in the coming months. If there is no escalation, then a return to a moderate upswing seems likely, including waning uncertainty, easy financing conditions and an expansive fiscal policy in several European countries.
US economy: Good prospects for an upturn, assuming the trade conflict does not escalate any further
The global trade conflict seems to have caused major economic damage worldwide. The direct effects of higher tariffs turned out to be less of a burden than the indirect effects of heightened uncertainty. The US is also increasingly affected by this, as the deteriorating business climate in the US industrial sector shows. For example, the ISM index dropped from 60.8 in August of 2018 to only 51.7 in June of 2019. A slowdown in growth momentum accompanied by decreasing inflation (core inflation was only 1.5% in May) provides leeway for key interest rate cuts. We expect key interest rates to be cut by 0.25 percentage points in both July and September. If the trade conflict does not escalate any further, there is a good chance that growth will pick up in the next few months and the US Federal Reserve can take a longer interest rate pause after the two steps we expect. We are optimistic about this because demand for residential real estate has already responded to lower mortgage yields and has risen. This reaction indicates that the monetary transmission mechanism is still functioning well – and this should soon be reflected in an overall economic upturn.
Asian economy: Good prospects for economic growth in Japan, slow economic growth in China
The Japanese economy is characterized by a dichotomy between an industrial sector burdened by the global trade conflict and a solidly growing service sector. In an international comparison, however, the Japanese industry seems to be holding its own. In June, the Japanese
purchasing managers' index for the industrial sector was just under the 50 mark at 49.3 and thus almost in line with stagnating production levels. By contrast, the purchasing managers' index for the German industrial sector has remained between 44 and 45 since March, signaling a deep recession. Interestingly, the German industrial sector performed significantly better during the financial market crisis in April of 2009 after a 23.6% slump in industrial production than the Japanese industrial sector did in February of 2009 after a 35.7% slump. This time, however, the German industrial sector appears to have been hit harder, mostly due to its strong dependence on the automotive sector and to noticeably declining exports to the UK and Turkey. Moreover, the Japanese industrial sector seems to be investing more heavily in digitization and automation, despite heightened global uncertainty, because a shortage of labor caused by ageing is more or less forcing it to. According to the Tankan survey, large companies are planning to increase their capital expenditure by 7.4% in the current fiscal year. The economic prospects for Japan thus still look good.
The Chinese economy suffered another economic shock in May after US President Trump suddenly imposed additional punitive tariffs on China. The main concern of the Chinese government seems to be the weak labor market. Therefore, the Chinese government and the Chinese central bank are currently announcing new steps to support the economy just about every week. However, they are always given in "homeopathic doses", as the Chinese government wants to avoid a noticeable increase in debt. Growth in China is therefore likely to remain sluggish, but a slump in growth is not expected because the government and central bank can take unrestricted countermeasures at any time. Furthermore, it is entirely possible that the trade war ceasefire will hold up and the conflict will not escalate any further, as US President Trump is unlikely to take any major economic risks prior to the US presidential elections next year.