210 (81-90)
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Financial markets continue to be dominated by speculation over the timing of Fed rate hikes and concerns over the health of the global economy. Growth forecasts have been cut on the margin in recent months, reflecting lower expectations for the second half of the year in the US and a materially weaker outlook for Emerging Markets. The Fed’s focus on external risks in their decision not to hike in September stoked these concerns. Despite these revisions, we don’t share the widespread pessimism. Domestic demand fundamentals remain solid in the US and Europe, and data in China are far from suggesting a sharp slowdown – leaving the world’s three largest economies on reasonably sound footing. EM growth remains a worry, but typical EM crises are unlikely given better external resilience (e.g., higher foreign reserves). Risk assets have rallied in recent weeks as markets have pushed back the timing of the first Fed hike. The interplay between markets and the Fed actually presents a challenge: better data raise the odds of a Fed hike, tightening financial conditions and thus making a hike less likely. This circular interplay is not new however, and has not prevented the central bank from raising rates in the past. But the Fed first needs confirmation that the US economy remains on track and that downside risks to China are limited – something we expect in the next few months. Only then can the Fed more credibly signal that rate hikes are coming, leading the market to price these hikes and limiting the scope of the likely initial adverse reaction. This is still possible by December, but the likelihood has diminished. In the meantime, the Fed’s delay puts pressure on the ECB and BoJ to ease further. We now expect an extension of ECB QE in coming months. While a continuation of recent gains is possible, markets will remain volatile in the near-term as focus narrows on US and China macro data especially. Further clarity on the macro backdrop and path of monetary policy will be needed for the next leg up in risk assets. David Folkerts-Landau, Group Chief Economist [more]
Markets in the last month were marked by the global correction triggered by China’s devaluation and the sharp leg lower in China equities. EM FX was particularly affected, with 5-10 percent declines across countries; commodities sold-off materially, with oil falling to its lowest level since the crisis; global equities often erased year-to-date gains, wiping out USD5tn of market capitalisation in a matter of days. High valuations in many cases justified an adjustment. However the correction, attributed to concerns over China and global growth and imminent Fed rate hikes, was overdone and not supported by any change in economic fundamentals. The growth outlook in the US, the eurozone and the UK remains robust and if anything has improved in the last couple of months. As for China, the main source of concern, while the trend of gradual deceleration of the economy continues we see growth improving into year-end, and don’t buy into the thesis of a sharp slowdown ahead. EM remains the weak spot, with growth momentum sluggish. The market correction has made valuations attractive in many cases, such as in equities and to some extent in credit. High volatility will likely remain, as it will take time for growth concerns especially in China to dissipate fully and markets to adjust to Fed hiking rates. In this environment, we remain constructive on US and Europe equities, and prefer sectors exposed to domestic demand. In credit, Europe should outperform the US given lower exposure to commodities and less sensitivity to US rates. As we approach the September FOMC meeting, the final countdown toward Fed hikes has started. In a special report this month we review the case for and against Fed hikes. We expect the Fed to hike this year; the exact timing of lift-off, September vs. October vs. December, is a very close call but we continue to see September as most likely. In any event, we do not share the view that starting the hiking cycle will be a policy mistake. [more]
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Greece, the sell-offs in China equities and in commodities dominated market attention in recent weeks and months. Greece is no longer in focus. The deal with Europe put an end to months of brinkmanship, and the risk of Grexit has receded for now – even if Greek political dynamics remain a risk in the next 3-6 months. The negative price action in China equities and commodities continues. Idiosyncratic factors can help explain it in part. The rally in China had been spectacular, comparable to that of the Nasdaq in the late 1990s, and was vulnerable to a change in sentiment; a correction was justified for many commodities given weak fundamentals. But the sell-offs also seem to reflect lingering concerns over China and global growth. Growth momentum does remain weak across EM, but is robust in the eurozone and has bottomed out in the US. We expect stronger growth in the second half of the year, especially in developed markets, backed by improving credit conditions that support private domestic demand. Global inflation remains low but has likely bottomed earlier this year. The fall in commodity prices certainly presents downside risks but does not change our expectation of gradually rising inflation, as the domestic drivers in key developed markets are improving. As a result, this will allow the Fed to hike rates this year. The exact timing (September, marginally more likely, or December) is less important than the fact that the pace of hikes will be very gradual and should not derail economic momentum. This environment is generally supportive for risk assets, and sell-offs provide attractive entry points. In rates, we expect US short-end yields to rise as Fed hikes approach while long-term yields drift moderately higher on improving macro data. In FX, improving US data and Fed hikes will lead to further dollar strength, while euro weakness will resume as ECB easing / Fed tightening divergence comes back into play; commodity currencies will remain under pressure. David [more]
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We seem to be approaching the conclusion of this episode of the Greece saga. Following rejection by Greeks of an agreement with Europe at the referendum, the odds of Grexit have risen materially. But we continue to see Greece staying in the euro as marginally more likely, not least because the majority of Greeks prefer so. Europe is intent on forcing an outcome either way in the coming days / weeks. It has effectively extended Greece an ultimatum: by 12 July the country must agree a set of actions and proposals that will form the basis for negotiating a third bailout programme; failure to reach agreement will lead to the EU discussing Grexit. Agreement will likely include tougher terms than those rejected at the referendum, given the deterioration of the Greek economy and the longer time period to be financed under a third programme. We would expect the negotiation of the new bailout programme to start immediately, with some aid to Greece under a bridge loan to finance upcoming debt payments and some liquidity for banks – but capital controls would still remain in place. Any sustainable solution to keep Greece in the eurozone will require debt relief. An outright debt haircut will be politically impossible. However, a conditional debt restructuring (along the lines advocated by the IMF) should be slightly more acceptable and would have an equivalent economic impact. Failure to reach agreement by 12 July would lead to an exit if the ECB suspends emergency liquidity support to banks, which will then effectively crystallise the insolvency of the banking system and increase the pressure on the Greek government to redenominate bank assets and liabilities while issuing IOUs. Even if the ECB maintains ELA, liquidity constraints and the deteriorating economy would ultimately lead to the same outcome. At multiple steps in the process decisions may take Greece from the road to Grexit back into the euro, and vice versa, though this late in the game turning back becomes increa [more]
Greece negotiations at last took a turn for the better, leading to a substantial relief rally as the prospect of Grexit diminished. The next step is to get the agreement approved in Greece; while we expect this to be completed in the next few weeks, the process may be noisy and result in a change in government coalition. In a repeat of prior years’ experience, global growth expectations have been marked down following a weak start to the year – but growth momentum is no longer slowing. The cyclical recovery in Europe stands out as the undeniable positive story this year, even if scope for further upside is now limited. In the US, the rebound in macro data confirms that the recovery remains intact and we expect 3% growth in the next few quarters. In China, the structural slowdown in growth continues, but recent fiscal and monetary easing will support short-term growth and the risk of a sharp deceleration has abated. EM more generally continue to disappoint as most major economies fail to gain traction. With uncertainty about the outlook for growth, global central banks have maintained a dovish bias. But central bank divergence will be a key theme in the second half of 2015 with the Fed taking a first step in normalising policy later this year while the ECB and BoJ commitment to easing remains. This macro and monetary policy uncertainty, in a world where trading liquidity has become a concern, has made markets more difficult this year. Markets have retreated or moved without clear direction over recent weeks, with several asset classes including equities and rates giving back earlier year gains. The current market environment is likely to persist, with volatility episodes increasingly likely. However, we don’t expect a material correction across the board given that fundamentals remain positive. In a special section this month, we highlight key research themes and trades that follow from our view of improving global growth and increasingly divergent monetary policies. [more]