The last nine months have witnessed a dramatic shift in the outlook for global monetary policy. That is thanks in large measure to the further deterioration in trade relations between the US and China, which have weighed heavily on business confidence. 
An escalation of tensions between the two superpowers could even push the global economy into recession next year, particularly if other countries are dragged into the conflict.
It all seemed so different last autumn, when growing numbers of central banks appeared poised to join the US Federal Reserve (Fed) in gradually removing the monetary policy punch bowl. Now, however, the prospect is suddenly for easier, not tighter, policy almost everywhere, including the US.
This rapid 180-degree turn in the monetary policy outlook has been driven by a material weakening in the global economic backdrop, which prompted the World Bank in June to cut its global economic growth forecast for 2019 to 2.6 per cent from 3 per cent six months earlier. It warned the risks to this forecast were largely to the downside.
While evidence of a slowdown in the all-important US economy has to date been patchy, president Donald Trump’s efforts to wage war on trade with China and others have begun to take a toll on business confidence. With inflation now seen falling even further below its 2 per cent target in 2019 than the Fed had until recently expected, US policymakers have begun to signal they are ready to lower interest rates for the first time since 2008.
Significantly, the central bank recently dropped a reference to being “patient” on borrowing costs since “uncertainties” had increased the case for a cut. US money markets reckon the Fed will be forced into slashing its main policy rate by between 75 and 100 basis points over the next 12 months.
Other central banks have turned equally dovish. Most strikingly, European Central Bank (ECB) president Mario Draghi warned recently that “in the absence of further improvement… additional stimulus will be required”.
Having hoped this time last year to deliver at least one rate hike while he was still at the central bank’s helm – Draghi steps down this autumn to be replaced by Christine Lagarde – his comments suggest the ECB has gone beyond standing ready to offset downside risks if they materialise and is now committed to further stimulus if the outlook does not improve. This represents quite a turnaround in its intentions. Rates cuts, a fresh round of quantitative easing, or a combination of the two, appear to be in the offing.
Of course, the ECB, like the Bank of Japan, has far less scope to loosen policy since rates are still stuck at record lows. This is a big concern. Although both central banks are understandably keen to dispel the idea they are out of ammunition, it is far from clear how effective a fresh round of quantitative easing would be, should either economy slide back into recession.
While it is possible the US and China will find a way to de-escalate trade tensions in the short term, the dispute seems likely to intensify over a medium to long-term view. Not only is neither side in a hurry to back down for fear of loss of face, the trade war is already morphing into a new cold war with technology taking centre stage. Worse still, Trump appears to be hell-bent on opening up other fronts in his trade battles.
The International Monetary Fund said on 6 June the US economy, which is already coming off a sugar high from last year’s huge tax cuts, could face “material risks” if Trump continues to aggravate trade disputes, with repercussions that may spill over to the rest of the world. The fact US public finances are on an “unsustainable path” magnified those risks, it added.
Against this backdrop, government bond yields have plummeted. Having reached a seven-and-a-half-year high of 3.23 per cent last October, 10-year US government bond yields on 25 June dipped below 2 per cent, a two-and-a-half-year low. On the same day, German 10-year bund yields fell to a record low of -0.3 per cent, while French yields turned negative for the first time.
Although they have already fallen a long way, the worsening economic backdrop means yields may have further to fall. That is especially true of the US since the Fed has more scope to lower short-term rates than other central banks.
As for other investment markets, there looks to be some value in selective hard-currency emerging debt markets. While investing in such assets is not without risks, many bonds are offering an attractive pick-up in yield relative to US Treasuries.
European subordinated financial debt also looks attractive. European financial institutions continue to strengthen their balance sheets, which has left this type of debt undervalued relative to more senior bank debt. It also looks cheap relative to non-financial corporate debt since the balance sheets of non-financial companies, in contrast to those of banks, are becoming increasingly stretched. That is especially worrying with the economic outlook deteriorating.
It was a precipitous drop in equities last autumn that prompted the Fed to halt monetary policy tightening. While the US equity market is once again setting new highs, this is largely because the market is being supported by expectations those rate cuts will come through. The current rally in equity prices is no reason to believe the Fed will turn hawkish once again, which would risk a major sell-off. Nonetheless, although we are broadly neutral on equities, we are looking to sell into strength given our concern over the economic outlook and the extent of the recovery in prices seen so far this year.
Elsewhere, worries the US-China trade war will intensify, potentially ensnaring other nations, means we are cautious on a number of Asian economies and their currencies, in particular low-yielding ones such as the South Korean won, and Taiwan and Singapore dollars.
Peter Fitzgerald is chief investment officer for multi-assets & macro at Aviva Investors. The views expressed above are his own and should not be taken as investment advice.