Our base case for 2020 is unchanged, looking for a global reflation dynamic to take hold that the bond markets are not positioned for. However, there are clear risks to this view and as ever, timing will be very important. We believe the current set up is the growth ‘trough’ in another mini-cycle that has been repeated multiple times since the 2008 crisis. The cause of these cycle downturns is always different but the response the same. This time, the trade war has been the primary cause and the response – monetary easing and fiscal spending – the same.
However, unlike 2012 (European crisis) and 2016 (emerging market credit crunch), the upswing will certainly prove less strong and thus likely be prone to bouts of disappointment in growth outcomes. The reason for this is this time round China is not engaging in the fiscal and monetary support anywhere close to the levels we have seen previously, undermining the ferocity of the recovery. Its focus is clear – to continue on the deleveraging path they have had since 2018 to promote financial stability above all else. The trade war was likely seen as good cover to blame outside sources for the pain of this necessary adjustment to support the switch from an investment lead to consumer growth economy. This has been occurring as China also slows structurally as GDP growth falls on the back of labour force saturation and the natural productivity growth slowdown that comes at its current stage of development.
This presents a problem for the reflation view that relies on China growth remaining supported and a buoyant Chinese currency. If Chinese growth issues – geopolitics or otherwise – worsen, the resulting response from the authorities will be to intervene in the currency or keep domestic rates high. This essentially represents management of its pegged exchange rate with the US dollar and will cause a tightening in domestic financial conditions. Exchange rates are generally allowed to float to rebalance economies externally as fundamentals change. So, if exchange rates are pegged and external rebalance is not allowed to occur, the economy will devalue internally via a fall in wages and prices. This will be a difficult political outcome for president Xi as the income hit will be extreme. A depreciated Chinese yuan is the more likely outcome and with it, China’s weak growth problems become a problem for the rest of the world. The US put yuan stability on the table during the phase one trade negotiations, which would have been a tough pill for the Chinese leadership to swallow given their fear of suffering a similar fate to Japan after the Plaza Accord. The bottom line here was continued disagreement between the US and China – which seemed highly likely – would surely precipitate yuan weakness.
If this had occurred, the Federal Reserve (Fed) would also have played its part, as the refusal to engage in more of an easing cycle (and not just insurance cuts) is propping up the dollar and preventing flows into emerging markets. If China’s economy weakens further and the Fed don’t react, then the resultant fall in the yuan would cause mass risk aversion in US markets (similar to the devaluation scare in 2016) until the Fed cut and get rates and the dollar down.
The Fed continues to not recognise the dangers of a strong dollar and their role in preventing tight dollar conditions globally. Shrinking central bank US dollar reserves (due to currencies being propped up) and the inability of emerging markets to ease sufficiently is keeping monetary conditions too tight and inhibiting the recovery.
Fed ‘QE-lite’ is a stopgap measure to support domestic funding but until funding conditions ease (through a lower federal funds rate and weaker dollar) the market will remain hooked on more and more Federal buying. Further spikes in US financing conditions will not only damage the US economy but also global financing conditions.
We remain cautious until there are clear signs Chinese growth is bottoming and/or the Fed makes further rate cuts and this logjam is broken and reflation can have a chance. Until there is resolution, bond yields will struggle to rise as global dollar liquidity continues to tighten. As growth remains lacklustre, there is a clear danger for risk assets unless this dynamic changes. We fear the Fed needs US equity market pain before they act – tightening global conditions almost guarantee that. Once we have more clarity and something gives, we will look to add reflation positions back to sizable risk levels. Until then, caution is warranted in global markets into 2020.
Mark Nash is head of fixed income at Merian Global Investors. The views expressed above are his own and should not be taken as investment advice.