Equity markets look buoyant, driven by Fed “patience” and hopes of a trade deal; meanwhile, government bond yields have fallen further as investors prepare for slower growth and its implications. Can both trends coexist for long?


1. U.S. inflation data suggests the Fed can keep its options open, and other sources of equity support can be identified.

Subdued U.S. inflation figures published this week (page 2) have reassured markets that the Fed is not going to be bounced into interest rate rises; a press conference by Jerome Powell after the FOMC meeting next week is expected to restate his “patient” approach, although markets could start to focus on changes around the Fed’s plan for balance sheet normalization as a proxy for monetary policy more broadly. An initial U.S./China trade deal could also provide a lift, even if incomplete. U.K parliamentary votes to avoid a hard Brexit and extend Article 50 should also provide support for UK and European equities.

 

2. But economic issues will eventually impact equities. And rates markets may be over-doing the gloom: we still expect a Fed hike.

But economic gravity cannot be ignored for ever. Recent Chinese data suggest industrial production growth has slowed further, and reveal that property sector worries have reduced land sales. In the Eurozone, industrial production is still down in year on year terms, despite hints of a recovery in some markets. The woes of the automotive sector cast a long shadow, most obviously in Germany (page 4). Problems in the real economy will at some stage have an impact on corporate earnings and hence equity prices: there may be hints of this already, with more U.S. companies giving negative guidance on Q1 earnings per share (EPS) than positive guidance (page 6) and consensus earnings growth predictions for Q1 have also fallen further. By contrast, on the fixed income front, we think that markets may be overdoing the gloom: their current belief that a Fed rate cut is more likely than a rate hike (page 7) looks mistaken and we still expect one more Fed hike on a 12-month horizon. As a result, we expect a rise in rates, particularly at the long-end of the curve, meaning that we continue to favour short duration fixed income assets. In short, current contradictory equity and fixed income market trends cannot be expected to co-exist in the long-term: we would expect equity market volatility and rising rates later this year.

 

3. Political debates around Brexit continue, but we still think that a soft Brexit is more likely than a “no deal” departure.

We examine the implications of the political debate around Brexit on page 3. Votes by the UK’s House of Commons to request an extension to the Article 50 process and (in theory) to rule out a “hard Brexit” boosted the GBP, although its initial gains have now come under pressure. Exactly how this political process will play out is unclear, but we believe that a soft and managed Brexit is still more likely than a “no deal” departure.

 

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