Financial markets already expecting sharp economic slowdown

Investment Policy, September 2019

Financial markets already expecting sharp economic slowdown

The latest phase in the trade conflict between the US and China, involving higher tariffs on further Chinese exports and (by way of retaliation) a devaluation of the Chinese currency by multiple percentage points, has led to an equity correction, above all in emerging markets, and to a further inversion of yield curves. It is possible the markets have now moved into a phase of exaggeration, as evidenced by extreme capital flows into government bonds, gold and the Japanese yen.

A month ago we wrote the following: “The financial markets currently appear to be in a – not altogether secure – state of equilibrium, volatility is back at low levels, and the moment of truth is nearing.” Well, the financial markets are emphatically no longer in balance, and “disequilibrium” would perhaps be a better description. Take, for example, the rapid rise in the global volume of negatively yielding bonds to some USD 16 trillion – in the second quarter alone, this figure rose by an eye-watering 50%. This means the bond markets are now essentially pricing in a recession – an extreme stance that forces the US central bank (Fed) to push through multiple interest rate cuts to bring the inverted yield curve back to normal. In other words, at the short end of the US yield curve (and yield curves of other countries), central bank interest rates will have to be cut further to counteract the economic slowdown and ward off recession. On that subject, the likelihood of a recession in the US remains below 50% according to the latest economic data, which have not proved that bad.


The situation of “overbought” equity markets, which was very much in evidence from the spring onwards, is now over. The inverted yield curve is a sign of economic slowdown (as now clearly priced in by the financial markets). The onus is now on central banks to take action to stave off recession. The impending rate cuts that we will see in September and in the fourth quarter have the potential to address the issue of inverted yield curves and stimulate parts of the global economy.

Corporate results for the second quarter turned out to be better than expected. In the US, an unusually high 77% of companies exceeded earnings expectations. In addition to earnings growth predictions, analysts' sales forecasts were likewise surpassed, though less so in Europe. For 2019 as a whole, the results expectations of the analyst community have become more realistic, as reflected in a decline of some 5% in earnings forecasts in the US and Europe. Indeed, earnings forecasts in the emerging markets have been trimmed by as much as 13%. All this shows that a great deal of negativity is now priced into equity markets. We think that the US president is mindful of the issue of re-election – after all, if equity markets and the US economy were to weaken significantly against a backdrop of excessive tariffs on consumer goods such as tablets and toys, his chances of being returned to the White House would be under threat. It appears that the bond markets have outpaced the equity markets in their anticipation of recessionary fears. As such, some sort of recovery in equities over the next few weeks and months – e.g. emerging markets compared to the World Index, or in quality stocks with lesser volatility (“Min Vol” stocks) relative to cash or bonds – would not come as a surprise.

Corporate results were not as bad as expected.

Gérard Piasko, Chief Investment Officer

The fixed-income markets have reached record levels in their anticipation of further rate cuts. This is true not just of the volume of bonds worldwide that now feature negative yields (see above), it also applies to the speed of the most recent price gains at the long end. It is only reasonable to assume that the Fed and the ECB (and probably also the SNB) will announce new measures to stimulate the economy over the coming weeks and months. In addition to rate cuts, this is likely to include a fresh round of bond purchases on the part of the ECB. If this scenario unfolds, corporate bonds could be the biggest beneficiaries, particularly as government bonds appear to have anticipated a great deal of negativity recently. This has led to a renewed widening of credit spreads, making corporate bonds more interesting.

In our last Investment Policy we observed that a striking feature of the currency markets was the very low level of implied volatility in historical terms, i.e. the market was anticipating relatively low fluctuations in currency rates. Implied volatility has now once again risen noticeably, mainly owing to flows into the so-called “safe haven” currencies, i.e. the Swiss franc (from EUR, but also USD) and the Japanese yen. The depreciation of the yuan orchestrated by China itself has also not been without consequences: various central banks in the emerging markets have been forced to cut their own key rates, thereby triggering a fall in emerging market currencies generally. On the other hand, this could soon stimulate the exports and economies of emerging market nations, as long as there is no further escalation of the trade conflict. To compensate for higher tariffs, China could then weaken its own currency further – up until now, some 70% of tariffs have been compensated for in this manner.

Geopolitical conflicts have intensified: These include the Sino-US trade conflict, persistent tensions in the Persian Gulf, the dispute between Japan and South Korea, and – last but not least – the policy shift of the new UK Prime Minister Boris Johnson towards a “hard Brexit”. All of this has increased demand for gold as a traditional safe haven and depressed bond yields to historically low levels. However, in the event of a correction to this extreme movement – e.g. if the economic data and equity markets were to stabilize or yield curves were to become less inverted against a backdrop of central bank rate cuts – consolidation in the gold market could result. Such a scenario should then stimulate demand for oil once again – particularly as supply risks in the Middle East have shown no sign of abating.

Gérard Piasko

Gérard Piasko

Gérard Piasko is CIO and head of the investment committee of private bank Maerki Baumann & Co. AG. Before he was for many years CIO of Julius Baer, Sal. Oppenheim and Deutsche Bank.

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Editorial deadline: 23. August 2019

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