There is still uncertainty regarding both, but we have stepped back from the brink. This should be enough to support further gains in risk assets such as equities, credit, and emerging market currencies in 2020. The dollar is a tougher call. It tends to weaken as safe haven flows abate, but firm as US rates go up.
We still hold on to our stronger dollar call against the major currencies in Q1 2020 due to growth differentials. Despite some green shoots in Europe, the US is doing better than the rest of the world and we expect this to continue in early 2020. Reduced odds of a hard Brexit and the “Phase One” trade deal remove tail risk for the entire world economy, not just for the signatories. As a result, many major central banks are sounding more upbeat (ECB, RBA, RBNZ) and this is feeding into the notion that the global easing cycle has reached an end. Perhaps that is true, but that still leaves the US with an advantage in yield and relative growth rates. We note that December Markit PMI readings across the globe have so far come in weaker than expected, while the US remains firmly in expansionary territory. Surprise fiscal stimulus out of Europe is a risk in our view, but even if it happens, it’s unlikely to come in Q1.
The Fed is likely to maintain its wait-and-see approach throughout 2020 and well into 2021. As the Fed remained on hold at the December 11 FOMC meeting, and following recent positive domestic and global economic developments, the tail risks have clearly fallen. As a result, US curve inversion (3-month to 10-year) ended October 10 and the market hasn’t looked back. Did we dodge a bullet? Markets are likely to remain on US recession watch, but our understanding of the signals from past curve inversions is that we will likely avoid recession in 2020.
The December dot plot suggests steady rates in 2020 but take it with a pinch of salt. The June dot plot suggested no cuts in H2 2019 and then the Fed went ahead and cut on both July 31 and September 18. The September dot plot suggested no more cuts in Q4 2019 and yet the Fed cut on October 30. The December dot plot also shows one hike in 2021 followed by another in 2022, while Fed Funds futures are pricing in one more cut in 2020 followed by steady rates in 2021 and 2022. While our call for steady US rates differs from both the dot plot and the Fed Funds futures strip, we suspect the latter is closer to the truth than the former. That is, one more cut seems more likely than two hikes.
There will be the regular annual rotation of regional Fed presidents in the FOMC starting with the January 29 meeting. In 2019, St. Louis Fed President James Bullard had the greatest dovish leanings, dissenting from the September 25 bp rate cut in favor of a larger 50 bp reduction. Although Bullard will not be voting in the coming year, like-minded dove Minneapolis Fed President Neel Kashkari will take on a voting role in 2020. Kashkari supported all 2019 rate cuts. While he has expressed satisfaction with current monetary policy given present economic indicators, he has been vocal about his willingness to back additional rate cuts should conditions weaken in the short term. The biggest hawks in the 2019 FOMC, Boston Fed President Eric Rosengren and Kansas City President Esther George, both dissented on all three 25 bp cuts in July, September, and October in favor of holding rates steady. While this pair will not be voting in 2020, hawkish leaning members Loretta Mester of Cleveland and Patrick Harker or Philadelphia will assume voting positions. Mester also opposed all three rate cuts in 2019 in favor of leaving rates unchanged, and Harker opposed the most recent two cuts for the same reasons. The fourth non-returning voting member Charles Evans of Chicago has remained mostly centrist with some dovish inclinations throughout 2019. The final new voter Robert Kaplan of Dallas is similarly centrist. However, he seems to be prone to somewhat hawkish preferences.
The US economy is doing better than anticipated in Q4. The Atlanta Fed’s GDPNow model currently estimates Q4 GDP growth at 2.0% SAAR, steady from the previous reading. Elsewhere, the NY Fed’s Nowcast model now has Q4 growth at 0.69% SAAR, up from 0.58% previously. It also raised its estimate for Q1 growth to 0.82% SAAR from 0.66% previously. The Atlanta Fed is likely overstating growth a bit and the NY Fed understating it, and we suspect the truth is somewhere in between. Either way, we are far from recession and the Fed is right to pause for now to assess the landscape. Because we are upbeat on the US outlook, we do not see further easing in 2020.
Christine Lagarde chaired her first ECB meeting December 12 after taking over as ECB President on November 1. Lagarde faces growing skepticism within the European Central Bank (ECB) regarding the need for further monetary stimulus as well as the efficacy of negative rates. That said, she gave a relatively upbeat outlook for the eurozone at the December meeting, noting there were signs of economic stabilization. Lagarde cited geopolitics and protectionism as downside risks, though somewhat less pronounced. While there have been signs of stabilization, these forecasts seem too optimistic and we see modest downside risks. December PMI readings suggest that 2019 is ending on a soft note.
At the press conference following her first meeting, Madame Lagarde said “I’m neither a dove nor a hawk, my ambition is trying to be this owl that is associated with a little bit of wisdom.” She is clearly bringing her pragmatic, straightforward approach that she honed at the IMF to the ECB. We think she will keep all options open and will not behave dogmatically in any way. We liked this approach when she was at the IMF and we see no reason to expect anything different going forward.
ECB’s “strategy review” to include climate change. The ECB’s strategy review is akin to the Fed’s so-called “framework review.” Call them what you will, but it’s clear that both central banks are undergoing an existential crisis in the current global environment of slowing growth despite low or negative interest rates. This will be the ECB’s first strategy review since 2003. Lagarde said she hopes to start the review in January and complete it by year-end. She said the framework has not yet completely agreed but acknowledged that it will include the “immense challenge” of climate change.
Markets have pushed out any notions of ECB easing. Surveys and market pricing no longer see another rate cut in this current cycle. Yet growth remains subpar and inflation is running well below target. While that argues for further easing, the bar to further easing is likely quite high. For the next quarter or two, we are on board with steady ECB policy. However, we cannot rule out further easing if the eurozone outlook has not improved by mid-year but Lagarde will need time to build a consensus for further easing. It won’t be easy, but it won’t be impossible either.
With monetary policy nearing its limits, the calls for fiscal stimulus have grown. Even if it happens, it could be more “qualitative” than “quantitative.” By this we mean that actions on the fiscal side could be more towards shifting the agenda on to environmental spending rather than supporting the economy as the chief priority. Still, the winds are even changing in Germany, especially after the Social Democrats (SPD) elected more left-leaning leaders. New SPD head Norbert Walter-Borjans said his party wants to improve the coalition rather than break it up but demanded that German Chancellor Angela Merkel’s Christian Democratic Union (CDU) review its balanced budget policy in order to boost the economy via fiscal stimulus. CDU officials said they still expect the SPD to honor the coalition agreement from last year, but the political calculus has clearly changed.
There were three big takeaways from the UK elections. (1) The Conservatives won a decisive majority, so Brexit is happening by the January 31 deadline. A majority of 78 seats in Parliament means that Prime Minister Boris Johnson is no longer hostage to the Brexit-hardliners and free to calibrate a deal with the EU to his liking. The UK will have an 11-month transition period to wrap up the deal, but many are skeptic Johnson can do so by the December 2020 deadline. We are less pessimistic. Johnson has proven to be a pragmatic politician and may be willing to make the necessary concessions to the EU that would “get Brexit done.” Either way, failure to do so would mean falling back on WTO rules. (2) The collapse of the far-left incarnation of Labour and the implosion of the Liberal Democrats suggests that the power vacuum at the center will eventually be filled by Labour. Our best guess is that Labour will emerge from a period of soul searching more risk-averse and nostalgic for the 10-year period when former Prime Minister Tony Blair (centrist) kept them in power. (3) The Scottish National Party will interpret their victory in Scotland as a mandate for a second referendum on independence. While not a market-moving theme, this will remain an important feature of UK politics.
Attention should now turn back to economic fundamentals. Here the story is not very compelling and it’s unclear how much room for improvement there is in 2020 given ongoing uncertainty about the UK’s future trading relationship with the EU. UK preliminary PMI readings for December were uniformly weak, and this weakness is likely to carry over into 2020. Ongoing uncertainty will still hang over UK businesses in 2020 and so the PMI readings are likely to remain subdued.
BOE Governor Mark Carney’s extended term ends on January 31. He was recently appointed as UN Special Envoy for Climate Action and Finance. In turn, Andrew Bailey was chosen to succeed Carney. This is a safe and uncontroversial choice. He was the most likely candidate by most observers, so it wasn’t a surprise. Bailey’s strong regulatory background will prove very valuable in the next stage of separation from the EU. We don’t have any predetermined view about the implications of this decision towards monetary policy going forward.
The next Governor will inherit a weak economy. We see no justification for the BOE to hike rates anytime soon. Headline inflation is running at 1.5% year over year, well below the 2% target. Growth remains sluggish, with the IMF forecasting 1.4% in 2020 and 1.5% in 2021 vs. an estimated 1.2% in 2019. The IMF does not see inflation hitting the 2% target until 2021. If nothing else, rates should be kept steady in 2020. If anything, a case can be made for cutting rates in 2020.
Bank of Japan (BOJ) kept rates steady in September, as expected. There were two dissents, with one in favor of lower rates and one in favor of changing forward guidance that currently sees current policy through at least spring 2020. The consumption tax hike goes into effect October 1. As such, the BOJ will likely wait to gauge the potential impact on the economy before moving again. WIRP suggests 54% odds of a cut October 31 and 83% December 19.
Press reports suggest that a US-Japan trade deal is stalling out. Talks ended this month and negotiations are reportedly at an impasse over the US threat to slap tariffs on Japanese autos. Japan is asking for a sunset clause that ends any deal if the US imposes such tariffs. The two countries had been working toward signing a limited trade deal, but more work is needed.
Japan has also been impacted by US-China trade tensions. However, it is also experiencing a homegrown crisis with its intensifying spat with Korea over the issue of colonial-era reparations. Both countries have put some trade restrictions into place on sensitive and strategically important material inputs.