A dovish pivot by the Fed regarding interest rate and balance sheet prospects supports risk assets (equities, corporate credit spreads)
The Fed shifted its bias regarding rate increases at its meeting on Wednesday. It proposed that the next rate move could go in either direction and announced that the decline of its balance sheet (end 2017: $4.4tn, current: $4tn or 20% of GDP) may be completed sooner than planned and with a larger terminal value of assets than previously expected (our estimates: $3.5tn vs $3.1tn).
In light of increased market volatility and elevated external risks (trade, slowing growth in China and Europe, Brexit), Chairman Powell suggested that a “patient” approach is warranted until the economic outlook improves. Policymakers appear keen on maintaining a neutral stance to the economy in the absence of inflation pressures, despite strong job gains and sustained wage growth (see Economics).
Trade negotiations between the US and China continued in Washington (30-31 January), with policymakers from both sides suggesting substantial and constructive progress has been made, albeit “much work remains to be done”. China has committed to increase its US imports in order to gradually contain bilateral trade imbalances, but it is unclear how other thorny issues will be dealt with (e.g. technology transfer, intellectual property protection). Talks will likely continue in Beijing in mid-February, while both leaders could meet in late February to finalize a potential agreement (prior to the March 1st deadline).
Euro area GDP data confirmed that growth momentum remained soft in Q4:18. Output was up by 0.9% on a quarterly annualized basis, from 0.6% in Q3 and 1.6% on average in H1. This was partly due to the (technical) recession in Italy in Q4:18 (-0.8% qoq annualized), as GDP contracted for a 2nd consecutive quarter. More worryingly, German and Italian indicators (IFO, PMI) suggest a continued loss of momentum for underlying activity in January. Persisting uncertainty surrounding trade, Brexit and global growth, as well as idiosyncratic risks, have likely weighed on business sentiment. Meanwhile, price pressures appear muted, with core inflation at 1.1% yoy in January (largely stable since mid-2017, ranging between 0.9% and 1.2%).
In the UK, PM May mustered support to renegotiate the Withdrawal Agreement with the EU, in order to change the Irish backstop provisions, while MPs in the House of Commons rejected an attempt to extend Article 50. Regarding the latter, MPs will have the opportunity to vote again on a potential delay to Brexit on 14th February.
Global equities ended January on a strong note, as the MSCI ACWI up rebounded by circa 8%, led by emerging markets (up almost 9%). The softening of the US dollar due, inter alia, to the Fed’s stance has supported EM assets. Some risks facing investors have moderated slightly compared with late 2018 (e.g. due to constructive trade talks, China’s policy easing), hence risk appetite has improved and risk assets have rallied.
The USD has lost circa 3% ytd in nominal terms due to softening growth momentum, political backlash and a sharp downward repricing of interest rate expectations. The depreciation is mostly against high yielding FX (CAD, AUD: -4% to -2.5%) and idiosyncratic plays (GBP:-2.6%), while it has treaded water against low-yielders (EUR, JPY), which also face economic deceleration issues.