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Economic Outlook: Headwinds Start Blowing Again
Richard Brown
The head of Kleinwort Hambros Yorkshire Office, Richard Brown, comments on the latest economic headwinds.

“Following on from the first quarter, Q2 in 2019 continued to see global equity and bond markets rally. However, global equities had a more muted rise over the last three months – +2.9% compared to nearly +11.6% in Q1 – and were volatile, with a sharp sell-off in May sandwiched between strong surges in April and June.

In contrast, global bond markets saw a much stronger gain of +3.5% in Q2 compared to +1.6% in the prior three months, as yields fell across most markets in the midst of trade wars fears, and the latest pivot towards looser monetary policy by key central banks.1

“Both of these factors continue to be powerful drivers of sentiment. In regards to trade, the G20 summit in the tail end of June saw the US position on China soften. Nonetheless, a quick resolution is unlikely, and tariffs are likely to continue for now. However, both sides simply have too much to lose in a protracted conflict; our base-case scenario still hinges on a deal by year-end.

“Moreover, while trade tensions have undeniably contributed to a global economic slowdown – particularly in manufacturing – services have so far remained relatively resilient due to robust domestic consumer markets, which in turn are being supported by lower unemployment and higher wages in the developed world, and by tax cuts in China. Indeed, it is likely the Chinese authorities will increase stimulus measures to mitigate the impact of US tariffs.

“Financial conditions, too, remain accommodative across the board. The Federal Reserve’s (Fed) shift to a dovish stance over 2019 has helped tighten credit spreads and lift risk assets. The dovishness is, however, linked to rising trade tensions which have clouded the macro outlook, with markets pricing a series of rate cuts over the next year. The Fed has hinted that cuts are possible, as inflation expectations have dropped sharply, and growth momentum is easing.

In the euro area where momentum is turning weaker as well, the European Central Bank has less room to manoeuvre as deposit rates are already negative; a new round of asset purchases is not yet on the cards. Fiscal easing may well prove a necessary adjunct.

“In the UK, the Brexit can has been kicked down the road to October 2019 at the earliest, with the increasing possibility of the incoming Conservative Prime Minister being a hard-Brexiteer. Another deadline extension and/or early election appears likely. The continuing Brexit uncertainty is being reflected in weakening sentiment – both in manufacturing and services – and slowing corporate profit growth; it is also clearly exhibited in GBP volatility. Nevertheless, we do expect an eventual deal of some kind – albeit with weak conviction – and Sterling to grind upwards over the next year.

“After the recent leg higher, equity valuations now stand between fair to slightly expensive, depending on the market. Nonetheless, we remain sanguine on the asset class which is in a strong uptrend, but without the over-bullish sentiment which would be a red flag. We also have allocations to investment grade bonds, High Yield credit and emerging market debt, which continue to be buoyed by favourable conditions including low inflation, dovish developed central banks and limited default risks.

“Nonetheless, prudence is critical. Over the second quarter, we increased duration in our government bond holdings – going from short to neutral – despite uncomfortable valuations. While yields have fortuitously fallen further since, we continue to believe government bonds offer poor value in absolute terms. Nonetheless, they continue to be critical in offsetting risks from equities and other risky assets, similar to our positions in gold and low volatility alternative strategies.”

Economic Outlook: Headwinds Start Blowing Again, 10th July 2019, 15:53 PM