Dovish Tone from Central Banks Lifts Markets

On the latest edition of Market Week in Review, Quantitative Investment Strategist Dr. Kara Ng and Rob Cittadini, director, Americas institutional, discussed the recent rise in markets, deteriorating economic data and newfound optimism surrounding the China-U.S. trade war.

ECB, Fed may slash rates in next few months

Dovish statements from central bankers led to a sharp uptick in markets the week of June 17, Ng said, noting that the S&P 500® Index closed at a record high on June 20. European Central Bank (ECB) President Mario Draghi kicked off the surge by stating that the ECB will provide additional monetary stimulus if economic conditions do not improve in short order, she noted. “This could include cutting rates, or restarting the ECB’s bond-purchasing program,” Ng stated.

U.S. Federal Reserve (the Fed) Chair Jerome Powell struck a similarly dovish tone the following day, she noted, preparing the market for interest-rate reductions at subsequent Fed meetings if growth remains subdued. “At Russell Investments, we now expect rate cuts at both the Fed’s July and September meetings,” Ng said, adding that this could be enough to un-invert the U.S. Treasury yield curve, barring any additional escalation in the trade war.

“Central banks essentially act as circuit breakers for the economy—using dovish monetary policies to protect the health of the economy,” she said, “and this is why the dovish chatter of the past few days has been very reassuring for markets.”

The rationale behind this year’s dovish pivot, however, is a bit more concerning, Ng said. “Economic data is deteriorating globally, and central banks have limited firepower to respond to this, in the form of interest-rate reductions,” she explained, noting that borrowing costs across the globe are already at historically lower levels. “The Fed is nine rate cuts from zero lower bound—which occurs when the short-term nominal interest rate is at or near zero,” she said, explaining that historically, the Fed cuts interest rates approximately 20 times to combat a recession. The ECB, Ng noted, already has negative rates.

Manufacturing surveys point to continued weakening

Zeroing in on the latest economic data, Ng said weakening in the manufacturing sector, coupled with a downturn in business confidence and business investment, is concerning. “The root cause of most of this is probably trade-related,” she said, “and my concern is that this could set off a downward spiral in confidence that could ultimately draw the globe into a recession.”

The yield curve, as measured by the difference between 10-year and 3-month yields, has now been inverted for a month, Ng noted. In addition, recently-released U.S. regional Fed manufacturing surveys painted a dismal picture. Lastly, flash Purchasing Managers’ Index (PMI) surveys from June showed the manufacturing and U.S. services sectors at levels barely above 50—the threshold between growth and contraction. The U.S. manufacturing sector logged its lowest reading in almost ten years, she said, adding that manufacturing activity continues to contract in Europe and Japan.

China-U.S. trade war: Bull- and bear-case scenarios for risk assets

Markets basked in optimism following a June 18 tweet from U.S. President Donald Trump, stating that he and Chinese President Xi Jinping would discuss trade at an extended meeting during the Group of 20 summit at the end of the month. “While this was incrementally good news, the president didn’t provide much in the way of substantive information—which leads me to believe the market may be on a sugar-high, in reading too much into this tweet,” Ng said.

Ng and the team of Russell Investments strategists see both bull- and bear-case scenarios for risk assets, she said. “Our bull-case scenario is that the U.S. and China reach an agreement on trade while central banks ease on a global level,” Ng stated, “and this is our low-conviction, most-likely scenario.”

The bear case for risk assets, she said, is a scenario in which there is no trade resolution, and central bank stimulus is bound by 0% interest rates. In this situation, a global recession would be possible, Ng noted.

“Ultimately, because there’s such an asymmetric risk around these two divergent scenarios, we’re more cautious than usual—and we continue to reiterate the importance a properly diversified multi-asset portfolio may play in times like today’s,” she concluded.

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