Dovish central banks: investors want more

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Equity investors focused on central bank language in July. On 10 July, during Jerome Powell’s semi-annual hearing before Congress, the S&P 500 index set an intraday record, and the next day, as he presented his monetary policy report, the Dow Jones 30 rose above 27,000 points. Equities continued to rally, slightly more erratically and at a less sustained pace than in June, as major central banks’ decisions and statements appeared to confirm the commitments they had made in previous weeks.

  • Very modest rise in global equities after late-month disappointments
  • ECB comments and growth concerns boosted eurozone fixed-income markets
  • The US dollar advanced in July despite the Fed’s key rate cut

Markets’ reactions suggest they think central banks are not doing enough…   

After the 25bp cut in the federal funds rate on 31 July, US equity markets appeared to “sell the fact”, as the old adage has it. What’s more, investors were disappointed by Chair Powell’s reference to the Fed’s move as a mid-cycle adjustment rather than the start of an easing cycle in key rates.

After gaining 6.4% in June, the MSCI AC World index rose by just 0.2% in July (in US dollars). The MSCI Emerging Market index had a rougher ride, with a 1.7% decline (in USD).

Exhibit 1: Global equities lost momentum in July

Exhibit 1: Global equities lost momentum in July

Trade tensions

International trade remained an issue for investors, with tensions between the US and Europe coming to the fore, with, among other things, the French government’s decision to tax digital majors and Donald Trump’s reacting with threats to French wine imports.

The trade truce between Washington and Beijing in late June produced no new headway in negotiations, while China’s 6.2% second-quarter year-on-year GDP growth (after 6.4% in the first) was the slowest since 1992. Trade tensions with the US are a risk, but Chinese officials appear to have room to support economic activity if necessary, even if they don’t want to rush things.

In developed economies, the second-quarter dip in growth after the positive surprises of the first quarter reflect the challenges faced by the manufacturing sector, which is running head-on into the protectionist measures implemented over a little more than the past year. Geopolitical tensions with Iran rose a notch around the Strait of Hormuz in July.

Exhibit 2: A slowdown in US and eurozone GDP growth

Exhibit 2: A slowdown in US and eurozone GDP growth

The domestic political situation in the main countries had no major impact on equities, but the change of tone on Brexit after Boris Johnson’s appointment as UK prime minister began to weigh on UK asset valuations, and sterling in particular.

Likewise, the difficulty of forming a government in Spain and tensions within the majority government in Italy have increased the likelihood of new parliamentary elections in coming months.

In the US, the 2020 presidential election campaign has, de facto, begun, and Trump’s statements are likely to trigger knee-jerk reactions on the financial markets, given the number of issues already on the table.

Lastly, the degree of unrest in Hong Kong is moving into new territory. However, for investors, it is hard to fathom.

Amid the prevailing lack of clarity, share prices were supported by better-than-expected US earnings.

  • The S&P 500, after setting a closing record a few days before the end of the month, ended July up by 1.3%.
  • In Tokyo, the Nikkei 225 rose by 1.2%.
  • European indices took a bigger hit on growth doubts and fears over global demand. The EuroStoxx 50 down by 0.2% as German shares were hit by poor numbers from the manufacturing sector.
  • Globally, with the exception of techs, investors fled cyclicals and piled into defensives, in particular in Europe.

Who is dependent on whom?

  • This looks like a fair question with the Fed having just lowered its key interest rate and the ECB virtually pledging to do the same within a few weeks as well as hinting at a new round of non-conventional measures.
  • Increasingly events are taking on the appearance of a race to the bottom, which central bankers are trying to justify on the basis of uncertain growth prospects, particularly in manufacturing activity, borne of trade tensions.
  • Very low inflation expectations are undermining the credibility of central banks’ inflation targets. These expectations are priced into inflation-linked bonds, an indicator that the central banks clearly have their eye on. Mario Draghi came right out and said so several years ago.
  • Equity markets sometimes appear to be driven more by monetary policy discussions in Washington and Frankfurt than by corporate earnings. This situation in which central banks are being driven by the markets and the markets are being driven by central banks looks like the new paradigm, and has resulted in simultaneous gains by equities and bonds since the year began.
  • Politics is also to be considered in all its different aspects (trade negotiations, new tensions in the Strait of Hormuz, Brexit in uncharted territory). Economic fundamentals, based on domestic demand within each region, do not look so bad, but it is hard to determine the outlook, given the many known unknowns that abound.
  • Central bankers have chosen pre-emptive policy to support economic activity, which provided investors with some reassurance. A fiscal relay would now be a good way to help restore confidence to economic actors, businesses in particular. Given the lack of leeway in monetary policy, the insurance policy the central banks have taken out does seem to cover most risks. Volatility in the next few weeks means some caution is warranted,  but it can provide new opportunities.

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Nathalie Benatia

Macroeconomic Content Manager

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