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Market Insights – 7th of October 2019

Each week, a team of experts shares its market views with you.

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Essentials

There is now a real risk of a technical recession in Germany. Manufacturing orders fell again in August, yet another sign that the economy is losing steam. These latest developments are putting more pressure on the government to bring in fiscal stimulus.

Uncertainty surrounding Brexit is weighing on the UK economy. The services sector has moved back into contraction territory, following in the footsteps of the manufacturing and construction sectors. It is still difficult to predict how Brexit might pan out – the divorce deadline is fast approaching and Boris Johnson’s most recent proposal has received a cautious reception in Brussels.

Although they fell short of expectations, September job creation figures in the USA were high enough to keep the economy at full employment. Unemployment dropped to 3.5% – its lowest level in 40 years – and wage growth remains under control, which means the Fed can keep loosening monetary policy without having to worry about a spike in inflation.

Central bankers and politicians play currency games

There have long been hopes that monetary policies would return to normal. But the window of opportunity closed in 2018 when the Trump administration launched a trade war against China. The ensuing global economic slowdown prompted major central banks to make an about-turn this year. Central banks in Europe, the USA and a number of other countries are now back in stimulus mode, which means they are loosening their monetary policies for the umpteenth time this cycle.

In many cases, one of their aims – albeit unspoken – is to weaken their currencies. After all, when a country has to kick-start a stalled economy, devaluing its currency is often one of the most effective tools available. But our 21st-century world is extremely interdependent and countries’ business cycles are very much in sync, so currency devaluation often turns into a zero-sum game between the main economic regions.

Countries or currency regions that weaken their currencies get to reap the benefits in the short term but then have to face the response. This is typically what happens in a currency war. Given that interest rates are negative and the ECB has begun injecting money into the economy again through another asset purchase programme, the Fed’s measured response is unlikely to prevent the dollar from gaining ground. That is unless President Trump manages to win over Fed Chair Jerome Powell or pushes him to resign. Emerging currencies also have upside potential, although much will depend on how the Chinese yuan moves and whether the trade war subsides. The fate of the pound, another weak currency, will also depend on political developments: it could gain ground if the risk of a no-deal Brexit fades. We should soon know what the future has in store for that currency, unless Boris Johnson – like Theresa May before him – finds himself asking for another Brexit extension.

USA: No recession in our scenario

The economic uptick that investors had been hoping for won’t materialise in the second half of the year, mainly because of the unexpected escalation in the US-China trade war.

However, we still don’t think a recession is on the cards – at least not for the next 12 months. Most models that forecast a contraction in US GDP focus on the yield curve, which represents the spread between three-month and ten-year government yields. The yield curve inverted back in May – something that has always happened before past recessions. But this time around, the bonds of a growing number of countries are subject to negative interest rates; this skews things by creating extremely high demand for US debt and compressing the long end of the yield curve.

Other economists sounded the alarm when the manufacturing sector entered contraction territory. But manufacturing accounts for only 15% of GDP. Demand in the services sector, which is the main driver of growth, is still robust, even if it has also fallen. It will therefore take more than a temporary contraction in manufacturing output to plunge the world’s largest economy into a recession.

It’s worth remembering that the best stock-market returns are achieved just after a recession and just before the next one, as investors give way to euphoria. We don’t think we’ve reached that point yet, which is why becoming bearish too early could mean losing out on potential gains.

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