Making sense of the market rebound

Two significant macro events have supported a return to risk-on behavior, partly erasing the weakness seen in late 2018. First, China strengthened stimulus measures and markets began to adopt a view that the worst of China’s most recent cyclical slowdown was probably left behind in 2018. Second, in early January, the tone of the U.S. Federal Reserve’s (Fed’s) communication appeared to take a dovish turn, suggesting fewer (if any) rate hikes ahead and more flexibility with respect to the Fed’s balance-sheet tightening. Minutes of the FOMC’s December 19, 2018 meeting released on January 9¹—coupled with a very dovish statement and press conference following the FOMC’s January 30 rate decision²—reinforced that view.

These macro developments, combined with some oversold conditions in equities, generated four important global market reactions:³

1. A broad risk-on tone has supported U.S. and global equities; the S&P500 Index has recouped about two-thirds of its losses from the September peak. Critically, this strength has been found globally, with every major equity market in the world posting gains year-to-date. 
2. Global central bank dovishness has kept most developed market bond yields well behaved and largely rangebound after markets spent December 2018 pricing out further rate hikes. Crucially, this change in policy rhetoric has supported a stabilization in the yield curve, which had aggressively flattened last December, triggering concerns about an impending recession. While the U.S. yield curve remains extremely flat, it does not appear in immediate danger of inverting.
3. Interestingly, despite a more dovish Fed and ongoing concerns about the United States’ growing twin deficits, the U.S. dollar (USD) has not materially weakened but instead remained flat. Still, a flat USD is more welcome to emerging markets (EM) (and U.S. multinationals) than a rising one, providing further support to global market sentiment.
4. Weaker bond yields, a stable USD and enthusiasm over Chinese stimulus have bolstered the EM narrative along with EM asset outperformance after a very difficult 2018.

Meanwhile, geopolitical developments continue to produce headline risks that whipsaw global markets. These risks are challenging for market participants, in large part because they are difficult to quantify, model, or forecast, and yet they can significantly alter the economic outlook for several key countries. The U.S. Economy Policy Uncertainty Index measuring trade uncertainty, for example, is at its highest level in almost 30 years.⁴ This uncertainty continues, in our view, to encourage investors to seek safe havens more than might seem typical.

From the asset allocator’s perspective, this continues to be a very tactical market in which we should expect persistent volatility. Even as Chinese and U.S. policy makers have alleviated some near-term concerns, markets will be carefully assessing the global growth profile outlook, which continues to appear soft and worsening. We should expect heightened reactions to headlines, economic data, and central bank policy over the coming months.

At the end of December, it became clear to us and to markets that China was moving from piecemeal, reactionary forms of monetary policy towards proactive, broad stimulus. This has provided a key support to EM, which relies heavily on Chinese growth and trade expectations.

What has China done so far?

The People’s Bank of China (PBoC) has recently been de-emphasizing the “neutral” component of its prior “prudent and neutral” monetary policy refrain and is now placing an emphasis on forward-looking flexibility. Indeed, three moves from the PBoC in the past two indicate it is now in full-blown “easing” mode:

• On December 19 last year, the PBoC lowered funding costs for commercial banks for the first time since February 16, 2018 in a new Targeted Medium-Term Lending Facility (TMLF).⁵ By itself, this measure was not significant enough to bolster broad growth but it did signal accommodative monetary policy and suggested broader easing ahead.
• On January 4, the PBoC cut the reserve requirement ratio (RRR) by 100 bps.⁶ While there were four targeted RRR cuts in 2017, this marked the first broad and unconditional rate cut and signaled a substantial shift in monetary easing.
• On January 24, the PBoC announced a new Central Bank Bills Swap (CBS) tool that allows investors to use holdings of bank-issued perpetual bonds to swap for PBoC bills.⁷ Critically, it does appear the tool’s primary purpose is to stabilize credit expansion and economic growth.

What’s next from policy?

We expect two to three additional RRR cuts in 2019, but perhaps more importantly, a complementary fiscal package that could include value added tax cuts and enterprise income tax cuts (to be finalized at the upcoming People’s Congress in March) and additional local government bond issuance.

However, the timing and size of these additional forms of stimulus likely depends on: (i) U.S.-China trade talk outcomes, (ii) Fed policy, (iii) the global growth outlook and (iv) Chinese corporate earnings. In our view, Beijing is not keen to undo its deleveraging and de-risking efforts of 2017-2018 and will likely err on the side of the least stimulus necessary to provide growth stabilization, particularly with respect to property and credit markets. Premier Li’s comments at the State Council’s January 14 meeting that China will not adopt an approach that will “flood” stimulus into the economy⁸ reinforces that view.

Will this stimulus be enough to support Chinese growth and markets?

In our view, the stimulus injected so far can be sufficient to provide temporary 12-18 month stabilization in the Chinese economy, mostly via improved investor confidence, Chinese market sentiment and the expectations of further easing ahead. There are, however, two important caveats. First, stabilization isn’t likely to materialize in economic data for several more months as stimulus tends to have lagged effects on growth. Second, while stabilization is on the cards, we’re not expecting a meaningful rebound or upswing in growth. In order to witness a sizeable rebound, we believe major infrastructure or property stimulus would be needed, which seems unlikely to us.

In addition, we think it’s worth highlighting that there were already some green shoots of stabilization visible in the economy in the last quarter of 2018, including industrial activity, corporate credit and a recent acceleration in leading South Korean economic data points that should support a less aggressive decline in first-quarter growth statistics before a more solid stabilization appears later this year.

All else being equal, this growth stabilization combined with additional rate cuts and corporate tax cuts should continue to be supportive of both Chinese bonds and equities.

Can Chinese stimulus and growth provide a tailwind to EM assets and/or global growth?

Once China’s economic data does stabilize, we expect the global economy to feel the improvement with a three-to-four quarter lag. This means that the rest of the world’s real economy is only likely to benefit late in 2019/early 2020, even if markets, such as China-tied copper prices, have priced in the improvement earlier in the year. For Europe, and Germany in particular, Chinese stabilization is good news and mildly improves our outlook for European growth in the medium-term.

What does stimulus mean for your currency view?

Near-term resolutions or even improvements in U.S.-China trade talks will provide short-term support to the renminbi (CNY) and we expect policymakers are keen for the USD/CNY exchange rate to remain below 7.0 until there is more clarity on the trade and global growth outlook. However, narrowing bond yield spreads between China and the United States and a shrinking current-account surplus are structural trends that are difficult to ignore. While we expect the USD/CNY exchange rate to breach 7.0 in 2019, it seems more likely that this will occur in the later part of the year rather than in the near term.

We are generally sympathetic to the idea that a sizable growth slowdown could occur in 2020. The negative impact on growth created by tighter monetary and fiscal policy and the impact of tariffs already in the system are important. It’s also clear that the U.S. economy is in a late-cycle stage and that high non-financial corporate debt could produce additional headwinds to growth. However, the amount of “known unknowns” remains too large for us to feel comfortable calling a recession that far into the future. Plus, mitigating factors include how the Fed and other central banks respond to a weaker growth outlook, the evolution of U.S.-China talks, and the potential for further global fiscal stimulus measures, particularly from Europe and China..

Right now, however, there are some important tailwinds in the U.S. economy in the next six months that we believe are underappreciated. Most of these center on the U.S. consumer:

1. Broad-based wage gains: U.S. jobs data remain extremely strong as job openings, initial jobless claims, nonfarm payrolls, and other data points continue to accelerate. The result of this tight labor market is ongoing wage gains across almost every measure.
2. Sizable tax refunds: U.S. households will soon receive their second year of sizable tax refunds. We expect some of this refund to filter through into the broad economy and continue to support consumer confidence, which remains at elevated levels.
3. Lower gas prices: Gasoline prices are down 22% since their October peak, which will provide some relief at the pump for U.S. households who spent an increasingly large share of their incomes on gasoline throughout 2017-18.⁹
4. Falling mortgage rates: As bond markets price out rate hikes and yields fall, the U.S. mortgage rate (along with other interest rates on consumer debt) has fallen rapidly. In our view, this should provide a temporary reprieve to the U.S. housing market.

These potential upside surprises for growth are important because they will, in our view, pave the way for an additional rate hike from the Fed mid-year. Markets are clearly underpriced for this outcome, especially following very poor December retail sales data, with future markets pricing in less than a 10% probability of a rate hike by even the September 2019 meeting.⁹

If we are correct, bond yields will need to re-adjust and likely the front-end of the yield curve should make one last push higher in this cycle. That move will be larger if wage inflation is viewed as creating broader core inflationary pressures in the economy.

However, higher rates may also create some volatility around equities, particularly if the 10-year Treasury yield climbs back towards 3%.

Is the outlook for EM still as favorable?

At the margin, EM remains an attractive asset class, though slightly less than three months ago. In the fourth quarter, EM benefited from a more stable USD, diminished expectations for U.S. and global rate hikes, and welcome stimulus from China. Looking ahead, we may see a short period of higher bond yields and a tactically stronger US dollar. However, overall, EM will continue to benefit from a reduction in geopolitical tensions and a more stable Chinese economy so we believe it might be too early to turn away from the asset class just yet.

Is there any good news out of Europe?

European economic data continues to disappoint, just as it did throughout 2018. But before we become too pessimistic on the trajectory of Europe, it’s worth remembering there are some mild upsides that should help the continent see a bottom in growth later this year. They include: a more stable China that supports evidence of rising wages. We will want to see a stabilization and improvement in Purchasing Managers’ Indexes before we get more excited about Europe but we also think it would be a mistake to dismiss the region entirely.

How do U.S. government shutdowns affect the economy?

Historically, government shutdowns haven’t significantly altered economic outlooks in the United States because any fall in employment or spending data rebounded in subsequent periods, leaving no material impact. That implies the economic data could actually see an artificial boost in the coming months as shutdown impacts from January are “unwound”. Economists will likely attempt to parcel out those rebounding effects, but it isn’t always straight forward. For example, the most recent U.S. government shutdown may have depressed business and consumer confidence in a way that is difficult to measure, so the multiplier effects may, at the margin, still be slightly negative on balance for growth.

1 Minutes of the Federal Open Market Committee, 18-19 December 2018. 2 FOMC press conference, January 30, 2019. 3 Manulife Investment Management, Bloomberg, as of February 12, 2019. 4 Bloomberg, Manulife Asset Management, as of February 12, 2019. 5 “Press release: PBC launches TMLF to spur lending to small and private businesses,” People’s Bank of China, December 21, 2019. TMLF offers rates 15 basis points (bps) lower than the existing Medium-Term Lending Facility (MLF). 6 “Press release: PBC decides to lower required reserve ratio for financial institutions to replace certain medium-term lending facilities (MLF),” People’s Bank of China, January 4, 2019. 7 “Press release: PBC Launches Central Bank Bills Swap to Support Liquidity of Banks’ Perpetual Bonds,” People’s Bank of China, January 24,2019. The tool was widely compared with “quantitative easing” because it’s an open-ended facility that could achieve considerable size. However, the tool is not currently buying fixed-income securities outright like other central bank QE programs. 8 “China seeks good start to year to help hit economic targets,” Reuters, January 14, 2019. 9 Manulife Investment Management, Bloomberg, February 12, 2019.