Goldilocks and the Three Bears

“Bear that in mind, yeah’” ? ???????? Arctic Monkeys, The View From the Afternoon

Written by Neil Staines, 4th October 2024.

Last week, we discussed the recent policy activism in China. We argued that after a protracted period of acute (and some might say self-inflicted) domestic demand weakness, Chinese authorities enacted a significant policy pivot. Initially, the liquidity measures were considered necessary but likely insufficient (or at the very least doubted) because liquidity without support for demand (and likely without addressing the weakness in the property market) is unlikely to alter the dial much. However, the second set of announcements, this time from the Politburo, were, in conjunction with liquidity measures, much more significant, at least in their aim to ensure the necessary fiscal spending to achieve change.??

Last week, we argued that while “it was not clear that these measures will be a panacea to all the problems the Chinese economy has faced over recent years, this is very significant from a liquidity and fiscal expansion perspective. At the global Macroeconomic level, perhaps more so!”. The subsequent rally in Chinese equities has been notable both in speed and magnitude.

While the developments are very significant to the global economy, not just China, with the Chinese markets closed for the Golden Week holidays this week, market attention has turned back to developed markets. In particular, the US, Europe and the UK.

The Three Bears???

This week in DM, the market focus has been shaped by rhetoric with Europe and the UK joining the inflation bear camp, following the Fed. I will leave it to the reader's imagination to allocate the mummy, daddy, and baby bear to the notable DM central bank players this week. Rather, we intend to discuss the bearish rate curve developments in DM more broadly and in conjunction with the activism in China to discuss the positive global growth connotations and the more goldilocksy backdrop that this provides for risk assets.

Specifically, having argued over recent weeks that the policy activism at the Fed (the September 50bp cut) was likely to increase the likelihood of both an October rate cut from the ECB and even a 50bp cut in November from the BoE, this week has seen some notable developments.

Bear Faced Truth?

Last week, we highlighted the reinstatement of the ‘Fed put’ in US equities as Powell stated that “markets can take this [the 50bp cut] as a sign of our commitment not to get behind (the curve)” and we argued that this was very important, from our perspective, especially for risk assets. On growth, the narrative continues to be relatively positive, with Services ISM data this week highlighting rebounding activity in prices and new orders (despite the more pronounced weakness in the employment component) and Chair Powell highlighting the recent GDP revisions that “remove a downside risk to the economy” - a factor they had been monitoring for downside risks. However, Powell also stated that they “would not need further job market cooling to get 2% inflation”, and that “economic conditions set the table for further disinflation”.

From our perspective, putting all this together we see Fed that is increasingly confident that upside risks to inflation have diminished, while at the same time the macro configuration continues to argue for a soft landing. While the language around the labour market is by no means one of immediate concern, there is an acknowledgement that the labour market has cooled significantly and that the Fed reaction function thus remains asymmetrically dovish.

Bear in Mind?

This week was also significant in Europe, particularly regarding the rate curve. Weaker-than-expected CPI prints at the start of this week (despite the fact that Lagarde told us at the September ECB that the September CPI print would be a downside surprise and not to extrapolate expectations) in addition to the weaker-than-expected PMI data last week (which was revised higher this week - from 48.9 to 49.6 on the composite measure), saw further rate repricing in Europe. Markets saw significant receiving in the swaps curve, and Bund yields briefly fell as low as 2.00%.

Commentators have quickly argued that the EUR can continue its move lower relative to the USD as rate repricing continues. However, we would argue that the repricing has already happened. The October rate cut is almost fully priced (94.6% probability), and the curve trough is now close to equilibrium around the middle of next year (a significantly faster rate path than previously anticipated). Further, it is clear from our analysis that Germany and Europe are likely significantly more impacted by China's growth impetus. The continuation of the current sentiment change in China could be a material positive for the German industrial growth model and for European economic fortunes.

The fiscal trajectory is the one area to caveat regarding the European growth trajectory and the monetary policy response. This week, despite pushing back the timescale for compliance with the Maastricht debt/deficit criteria (2029 from 2027), France has proposed a significant (EUR 60B) package of tax hikes and spending cuts. Italy is also considering windfall tax rises. Fiscal retrenchment in Europe will likely lead to a more (or even to justify the current pricing of) dovish ECB reaction function.?

Bear Necessities?

As we suggested last week, the monetary trajectory in the UK is also likely linked to the fiscal path. If, as we expect, there is a fiscal tightening bias from the October UK Budget (even adjusting for some liberal ‘renaming’ of some parts of the UK debt to flatter debt/GDP statistics and give spending headroom to the new government), as well as the materialisation of what we see as a weaker underlying demand trend in the UK, this is supportive of a more dovish, activist BoE.??

Indeed, it is interesting that after a long period of quiet. Governor Bailey this week warned against the prospect of a more activist BoE, stating that he “sees a chance of more aggressive rate cuts”. It is possible that the BoE has received plans or had discussions with the Treasury or even the Chancellor about fiscal plans (or indeed, they have done their own sums). We continue to see the risk of lower (front end) rates - the long end may be more hostage to the credibility or otherwise of the Budget at the end of October - Just a week before the November BoE meeting.

The Long & Short of it…

From a macro perspective, the three DM central bank bears (or perhaps more correctly, doves) support our confidence in our long-held macroeconomic views of continued disinflation and growth moderation (but not recession). If we add the fact that we also see the activism in China as positive for domestic demand, for the region, and for global economic stability, then the three bears this week have likely contributed to a significantly more goldilocksy backdrop for global equities.

What is happening next week?

Sources:

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