BlueBay Asset Management: American supremacy

April 26, 2019

The numbers don’t lie…US economics look rosy, while Europe trails on lacklustre growth and EM is rattled by Turkish and Argentine troubles.

American supremacy has been a growing theme during the past week, as US stocks moved to record highs, buoyed by supportive data and a benign policy backdrop. US Q1 GDP data is due to be released today, with the Atlanta Fed Nowcast estimate having moved up to 2.8% for the quarter, buoyed by consumer and labour market data. 

Dollar leads the FX story

US economic outperformance has also seen the dollar begin to move firmer in recent days.

Currencies have largely been out of the limelight lately, with volatility dropping across the major crosses and, while an improving backdrop for the global economy should point to some growth convergence ahead, for the time being, it seems that the US remains dominant and this could, in our view, create a risk for the dollar to break stronger should upside surprises persist.  

Rates cut unlikely, in our view

Notwithstanding this, Treasury yields have rallied in the past week and in this regard, it seems that market participants are looking for confirmation of a benign trend in prices to further confirm a dovish shift in the mindset of the Federal Reserve (Fed).

One school of thought argues that if inflation is failing to show up at this point in the expansion, then there is a risk that it will serially undershoot during the next economic downturn.

There may certainly be some logic to this line of thought, yet to conclude that it would be wise to try to create inflation by cutting rates and stimulating demand further would seem like a reckless approach to monetary policy in the extreme and something not warranted at a time when it appears that growth remains firmly above the long-term potential growth rate.

In this context, some of our own dialogue with US policymakers has reviewed past hiking cycles, with particular interest on how the FOMC cut rates in mid-1995 during the middle of an expansion, following an 18-month period when rates had risen by 300bps to 6.0%.

Although this historical period could suggest that rates could be cut during the current economic expansion, we would note that real rates today are almost 300bps lower than was the case in 1995.

Also, in the six months prior to the 1995 rate cut, GDP growth had slowed by more than 2% from its average in the prior 12 quarters.

In this context, we could see how a Fed rate cut today may be justified if growth dropped below 1% for a six-month period, or if core inflation remained stuck below 1.5% for a number of months – yet both of these seem unlikely, in our view, today.

By contrast, we would assess that if GDP growth pushes above 3% (materially above the last FOMC 2.3% projection for 2019) and were core inflation to breach 2.5%, then higher rates would seem very likely to follow.

With the second quarter having tended to be more positive than first-quarter growth in recent years, such an outcome on growth cannot be ruled out – even if it seems that the inflation dynamic remains much more stable for the time being.

Europe trails its transatlantic peer

In contrast to recent US data, European figures have remained lacklustre. This week’s IFO series confirmed that the underperformance of manufacturing and auto sectors is yet to abate, and although we feel more hopeful going into next week’s eurozone growth data, it seems that there is limited evidence of a convergence in global growth and more of a picture of rising US supremacy for the time being.

Elsewhere in the eurozone, Greece impressed with a 2018 fiscal primary surplus at 4.4% - well above expectations. We continue to believe that the extent of the fiscal transformation in Greece is yet to be fully digested by markets and rating agencies and we remain constructive in our view of GGB spreads.

Over the week, the periphery traded somewhat weaker as investors worried over the outcome of an S&P rating review for Italy due Friday evening. We believe this is likely to end with an unchanged BBB rating, or else a move to low BBB with a change in the outlook to ‘stable’.

We remain very sceptical that Italian investment-grade ratings will come under pressure any time in the foreseeable future.

All quite in corporate credit

In a holiday-shortened week, there was little to report with respect to corporate credit, with spreads consolidating following a strong start to the month.

Idiosyncratic stories rattle EM

Emerging markets (EM) traded softer as the dollar firmed and, in Argentina, a move in CDS spreads to a new high above 1,000bps highlighted growing risks as opinion polls suggest an increased risk of Cristina Kirchner defeating Macri in the October election. Were this to occur, we see elevated risks that this could see the need for a further bailout package and a likely bail-in of international investors.

Although this remains more of a tail risk than a central view, we have been reducing EM exposure following a period of positive performance over the course of the past week, as it feels like headwinds from Turkey and Argentina could pose an obstacle to future performance, in our view.

Looking ahead

Growth and inflation data for Q1 will be the focus for us in the next several trading sessions.

At the end of next week, Japanese markets will be closing for a 10-day holiday to celebrate the change of Emperor and this could lead to some position squaring with investors in Tokyo particularly unaccustomed to taking such an extended break.

However, looking through the noise, the message of a robust US economy seems to be one which seems unlikely to change anytime soon. In America, it seems like the sun is destined to keep shining.