Investors have heeded our advice and adopted a risk-off approach over the last quarter — the yields of core government bonds have fallen, equity markets have had a mixed performance and emerging market assets have sold off. We attribute the decline in core government bond yields to a fall in the term premium, rather than a lower expected path for interest rates. Given investor uncertainty, in part related to simmering trade tensions, and our expectation that a global recession is on the horizon, our top-level asset allocation is unchanged in Q3.
For more a more detailed explanation of why we anticipate a recession in 2020, please see a recent News in Charts: ‘Time to batten down the hatches?’, 14 September 2018. In short, with the US already operating above capacity, and with growth set to remain well above its post-crisis trend both this year and next, we believe the economy will overheat, with rising inflation and interest rates tipping the US economy into recession in 2020, dragging the global economy down with it. Perversely, a significant escalation of the Sino–US trade tensions is one of several factors that could postpone the correction. Ultimately, however, in this world we would anticipate an even bigger recession further down the line as global imbalances build.
We have revised up our forecast for China’s growth this year, which we base on our China Momentum Indicator (CMI), as the economy has outperformed our expectations over the past three months. Although we correctly predicted that the renminbi would depreciate, it has done so a lot faster than we anticipated, which seems to have boosted growth. The bigger picture, however, remains that we think that China’s growth has peaked, and we expect real growth to slow by more than the government’s official forecasts imply. Trade tensions are reflected in the drop in our China Exposure Index (CEI). (For more on the CEI see the Fathom Proprietary Indices section of Thomson Reuter’s Eikon Chartbook or contact Fathom Consulting.)
We have retained our overweight bonds/underweight equities position, although we have made a few adjustments within this broad allocation. We have trimmed our US GDP growth forecast for 2018 from 3.2% to 3.0%, although this was simply the arithmetic consequence of revisions to last year’s data. Over the course of 2018, we have made only small changes to our forecasts for US GDP growth and inflation, while the consensus estimate for both has risen and moved a lot closer to ours. The economy expanded at a healthy clip in Q2, and we anticipate strong growth in the coming quarters. And while we have trimmed our 2019 headline inflation forecast due to a weaker outlook for oil prices, we still expect core inflation to rise a lot more than most other forecasters do (the charts below were created using data from the Reuters Poll of economic forecasters).
In ‘Brexit Britain’ more or less anything could happen — politically and economically — over the next few months. On balance, we feel that the prospects of a ‘No Deal’ departure next March are slightly overdone. Nevertheless, we have reduced the weight we attach to our central scenario, which sees the UK leave with a withdrawal agreement, ushering in a long period of transition where uncertainty about the terms on which the UK will trade with the rest of the EU remains elevated for some time. The probabilities we attach to the ‘tail risks’ of a ‘No Deal’ Brexit, or indeed no Brexit at all, have risen. The distribution of possible outcomes for the UK economy is correspondingly large. To illustrate, we see GBPUSD lying anywhere between something close to parity and something north of $1.50 by the middle of next year. We have cut our forecasts for UK ten-year gilt yields.
Our forecasts for GDP growth and inflation in the euro area are little changed, although we have cut our end-2019 forecast for the European Central Bank’s policy rate by 25 basis points (which we communicated to clients in a note on 6 July 2018). For this reason, as well as recent developments in the bond market, we have trimmed our forecast for ten-year German Bund yields from 1.00% to 0.70% and 1.40% to 1.10% for end-2018 and end-2019 respectively.
We have made only small changes to our equity forecasts for 2018 and 2019. We have also made only small changes to our foreign exchange forecasts in our central scenario for end-2018, with the exception of USDCNY, which we have revised from 6.80 to 6.95. In our central scenario, we have revised up our end-2019 forecast for GBPUSD from 1.27 to 1.35.
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