Uncertainty stemming from multiple sources is the unsettling theme that runs through today’s economic environment. Broadly, there is a loss of momentum.
Economies that had been surprising on the upside are now surprising on the downside.
In the US, commercial banks have begun tightening toward consumers and in Europe, Germany’s two-tier economy reflects a strong domestic services sector but a weak exports sector because of China’s slowdown.
All the while, ongoing trade tensions are impacting export markets everywhere.
In this context, the focus is on how central banks will react, given current inflation expectations.
No central bank around the world is reaching its inflation targets because inflation expectations are depressed. How they can improve the situation while keeping markets satisfied becomes increasingly challenging.
In the US, markets are pricing in two rate cuts by the end of 2019 and in Europe, German 10-year Bund yields have dipped into negative territory, embarking on a trend that resembles Japan’s.
If inflation expectations continue to drop, central banks will eventually be compelled to act.
Meanwhile in markets, there is a conflicting message between equities and bonds – with the S&P 500 telling a different story to US 10-year bond yields.
Therefore, markets need a margin of safety via reduced valuations. Prices are coming down until earnings start to rebound in the second half of this year.
Markets are discounting further economic slowdown and favouring “quality” stocks – companies with strong balance sheets, at the sake of buy-back, debt-ridden companies. At the same time, markets are putting pressure on central banks to act in their favour.
Credit markets are becoming very selective – so markets are becoming sensitive to the strong balance sheet quality of companies.
Italy has revived the idea of 'Mini-BoTs', which would introduce a parallel currency to the euro. Credit risk has risen as a result, which could lead to reduced bank lending.
At the same time, liquidity swings are impacting volatility, creating spikes, and we can expect more going forward, even if the average level remains subdued.
Geopolitics continue to keep macro economy and market watchers on their toes.
After finally seeing a trade deficit reduction with China, the US has turned its attention to Mexico, a key beneficiary of the US-China trade war, with the stemming of illegal immigration across the border thrown in for good political measure.
However, the light at the end of the tunnel is coming into view.
Every time the Chinese government stimulates, lending picks up and eventually emerging market earnings follow.
At the political level in Europe, fiscal spending is also increasingly on the agenda. These measures should prop up domestic economies and consumer spending, even as international trade falters.
Alexandre Tavazzi is the head of CIO office and global strategist at Pictet Wealth Management