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Richard Buxton: Yet deeper into the looking glass

It is clear that 10 years on from the global financial crisis, we are a long way from back to normal

A year ago, the US economy was on a tear, boosted by the sugar rush of Donald Trump’s tax cuts. China, on the other hand, was already slowing materially in response to the authorities’ attempts to tighten the flow of credit. Beijing’s initial misreading of Trump’s trade war initiative against China – where the leadership appeared not to take him seriously at first – was reversed in due course. But not before it had further weakened activity in China, with significant disinvestment by international investors, and corporates redirecting investment to other Asian countries such as Vietnam, to avoid potential tariffs.

A firm US dollar as the Federal Reserve marched interest rates upwards exacerbated the pain caused in many emerging markets by the increasing growth differential between the US and the rest of the world. Export-sensitive Europe was the next to feel the impact of the slowdown in China and this was reflected in the rolling correction in equity markets of 2018 – starting in emerging markets, moving into Europe and eventually even hitting the seemingly immune US stockmarket. This year, the pattern is likely to be reversed.

Throughout the second half of last year, the Chinese authorities switched to gentle but steady stimulus: a tax cut here, an easing of bank reserve requirements there, targeted stimulus initiatives and, of course, engagement in discussions with the US on trade. We have no trade deal yet, but it is clear that for economic and political reasons, both sides want one.

Purchasing managers’ surveys plummeted from the autumn onwards across the global manufacturing base, suggesting that there was a very real downshift in economic activity. But the first signs of activity forming a base are emerging in China – the first country to slow and to deliver a policy response. We probably have another difficult three months of data to emerge from Europe, although even here, one might argue that the surveys have been sufficiently poor of late that all the bad news is fully reflected in markets. But, in time, an improvement in China should be felt in Europe.

Meanwhile, in the US, the economy is descending from its sugar-rush highs. Consumer balance sheets are fine but the consumer is taking time out. Jobs growth is slowing and there could be rogue months ahead where unemployment actually ticks up by a little.

The bond market has spoken. Where were you on 22 March, the day the yield curve inverted? Bonds are saying that the Fed has already overdone it and needs to ease. The Fed itself has gone sufficiently dovish as to signal no more rate hikes, but the bond market has leapt ahead to price in cuts later this year.

The bond market is probably right. President Trump, freed from the Mueller investigation concerns and with all eyes on next year’s election, will be breathing down the central bank’s neck to ensure that policy is stimulatory and activity picking up into 2020. Quiescent inflation provides little excuse for the Fed to stand firm if the data is indeed softening.

Expect a rate cut this year. While the pattern of data will be mixed, on balance expect China to surprise increasingly on the positive side, eventually feeding through to Europe. The US will be last, testing the bulls with rocky data for six months before a policy response encourages investors to look for signs of a soft landing.

Now let’s stand back a moment. The US economy has been curbed by interest rates hitting 2.5 per cent, or less than 1 per cent in real terms. This is not normal, by the standards of previous cycles, which have required far higher levels of real interest rates.

Yet after only a few months of quantitative tightening, US credit markets were gluing up, spreads were widening and corporate bond issuance was getting tricky. The bond market is calling for policy easing, with rates at 2.5 per cent.

Now 10 years on from the financial crisis, it is clear we are a long way from back to normal. The Fed has acknowledged that all hopes of shrinking its balance sheet back to pre-crisis levels have evaporated.

It is in introspective mood about future policy tools. Google searches for “modern monetary theory” are through the roof. Grown adults discuss the merits of central banks funding large government deficits in perpetuity. The European Central Bank which, unlike the Fed, never managed to get interest rates above zero (or negative for banks), muses about what on earth it could do next – with the additional complication of not having a single sovereign state behind it.

Blame demographics. Blame millennials for wanting less “stuff”. Blame digitisation. Blame consumers awaiting electric vehicles, rather than buying a new car. Blame China for gently deflating after the biggest capex binge of modern history. Blame the creators of the euro, with its permanent growth imbalances across Europe.

But whatever your villain of choice, in a world of weak demand, expect more unconventional policies from central banks.

We have further to go through the looking glass.

Richard Buxton is head of UK equities at Merian Global Investors

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