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Following a savage equity sell-off in December, markets turned around during the last week of 2018 and have achieved impressive double-digit gains since. The rally was initially driven by an improvement in the economic data flow but later received an important impetus from a moderation in the Fed’s stance at the January meeting. At the meeting, the FOMC appeared to ratify well-entrenched market expectations and announced a pause in its rate hiking cycle (despite three rate hikes being pencilled in for 2019), while allowing for a reconsideration of the run-off rate of its balance sheet (previously considered to be on “auto-pilot”). However, these developments have also created a conundrum: activity data have continued to weaken whereas asset prices have continued to rise, eliminating any valuation gaps that may have appeared in the wake of the previous sell-offs.
Further gains in cyclical assets will thus critically depend on the outlook for both activity and inflation, not just in the US but globally. The change in the Fed’s stance, while widely anticipated, certainly acts as a support for growth and asset prices for the remainder of the year. However, the outlook in Europe and China is of similar importance and, indeed, the two are partly intertwined. What is more, central banks universally face persistent undershoots of inflation relative to their targets and have had to reconsider their policy stance against this fact. The Eurozone economy has disappointed ever since its short-lived fillip in late 2017 and has continued to do so throughout 2018. Indeed, it has witnessed a continued downdraft in industrial production throughout 2018 and its largest economy, Germany, only narrowly escaped a technical recession thanks to a flat GDP outcome in Q4. Various PMI measures across the Eurozone have registered a bounce in February (as well as the aggregate index), but it remains too early for this to serve as a definite signal for the resumption of faster growth. At the same time, inflation remains significantly below target (of “below 2%”) and the outlook has continued to be revised downwards by the ECB (even 2021 HICP is now seen at only 1.6% yoy). The ECB belatedly reacted to this persistent undershoot by moving any rate hike into 2020 (which the market had already priced) and instituting a new liquidity measure in the form of the TLTRO-III (seven separate two-year operations beginning in September 2019). The ECB also assured market participants that it intended to fully reinvest maturing bonds for an “extended period” after its first rate hike. But while these actions are certainly a boon to the financial sector and serve to narrow Italian bond spreads, they are unlikely to move the needle much in terms of the inflation outlook. It thus remains to be seen what other tools the ECB could eventually resort to and President Draghi’s reference to “pervasive uncertainty” seemed to express his concern in this regard. It echoed the Federal Reserve’s earlier comments about “external risks” and their perceived impact on domestic policy.
Source: City of London Investment Management
*The publication reflects asset performance up to Februry 28, 2019, and macro events and data releases up to March 12, 2019, unless indicated otherwise.
The information contained herein is obtained from sources believed by City of London Investment Management Company Limited to be accurate and reliable. No responsibility can be accepted under any circumstances for errors of fact or omission. Any forward looking statements or forecasts are based on assumptions and actual results may vary from any such statements or forecasts.
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