Global economy still fragile, geopolitical situation unstable

Investment Policy, July 2019

Global economy still fragile, geopolitical situation unstable

The global economy is still fragile, and the geopolitical situation remains unstable. The US central bank has hinted at possible rate cuts, but these are already priced in by markets. The investment policy remains “security before return”, with a partial underweighting of equities being our preferred method of capital protection. Equity markets experienced another sharp rise in valuations in June. Economic and geopolitical uncertainties are currently still too high for investors to relax their vigilance. 

The global economic situation remains fragile. The downturn in manufacturing activity has gathered pace all around the world in recent months. The majority of leading indicators in both the manufacturing and services sectors are exhibiting greater vulnerability, something that is apparent not just on the demand side, but also in production. The main risk is a further intensification of the trade conflict between the US and China. Tariff increases could become an unwelcome phenomenon in Europe too. It should not be forgotten that, as an export-oriented region, Europe – including Switzerland – would be more affected by any weakening of global trade than America. And in any case, the conflict between the US and China has long been about more than just trade. As we commented last year, this dispute is no less than a manifestation of increasing rivalry over geopolitical power in both the technological and military spheres. Moreover, the attacks on tankers in the Persian Gulf close to the Strait of Hormuz, through which 35% of global oil production passes, show the dangers inherent in a confrontation between Iran and US, thus adding to the instability of the geopolitical situation.

Even if there have been certain signs of temporary stabilization, equity markets remain susceptible to corrections as a result of economic and political uncertainties. There have been further rises in the valuations of key equity markets. In recent economic cycles the average correction to US equities amounted to some 10%; in addition, on average there have been three corrections of around 5% each year, rather than just one, which highlights the vulnerability of equity markets in the current situation. For Europe, the risk of punitive tariffs being slapped on imports of cars and automotive components to the US has not yet been banished. Such an imposition would lead to downgrades in the earnings forecasts  of European companies, particularly in Germany. As a general rule, corporate earnings (and therefore equity markets) in the Eurozone and the emerging markets react with particular sensitivity to trade conflicts, as these regions are more open economically than the US. Furthermore, the US has far more freedom of manoeuvre than the Eurozone in the area of monetary policy.

Eurozone corporate earnings are particularly sensitive to trade conflicts.

Gérard Piasko, Chief Investment Officer

The key fixed-income markets have seen a clear decline in yields over the last few months, a development led by government bonds. This has underlined once again that the primary function of bonds generally – and government bonds in particular – is to provide the investor with diversification against equities. Bond modules above all provide diversification against equity modules for currencies that are less volatile. In other words, bonds denominated in the world’s key currencies provide better diversification than emerging market bonds, 
which are more fundamentally affected by the trade dispute. 

The resurgence of discussions between Italy and the European Union over the latter’s budget deficit has been a recurrent theme in the fixed-income markets in recent weeks. When Italy’s populist governing coalition announced a budget deficit of 2.4% of gross domestic product (GDP), the EU demanded clarification from Italy with respect to the agreements reached to contain the level of outstanding Italian government debt, which currently stands at 135%. As the EU is within its rights to initiate disciplinary measures against Italy, there is a risk of further rises in spreads between Italian and German/Swiss bonds. 

At the time of writing, tensions between US and China remained unresolved, and the risk of punitive tariffs against the Eurozone was still potent. Both of these factors increase the risk of rising volatility in the international currency markets. As we described in our commentaries in the first quarter, not only was the level of volatility priced in by equity markets unusually low in a historical comparison in the first few months of 2019 but the volatility priced in by currency markets was likewise extremely low. Although volatility has now risen, there is potential for further rises. As explained above, we would not be surprised to see emerging market currencies (despite their low valuations in historical terms) become even more volatile, in keeping with developments in the trade conflict. However, we could also see a return of greater fluctuations in both the USD/CHF and EUR/USD currency pairs.

The commodity markets are now also becoming much more volatile. Crude oil is a case in point: Following its strongest start to the year since 1999, namely a rise of more than 35%, the oil price has since declined by more than 20%. This shows two things. Firstly, of all asset classes, commodities can often be the most volatile. Secondly, uncertainties over the two key factors driving commodity markets, supply and demand, are particularly high right now. Unlike with equities and bonds, where coupons or dividends provide an additional return, income streams are not a factor for commodities: here almost everything revolves around anticipation of changes in supply and demand. Where industrial metals are concerned, the trade conflict and fears of a further slowdown in Chinese economic growth have hit copper in particular, as demand for this metal is dominated by China. In the oil market, hopes of a resolution to the trade dispute buoyed demand in the first quarter. As the trade conflict intensified, however, investors scaled back their demand expectations, which in turn triggered a correction. The latest newsflow will continue to determine volatility levels over the next few weeks. Prices in the oil market will be additionally driven by international inventories (which have recently risen) and a possible further production cut by OPEC: this organization recently downgraded its estimate of demand for oil.

Gérard Piasko

Gérard Piasko

Gérard Piasko is CIO and head of the investment committee of private bank Maerki Baumann & Co. AG. Before he was for many years CIO of Julius Baer, Sal. Oppenheim and Deutsche Bank.

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Editorial deadline: 20 June 2019

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