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The return of the central bank put?

7 June 2019

Stock markets had a very good week – for all the wrong reasons. Economic data reports confirmed that 2018’s US economic expansion is rapidly decelerating towards outright stagnation as companies appear to batten down the hatches in anticipation of an all-out trade war, not only with China but now also with neighbour Mexico. Central banks, which until recently had been firmly on an interest hiking path, downgraded their near term growth forecasts and assured capital markets that they are willing to consider reversing monetary policy fully and to counter slowing growth with rate cuts or even a restart of QE.

The reason stock markets rallied on the bad economic news was that the central bank announcements indicated to them that monetary policy stimulus would once again come to support them – as it did during most of the 10 years since the global financial crisis (this is what is referred to as the ‘central bank put’). And while the economic slowdown more or less forces them to help inflate asset price valuations, many market participants still consider it quite likely that the reason for the slow down – the trade war – will end before it can seriously derail the remaining global economic growth dynamics.

Such a combination of renewed benign monetary conditions, and a boost of sentiment and pent up demand-release from a winding down trade war, could create a truly ‘Goldilocks’ period of re-accelerating growth, fuelling stock markets through corporate profit growth. Unfortunately, the assumption of an end to the trade war depends crucially on the Trump administration (which cannot be described as predictable) – even if all rational arguments tell us that  a Trump, seeking re-election, will do everything to re-accelerate the US economy before the 2020 election year.

After a weak May in terms of asset class returns (see the table below), the good start to June is welcome, but it does feel uncomfortable and fragile. Stock market valuations will continue to feel very vulnerable, until some re-assurance emerges that a trade deal between the US and China is likely over the next three months, and that Trump will keep the other looming trade conflicts (Mexico, Europe, Japan) to a minimum, which will please his electorate without particularly restricting trade.

In such an environment of binary outcomes it is near impossible to establish conviction behind any particular portfolio positioning because downside risk and upside opportunities appear finely balanced. We are therefore content for the moment with our neutral asset allocation and slight underweight to US stock markets.