3rd Quarter 2018
Global growth: Global economic growth is currently less dynamic and less synchronised than six months ago, but remains solid. The global manufacturing purchasing managers' index (PMI) recently reached an eleven-month low, suggesting a slowdown over the next few months. On the other hand, the global service sector is flourishing, with its PMI achieving one of its best values in the last three years in June. Regional differences are also becoming increasingly noticeable. While Europe's growth momentum is fading, the US seems to be outperforming. This regional divergence can also be seen in the leading indicators of the OECD and their increasing standard deviation.
USA-China: Last year, the USA imported a total of around USD 800 billion more goods than it exported. US President Donald Trump promised voters that this trade deficit would be reduced. As a first step, the US government introduced tariffs of 25% and 10% respectively on steel and aluminium imports. Retaliatory measures from China, Canada, Mexico and the EU followed.
In 2017 trade with China accounted for approximately 45% of the total US trade deficit in goods. At the turn of the century it was less than 20%. Unsurprisingly, Mr Trump's stance towards China has intensified in recent months. At the end of March, tariffs of 25% on imports worth USD 50 billion were announced, which have been partially applied since 6 July. China reacted swiftly with retaliatory measures, which also took effect on 6 July. Then came the message from Washington that the imposition of a 10% punitive tax on a further USD 200 billion of imports from China was being examined. If China again takes countermeasures, President Trump warned in mid-June that further tariffs on another USD 200 billion of imports would follow. The latter is unlikely, because it is not in Donald Trump's interests with regard to the US midterm elections in November. Tariffs on a total of USD 450 billion of Chinese goods would mean that nearly 90% of all imports from China would become more expensive, which would then also be very noticeable to US consumers. Furthermore, additional retaliation by China would likely put pressure on the US agricultural sector in swing states such as Ohio and Iowa.
The second largest deficit results from trade with the European Union, consequently the EU is now also in Donald Trump's crosshairs. At the end of June, the US President announced possible punitive tariffs of 20% on European automotive vehicles and parts. The EU warned that such a decision could lead to retaliation that would affect US exports worth USD 294 billion.
Growth: As suggested by the leading indicators, economic growth lost some momentum in the first quarter of 2018 compared to the second half of 2017. Gross domestic product grew by just under 0.6% in the first three months of this year compared to the previous quarter. However, this is still strong, especially considering that average GDP growth per quarter since the financial crisis has been 0.4%. According to survey results, however, acceleration in growth in the coming months is unlikely. Consumer sentiment has stabilised, the KOF economic barometer is only slightly above the long-term average, and the purchasing managers' indices for industry and services fell slightly in June, but are well above the growth threshold of 50 points, at 61.6 and 57.6 respectively. The State Secretariat for Economic Affairs (SECO) is sticking to its GDP growth forecast of 2.4% for 2018. The analysts surveyed by Bloomberg are slightly less optimistic and anticipate an expansion of 2.1%.
Labour market: The situation in the labour market is improving steadily, as a result of the positive economic situation. The unemployment rate reached 2.4% in June, which is a significant decrease since the start of the year, when the unemployment rate was still 3.3%.
Inflation: Inflation rose by 0.3 percentage points in the first half of the year, reaching 1.1% in June. The main driver of this development was an increase in energy prices. If energy and food are stripped away, there was no increase in inflation. This so-called core inflation has risen by 0.5% since the beginning of the year. Inflation is still in line with the definition of price stability of the Swiss National Bank (SNB). The SNB also does not expect any further significant increase in consumer prices and is forecasting an overall inflation rate of 0.9% at the end of the year.
Growth: Economic growth in the eurozone lost momentum in the first quarter of the year. GDP grew by 0.4% quarter-on-quarter, about 0.3 percentage points lower than the quarterly average growth in 2017. The decline in goods exports was the driving force behind the slowdown. Early indicators such as the PMI and the European Commission's Economic Sentiment Index decreased sharply at the beginning of the year, but these have now stabilised and continue to point towards robust expansion. Analysts expect GDP growth of 2.2% for 2018, which is 0.4 percentage points lower than last year's growth, but still well above the euro area's trend growth. However, the political situation in Italy and the trade dispute with the US could further cloud sentiment and dampen expansion.
Labour market: Thanks to the robust economic climate, the labour market has continued to recover, although regional differences persist. In May, the unemployment rate for the eurozone fell to a nine-and-a-half-year low of 8.4%. In Germany, with a jobless rate of 3.2%, there is almost full employment, whereas over 20% of the Greek labour force is still looking for employment.
Inflation: The first estimate for eurozone inflation in June shows a rise of 0.1%, to 2.0%, but core inflation remains unchanged at 1.0%. Energy price effects are likely to continue to play the biggest role in the coming months, while core inflation is expected to change only minimally. Consensus forecast for headline inflation in the third quarter is currently 2.0%.
Growth: GDP grew by 2.0% on annualised basis in the first quarter. Although this is weaker than at the end of 2017, it constitutes a better start to the year than has usually been the case in recent years. Despite intensified rhetoric on trade policy and volatile stock markets, consumers remain optimistic about future economic development and producers rated their situation in June as positively as at the beginning of the year. The economic outlook therefore remains positive, which leads the US Federal Reserve (Fed) to expect GDP growth of 2.8% for the current year.
Labour market: Despite a tight labour market and an increasing shortage of skilled labour, the unemployment rate fell again in the last three months and reached 4.0% in June. Growth in hourly earnings has fluctuated between 2.4% and 2.7% since mid-2016, but is expected to pick up somewhat in the future. An indication of rising wages is provided by the high proportion of the population that is voluntarily leaving their job. The so-called "quits" statistic shows a strong correlation (0.67) with wage growth, with a lead of six months. Currently, the quits rate is at a thirteen-year high of 2.3%, which would imply wage growth of about 3%.
Inflation: Measured in terms of the personal consumption expenditures (PCE) deflator, the preferred price measure of the US Federal Reserve, inflation in May stood at almost 2.3%, or 2.0% without energy and food prices. Core inflation is thus in line with the Fed's target. In view of increasing inflationary pressures, inflation may likely overshoot the 2.0% target slightly in the coming months.
Review of Q2: Up to the middle of May 2018, the rates of return on ten-year government bonds in Switzerland, Germany and the US rose significantly. There then followed a sharp decline in yields until the end of May, triggered by political turmoil in Italy. After a brief rebound, concerns about a trade war became the focus of market participants, causing yields to fall further. Overall, the yields on ten-year government bonds fell from 0.03% to -0.06% in Switzerland, and from 0.50% to 0.30% in Germany. In the US, yields moved by around the same amount but in the opposite direction, from 2.74% to 2.86%, amid a strong economic backdrop and rising inflation rates.
In this environment, credit spreads continued to widen. In the US, the widening of spreads was amplified by the tax reform, as companies repatriated funds, most of which are invested in USD bonds. The sale has led to an oversupply on the bond market. In Europe, credit spreads increased mainly due to the political uncertainty.
Outlook: The US Federal Reserve again raised its policy rate in the middle of June, to a target range of 1.75% - 2.00%, and its economic projections suggest a rate of 2.375% for the end of 2018, implying two further rate hikes this year. At the end of 2019, the FOMC members expect a Fed Funds rate of 3.125%, and a cyclical peak of 3.375%, above the estimated long-term equilibrium of 2.875%, by 2020. Without a significant acceleration in inflation, US ten-year government bond yields are unlikely to rise above 3.5% in the long term.
The European Central Bank (EZB) announced in mid-June that asset purchase programme was due to cease by the end of December 2018. It was also announced that interest rates would not be increased until at least the second half of 2019. With this forward guidance, the ECB has significantly reduced the uncertainty surrounding future interest rate developments in Europe. A major rise in interest rates is not expected, but interest rates are set to trend higher in the medium term.
Despite the robust recovery, the SNB has opposed a tightening of monetary policy. It still considers the Swiss franc to be trading above its fair value. It is therefore unlikely that the SNB will tighten its monetary policy before the ECB. As in the past, Swiss interest rate developments are thus strongly tied to monetary policy in the euro area.
Review of Q2: After a volatile first quarter for European and US shares, markets began to recover in April. However, the next bout of volatility followed in late May, when a coalition was formed in Italy between the 5-Star Movement and Lega Nord, two eurosceptic parties, leading the Euro Stoxx 50 to fall almost 5% at the end of May. In June, US trade policy returned to the spotlight, as the Trump administration stepped up its rhetoric. The deterioration in sentiment was also evident in the VIX volatility index, which reached an annual average of 17.4 at the end of June, well above the 2017 average of 11.1 and thereby edging closer to the long-term average of 19.3.
Despite political uncertainty, the fundamentals continue to be constructive for equities. Thus, the S&P 500 rose by 2.9% in the second quarter. The Euro Stoxx 50 recorded a price gain of 1% and the Swiss stock market, as measured by the SMI, lost 1.5% in the second quarter.
Outlook: The economic backdrop is set to remain supportive for equities, but slowing momentum in Europe and the more restrictive monetary policy in the US make equity markets more vulnerable to political uncertainty. Mr Trump's trade policy is thus likely to remain a source of turmoil in the third quarter. The growing fears of an escalation into a fully-blown global trade war and the associated reporting are clearly reflected in the performance of global equities.
In the first half of the year, a total of 723 articles regarding "trade war" were published via Bloomberg. Over the last few months, it has become apparent that the more articles are being published, the weaker the MSCI World Index is, i.e. there is a strong negative correlation (-0.6).
Review of Q2: The EUR/CHF exchange rate climbed towards the 1.20 mark in April and reached CHF 1.199 per euro on 19 April, the highest level since the minimum exchange rate was abandoned on 15 January 2015. Amid heightened fears of a new euro crisis in May, the Swiss franc again became more attractive to investors as a safe haven. At the end of the second quarter, the EUR/CHF exchange rate fell to 1.16, which corresponds to a depreciation of the euro by about 1% against the Swiss franc since the start of the year.
A dollar rally began in April, during which the US dollar gained 5.5% on a trade-weighted basis up to the end of June. The stronger economic outlook and monetary tightening in particular have supported the US dollar in recent months.
Outlook: Further interest rate hikes in the US and the resulting increased interest rate differential with Switzerland and the euro area support the US dollar. US trade policy, on the other hand, could dampen economic growth and thus weigh on the greenback. An additional burden on the US dollar is the twin deficit, the simultaneous fiscal and current account deficits, as we highlighted in our most recent market report.
The future development of the Swiss franc and the euro is dependent on the formation of a government in Italy and on how investors assess the risk of a global trade war. If there is no further escalation, the euro is likely to regain some strength, thanks to continued robust growth in the eurozone and the impending end of the ECB's asset purchase programme.
Although the SNB is still willing to intervene in the foreign exchange market if required, it is also likely to take its time, if the political volatility continues. In the most recent risk-off episode, no major change in the sight deposits at the SNB, which is seen as an indication of market intervention, was evident. After all, the Swiss franc is still 6% weaker than a year ago.
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