Global Investment Outlook:

• Our quarterly Global Investment Outlook is now available, including a lead article entitled “Green Shoots Pruned by Protectionism.”

Dovish Fed:

• Bond yields have fallen and the stock market has surged in the aftermath of the Federal Open Market Committee (FOMC) decision to leave its policy rate unchanged and introduce dovish language. A rate cut at the next meeting in late July must now be the default assumption, though it is not a guarantee.
• The dovish pivot was more substantial than we had anticipated, and was reflected in a variety of comments and developments:
  • The median forecast among FOMC participants is for an unchanged policy rate in 2019. But this conceals a heavily skewed distribution: just one person calls for a hike, eight look for an unchanged policy rate, and eight call for rate cuts. Thus, a bare minority of eight participants out of 17 now recommend rate cuts in 2019. That’s up from zero as of March.
  • Seven of these eight dovish forecasters favour two rate cuts this year. This highlights the possibility of a 50bps cut (or, this could simply be delivered via two 25bps cuts). Central banks do frequently “take the elevator down,” meaning they are more willing to move briskly when cutting than when raising rates.
  • Fed President Bullard dissented from the most recent decision that left the policy rate unchanged, preferring an immediate 25bps rate cut.
  • As expected, the text removed the promise to be “patient” in determining what future adjustments to the fed funds rate may be appropriate – a hint about acting sooner rather than later. Similarly, it added wording to “act as appropriate to sustain the expansion” – a hint about rate cuts that Fed Chair Powell had previously delivered in a speech.
  • The Fed downgraded its inflation forecast from 1.8% to 1.5% for 2019. It also indicated that inflation may be the most important variable right now. Undeniably, market-based inflation expectations have also declined over the past year. However, neither the 30-year breakeven nor the 5-year—5-year forward breakeven rates are as low as they were in 2016. And, both are only a tenth a percentage point below the Fed’s inflation target (though normally inflation expectations run a few tenths above the target given the existence of a risk premium within the TIPS – Treasury Inflation-Protected Securities – market).
  • The Fed’s long-term estimate of the fed funds rate fell from 2.8% to 2.5%. This suggests that the Fed is already basically at the neutral rate, as opposed to operating below it as previously imagined. Thus, one could defend a rate cut on purely technical grounds even if there had been no change in the broader outlook.
  • Powell said the case for policy accommodation has strengthened, and the Fed will act promptly, if appropriate.
  • Powell emphasized in the press conference that the Fed’s focus is on sustaining the economic expansion. This hints that rate cuts are being viewed as a pre-emptive tool to sustain growth for longer despite the lateness of the cycle, rather than as a reactive response to the end of the cycle.
• The Fed indicated that “uncertainties about this outlook have increased.” This isn’t purely dovish as it indicates that risks extend in both directions. It also hints at a high degree of data dependency.
• The dot plots reveal a mix of people calling for rate increases and decreases, rather than the usual binary debate between a change in one direction versus no change.
• Although not all Fed participants are voters, a change in the opinion of a single participant could theoretically tilt the balance between leaving the policy rate unchanged versus cutting in July.
• The press conference emphasized that cross-currents have emerged, and that the committee would need to see more evidence of weakness to act.
• Rounding out the decision were some hawkish counterpoints that emphasize the outlook is not entirely grim and that rate cuts are not fully locked into place:
• “The labor market remains strong and … economic activity is rising at a moderate rate” (though note that growth was previously described as “solid”).
• The Fed said that household spending growth has picked up (though it noted that business fixed investment has been weaker).
• The Fed is not keying off of any single variable or outcome. It is watching several things, including whether trade relations deteriorate or improve, whether the labor market has genuinely weakened or the May print was just a blip, and whether inflation remains low. There is a fair chance that trade relations remain static over the coming months, that the next payroll number is better, and that core inflation edges higher (there is a credible argument that temporary factors have depressed inflation recently). Thus, while a rate cut is increasingly the default expectation for July, it is possible that the next round of data reverses that expectation.
• The Fed actually upgraded slightly its growth forecast for 2020, and left 2019 and 2021 unchanged. Similarly, the Fed slightly downgraded (in a good way) its unemployment rate forecast, by 0.1ppt for each of 2019—2021. The argument for monetary stimulus is thus due primarily to diminished inflation, a lower than imagined neutral rate and greater downside risks, rather than that the base-case economic outlook is suddenly worse. To some extent a decent growth outlook is nearly always baked into the cake as anything less would motivate additional monetary easing, which would in turn restore the growth outlook. Still, the fact that the 2019 outlook specifically is unchanged hints that this is not primarily a growth story. The Fed has only a limited ability to influence growth in 2019: the year is half over and the lags involved make near-term rate decisions more relevant for 2020 growth.
• The bottom line is that the Fed has gone to a great deal of effort to signal a likely rate cut at the next opportunity. While this is therefore more likely than not, we do not believe it is an automatic outcome. Relevant pivot points include:
  • U.S.-China negotiations
  • the next set of economic figures
  • upcoming inflation readings.

Any of these could improve, discouraging Fed action. As such, the market may be too confident in its pricing.

• Furthermore, we must confess to some squeamishness about the sugar high that risk assets like equities are experiencing every time expectations for the Fed become more dovish. Case in point, the stock market went up when the most recent job numbers were weak. Undeniably, that development increased the prospect of rate cuts, and monetary stimulus helps growth. But unless one actively forecasts a policy error, the stimulus should be proportionate to the weakness, restoring growth to where it would have been absent the weakness. In this sense, the prospect of additional monetary stimulus should be at best a neutral development, and arguably a slightly negative one in that stimulus works with a lag, leaving an unaddressed period of temporary weakness before the policy support kicks in.

Other central banks:

• As per the tradition of the past decade, other central banks have not been quite as nimble in their recent moves as the U.S. Federal Reserve. But there is nevertheless a similar pivot away from tightening and toward easing elsewhere.
• Slower global growth, low inflation expectations and concerns about protectionism are common obsessions for most central banks.
• While many pundits fret about a currency war breaking out, we instead tend to view the foreign exchange rate as merely one of several ways in which monetary policy is transmitted through to the economy. Yes, at a time of economic weakness most countries would like a lower exchange rate. But delivering rate cuts when one’s economy is weak is hardly sinister or a beggar-thy-neighbour policy. Alas, when global growth slows in a synchronized fashion, it reduces the efficacy of any one country’s monetary policy. Exchange rates tend to be neutralized as all central banks are moving in a similar direction.
• The European Central Bank (ECB) made a small step in a dovish direction in early June. It promised not to increase rates until mid-2020 at the earliest (later than the previous end-2019 promise), and initiated a new liquidity program. However, markets were dissatisfied and ECB President Draghi recently signaled that rate cuts and possibly even more quantitative easing were very much on the table. The market has now priced in a return to stimulus by September. German bond yields are already deeply negative, signaling that a great deal of monetary stimulus is already effectively in place.
• While not signaling any immediate action, the Bank of Japan acknowledged elevated downside risks and emphasized that it still possesses the ability to cut rates or deliver additional quantitative easing. The Bank also indicated that it doesn’t mind if the 10-year bond yield drifts below the -20bps lower bound of its target range.
• The Bank of England had previously been on a tightening trajectory, but all mention of that was scrapped at the latest decision. The Bank downgraded its growth forecast against the backdrop of a possible no-deal Brexit and global growth concerns.
• The Bank of Canada rendered its latest decision before the rest – in late May – and has been more hawkish than the rest, arguing that the Canadian economy is performing well. Even as global sentiment shifts toward rate cuts, it may be harder for the Bank of Canada to get fully on board as recent domestic inflation readings have been surprisingly brisk, in contrast to almost everywhere else. While there is little reason to think Canadian inflation is about to permanently deviate from the rest, it makes the Bank of Canada the laggard for the moment.
• Gazing beyond developed countries, monetary stimulus has also lately been applied in major emerging-market nations such as China, India and Russia.
• The need for monetary stimulus is not in itself a good thing. But it is nevertheless heartening that when global growth stumbles, central banks remain alert and capable of at least cushioning the fall.

Iran tensions:

• Tensions between the U.S. and Iran have reignited over the past year since President Trump pulled the U.S. out of a multilateral nuclear deal that had been struck between Iran, the U.S. and its allies under former President Obama. The reapplication of sanctions have damaged the Iranian economy badly.
• In retaliation, Iran has recommenced its uranium-refining operations and will shortly exceed a limit set by the original deal, which is still theoretically in effect for all signatories other than the U.S. Iran may not be far from possessing nuclear weapons for the first time.
• Heated rhetoric on these subjects has lately turned into action. Iran has downed two U.S. military drones and attempted to take out another. It is accused of hitting foreign oil tankers with mines in the crucial Strait of Hormuz through which around a third of the global oil supply transits. Two Iranian drones have also attacked crude pumping stations in Saudi Arabia. Iranian-supplied militants in Iraq have fired rockets on U.S. interests on several recent occasions. One of these was sufficiently close to the U.S. embassy in Baghdad that the embassy was evacuated of all but essential personnel.
• Iran’s motivation appears to be to express its anger at U.S. sanctions and the country’s inconsistent approach to Iran. In so doing it is gambling that the U.S. does not have the capacity or desire to wage a serious war. By one measure, Iran is currently ranked as having the 13th most powerful military in the world, with 534,000 active military personnel.
• For the moment, Iran’s gamble is probably correct. So long as Iran does not continue to lash out at the U.S. or American allies in the Middle East, nothing will likely come of recent events.
• But we cannot reach this conclusion with absolute certainty. For one Iran has been unusually belligerent in its recent actions, continuing even after the message has been received loud and clear.
• A change of heart in the White House could yet escalate the situation. The U.S. has sent limited additional military personnel and assets to the area, and very nearly launched a strike on Iran before pulling back at the last moment.
• Furthermore, the U.S. may not be willing to let Iran progress all the way to nuclear weapons, possibly choosing to intervene as that date grows nearer.
• These various risks have helped to elevate oil prices – the main globally significant commodity produced in the area. Whereas we always felt that the risks surrounding North Korea were quite limited, the risk surrounding Iran at present is very real, even if not our base-case expectation.

Other items:

• All eyes will be on the G20 meetings that take place in Japan at the end of this week. The focal point will be a meeting between U.S. President Trump and Chinese President Xi. A recent phone conversation may have reduced tensions slightly, though we do not budget for a trade deal to be announced at the summit. Equally, we don’t expect the threat of U.S. tariffs on a further $300B in Chinese products to be acted upon, though the threat may be repeated. Altogether, the outcome should be fairly neutral relative to market expectations, though the risk of deterioration is probably greater than the risk of a sudden and happy resolution.
• The USMCA trade deal between the U.S., Mexico and Canada is currently on the back burner, but there is some slight forward progress. Mexico has just ratified the deal, meaning it is now one-third of the way to the legislative finish line. Canada has also indicated a willingness to approve it now that the U.S. has waived steel and aluminum tariffs against Canada. U.S. congressional approval remains the sticking point, with Democrats still broadly against. Logistically, it may be difficult to approve the deal before the fall – The Democrat-controlled House Ways and Means Committee can delay it for up to 45 Congressional days (this means many more than 45 total days). But the odds are generally improving for its eventual approval. Most politicians recognize the deal is in the economic best interest of Americans. It could be resolved as a bargaining chit during budget negotiations this fall. Democrat Nancy Pelosi – Speaker of the House of Representatives – has indicated that she has the votes to approve it if she is so inclined.