Reflation, yes. Remake from 2016/7, no!

Date: 25 March, 2019 - Blog

The macroeconomic and market context shows interesting similarities with 2016.

Weakening economic conditions, high volatility of risky assets and raw materials (oil), feverish central bankers, Chinese recovery. The economic alert was only temporary and everything had ended quite well for the markets that year… From the first quarter of 2016, the world MSCI increased by 50% and oil by more than 40% in 20 months, while long-term rates (10-year US government) went from 1.5% to 2.5% at the same time. In terms of monetary policy, the Fed had raised its key interest rate (by only 25 bp) instead of the 100 bp expected in 2016. Incidentally, it had stopped raising rates when the Chinese manufacturing industry index fell to 48, exactly the same figure as in December 2018… With regard to the similarities in 2019, J. Powell seems to follow J. Yellen’s scenario at the time. Like her, he delays. The question is whether we will practically experience similar weaknesses in the Chinese economy, raw materials and the yuan. An unofficial monetary armistice had been concluded at the Shanghai G-20 between the major economies, putting an end to the sharp rise in the USD. In return, Beijing had stopped the competitive devaluation of the yuan.

With regard to the differences with 2016, China is playing a new role in economic policy. In recent months, it has introduced tax cuts and incentives to gradually stimulate consumption. Incidentally, additional tax measures have just been announced at the March plenary session. It has also injected massive liquidity into the banking system, discreetly opening the door to a Chinese style QE (pro-gressive and targeted) and the rescue/recapitalisation of banks in difficulty. Beijing is also taking further steps to open its financial markets. However, China will continue its regulatory efforts to limit the negative side effects of past and present easing (for example, the uncontrolled shadow banking system that has fuelled excessive leverage). Let’s face it, China faces a classic dilemma: ensuring external stability (stable currency) while stimulating domestic growth (private sector). In 2016, inflationary expectations reflected the risks of deflation (US 5-year inflation swaps had fallen below 1.4% and in the euro area below 0.5% in the fourth quarter).

The situation is radically different now, resulting in more moderate risks for central banks. Wage pressures are greater, particularly in the United States, where they could finally tie the Fed’s hands. (Geo)-political decay and trade war were absent in 2016. In conclusion, there is no doubt that a new Chinese economic policy – of reflation – is being confirmed. It is less readable than previous ones and its response time on the economy is more uncertain. For the time being, Beijing does not (yet) dare to lower its key rates until a commercial agreement is reached with Washington. Global deflation risks are lower than in 2016 and further fiscal easing in the United States is unlikely. It is possible that the Fed will resume its monetary normalisation in the second half of the year, due to the end of the cycle. So reflation yes, but of a very different nature and scope than in 2016. There is therefore little chance that equity markets will start to catch fire again as in recent years.