What if America sneezed and no-one cared?
Markets are used to synchronized and predictable global economic cycles. China stimulates, and, in a few months, the European export data looks rosy. The US hikes interest rates, and EM growth heads lower. The leads and lags in global macro were known.
Today the picture is different and will stay that way for a considerable period as globalization 4.0 retreats. De-synchronized economic cycles present rates and foreign exchange (FX) markets with multiple relative value opportunities which, in theory, should offer better risk-adjusted returns.
Markets are currently pricing in divergent trends. Can the Federal Reserve (Fed) really embark on a cutting cycle as currently priced (Figure 1) without dragging the rest of the world with it?
Figure 1: Significant cuts priced in the US compared to Europe
Cumulative central bank pricing over 2 years, bps
We look at three areas that suggest this divergent trend can continue, at least over the course of this year.
The tradeoff between economic growth and physical wellbeing differed across the globe, as did the economic response. The US reopened quickly with consumers flush with stimulus payments and asset price windfalls – household wealth as a percentage of GDP was at all-time highs. The punchbowl was overflowing.
At the other end of the spectrum, China has done little to boost the consumer since 2020 with crackdowns on real estate and a lack of stimulus cheques. But it has now reopened (ignoring the fleeting 2020 reopening) and the consumer rebound is beginning to take place, aided by a large credit expansion and a loosening of real estate regulation.
The US already had its reopening party and savings have been run down. The first guests are starting to arrive in China and resulting tailwinds will be bigger in Europe.
Figure 2: Excess savings in the US have been eroded
The weaponization of gas triggered generational moves in the current accounts of energy importers and exporters. Since Europe and much of Asia import most of their fuel, their cost of energy as a percentage of GDP surpassed levels seen in the original OPEC crises of the 1970s. Entire regions were threatened with deindustrialization as production moved to areas where energy inputs were cheaper.
The subsequent fall in energy costs in these regions is now providing a growth fillip despite rising global interest rates, while energy exporters, including the US, now find themselves at a disadvantage relative to their 2022 position.
Figure 3: Euro Area tailwind from rebounding energy sector
Euro Area Industrial Production, index (Dec19=100)
Figure 4: Tailwind from lower gas prices
3. Growth & Inflation Divergence
A combination of factors including regional banking stress, the Fed being further along in the hiking cycle, and the erosion of excess savings have led to a deterioration in US leading indicators.
The divergence in the services sector of the US versus the European economies is stark. On the one hand, it clearly shows European outperformance. However, if we are being balanced, the underperformance of the US service sector has tended to lead in recent downturns.
Figure 5: US growth underperformance
The other key factor is the very divergent inflation trends. Whilst the US is showing encouraging signs of disinflation, this is simply not the case for the Euro Area, UK, or Japan right now.
Figure 6: Core inflation only falling in the US
What does this mean for central banks?
One way to approach our question is to investigate whether the Fed can really pause their hiking cycle and start cutting rates without impacting the other Developed Market (DM) central banks.
Our internal analysis of previous cycles, shown in Figures 7 and 8, indicates that most DM central banks can and do continue to hike after a Fed pause. It is only once the Fed’s cutting cycle begins that the rest of the world tends to follow suit soon after.
Figure 7: Other centrals can hike during a Fed pause…
Figure 8: …but not when the Fed is cutting
If the growth environment is bad enough for a US cutting cycle, it seems likely there will be contagion. However, timing matters and the Federal Open Market Committee (FOMC) will be keen to pause for some time before cutting rates, perhaps in late Q3/early Q4 this year.
Given the reasons discussed above and historical precedent, this window of divergence can continue for the next couple of quarters and maybe longer if DM inflation outside the US continues to surprise on the upside.
Active management can help navigate these uncertain waters. As we approach a potential US driven downturn, it make sense to be overweight US duration and in steepeners but more cautious elsewhere.
In the currency space, higher relative growth and the end of the European Central Bank’s (ECB) negative interest rate policy could see capital flow back to Europe after a decade or so of outflows (Figure 9) – as such we remain US dollar bears and long Euro as one way to express this view.
Figure 9: Capital flowing back to Europe
Opinions, estimates, forecasts, projections and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. There can be no guarantee they will be met.