Authored by Michael Every of Rabobank

When your equities Bloomberg page looks as red as mine did yesterday, you know that fear is driving the market. “Investors hopeful Trump’s tough trade talk is just bluster”, the FT writes in its markets section today. Well, clearly many investors out there are not putting their money where their mouth is at the moment. The S&P lost more than 1.6%, outstripping the losses seen in the European trading session. The iTraxx Crossover index jumped more than 15bp, which is a significant move after its gentle upward trajectory that started mid-April. Flight to quality obviously benefited government bonds, with German 10y yields dropping firmly below zero once again. Italian bonds were the main exception, but more about that later.

The fact that Chinese Vice-Premier Liu He is still expected to arrive in Washington tomorrow to keep the talks going is probably the reason why this has not turned into an absolute meltdown. But will he be able (and in a position?) to change the US’s preliminary verdict that China has been “reneging on prior commitments”, as it was put by US Trade Representative Lighthizer? Time is running short, and the risk of President Trump pushing on with the new tariffs on Friday is too high for comfort. And even if China were to cave in before or even after the introduction of those new tariffs, one could question whether it eventually leads to a better and more sustainable deal, or actually to a worse and less sustainable one. The market may have reason to fear the latter.

Another reason for the market to remain on edge is the fact that the data aren’t exactly reassuring either. Chinese exports growth plunged from 13.8% y/y in March to -2.7% in April. Imports, on the other hand, improved more than expected, with the annual growth rate rising from -7.9% to 4% in April. A weaker number for exports was to be expected given the post-Lunar holiday rebound in March, but it also suggests that whilst China’s domestic demand growth may have started to bottom out, slower growth of demand in Europe and the US is still affecting China with a delay. So the undertone of these data –which chimes with recent PMI surveys– remains one of sluggishness. The German industrial production numbers provided a small ray of light, rising 0.5% m/m in March after 0.4% in February, but this is probably driven to a significant extent by the (long overdue) rebound in car production. Which is brings us to Europe.

“Growth [in the EU] continues at a more moderate pace”, concluded the European Commission yesterday in its spring 2019 forecasts. While the EC sees growth in all of the member states this year, they identified Germany and Italy as the laggards. The German growth forecast was cut to 0.5%, and the Italian GDP projection –already at a meagre 0.2% in the previous release– was reduced to just 0.1%. Crucially, for Italy, a large part of this forecast hinges on the assumption that global growth and trade pick up again in the second half of the year; which certainly isn’t yet a given considering the re-emergence of tensions between US and China.

And particularly for Italy, this puts further pressure on the government’s spending plans. As a result of the lower growth estimates and an expansionary fiscal policy, the Commission now estimates Italy’s 2019 budget deficit to come in at 2.5% of GDP and –more importantly– 3.5% in 2020, which would constitute a breach of the Stability and Growth Pact. After a heated debate between Rome and Brussels on Italy’s budget last November, these deficit projections will probably lead to renewed pressure on Italy to tighten its belt after the European elections later this month.

Deputy Prime Minister Salvini certainly seems to expect as much, and was quick to attack the EC’s forecasts, saying that “they never got one right”. We’re inclined to agree, but with the stipulation that it generally feels like the Commission’s forecasts have on balance been too optimistic! He added that “in this sense, that forecast appears to be more a political than an economic one.” To which we would like to remind him that his complaints about the European Commission’s forecasts come shortly after the Italian government had to raise their own 2019 deficit projection from an incredible (literally!) 2.04% in November to 2.4% in April. If that isn’t the pot calling the kettle black…

These forecasts were worse than the market’s expectations and, together with the prospect of a renewed budget conflict with the EU, this left little in the way of spread widening. Indeed, while outright Italian yields were just a little higher on the day, combined with declining bond yields in most of the Europe, 10y BTPS ended the day 8bp wider versus German Bunds.

The latest evidence that the US-China trade conflict and the sluggish growth in particularly China and Europe are leaving their marks on the global economy comes from the RBNZ. New Zealand’s central bank decided today to cut its target rate by 25bp to 1.5%. The RBNZ saw need for these cuts “to support the outlook for employment and inflation”, after these data disappointed recently. More importantly, RBNZ Governor Orr didn’t rule out further cuts, if this proves to be necessary: “Our forecast track is a slightly lower path than just one cut, but the uncertainties around that path are large.” Although the RBNZ’s next move clearly remains data-dependent, these comments bolstered the market’s expectations of another cut this year and may put some further pressure on Kiwi rates and the New Zealand dollar. Our FX strategists expect NZD/USD to continue to drift lower towards 0.65 on a 3 to 6 month horizon.