Baby shark

Following price action as irritating as the latest viral internet sensation, a change in the tide could result in better fishing grounds for an alpha catch. 

Global risk appetite has continued to improve in the past week, with volatility starting to drop from the elevated levels seen through the end of last year.

Recent comments continue to suggest that a US/China trade deal is on the cards in the weeks ahead, and this impression was affirmed in our meetings with policymakers in Washington during the course of the past week.

The sharp sell-off in financial markets during the fourth quarter appears to have caused a shift in the US administration, and while issues such as IP theft and data security have not gone away, there is a desire not to create outcomes which exacerbate downside risks to global growth.

In this context, we feel sure that President Trump will want to take credit for the 'best China deal ever', given a desire to register a win at a time when investigations into his alleged past wrong doings, coupled with a growing agitation at the government shutdown, mean that he would like to take the opportunity to deliver some good news.

From political impasse to economic distortion 

The shutdown itself we see as more of a political issue than an economic one, but an increasing number of anecdotes coming from those facing financial hardship as a result of the impasse reflect badly on both parties.

We would also note that this could lead to a substantial distortion with respect to the next jobs report, with the unemployment rate spiking and total payrolls growth possibly set to dip below zero, due to a drop in the government sector. This could weigh on sentiment, with the impasse possibly set to drag on for another month or even longer.

Elsewhere, our analysis continues to support an upbeat view on domestic US economic growth, though the absence of inflation may underpin the Fed's willingness to pause on rate hikes for the time being.

This notion appears supported by San Francisco Fed research into instances where the unemployment rate at a regional level has reached ultra-low levels. In such cases, it seems there is no evidence to suggest that wages accelerate materially (and so no inference of a hockey stick-shaped Phillips curve).

In light of this analysis, it seems that the Fed is feeling more relaxed with the unemployment rate undershooting its NAIRU target, at a time when price pressures elsewhere remain very benign.

As such, we have adjusted our view to look for just two rate hikes in the current year - with no change in policy before June. Meanwhile, we continue to see recession risk as extremely low and see the risk of a downturn in 2020 as very modest, with policy remaining far from restrictive.

Domestic data shines a light

In Europe, disappointing production data suggests that the growth rebound in the fourth quarter of 2018 may be underwhelming, following on from weakness in Q3. Inflation in the eurozone seems more likely to fall than rise in the months ahead, and we expect policymakers to remain accommodative.

Domestic data has been more encouraging and economic activity should pick up in the first quarter of 2019, but it seems as if rates will stay stuck at current levels for an extended period. This is helping to anchor Bund yields and we feel that a 'hunt for yield' could resurface in the eurozone, making spreads across the periphery stand out as attractive.

In this context, Italy saw more than EUR40 billion in demand for a new 15-year deal this week, and we retain a constructive view on spreads, as political newsflow continues to die down.

More generally, a relatively benign backdrop for US rates and positive developments on trade could help underpin a rally in risk assets in the first half of the year. We remain relatively constructive on sovereign credit and emerging markets against this backdrop, though remain much warier with respect to corporate credit - just because we see ongoing supply continuing to present a technical overhang, against which it will be difficult for spreads to move materially tighter.

Brexit deadlock weakens UK government

Elsewhere, attention remains focused on the UK and the ongoing shambles surrounding Brexit, which makes the UK something of a laughing stock overseas.

With Theresa May's deal decisively beaten, we are very skeptical that she will be able to extract any material concessions from EU partners, such that this passes on another subsequent vote later this month. The prime minister is keen to find cross-party support for her plans, but it seems unlikely, in our view, that Labour would want to do too much to bail out the beleaguered PM, given how the Conservative Party seems to be driving towards self-destruction.

Although it is clear that there is a widespread desire to prevent a highly disruptive 'no-deal' Brexit, it remains unclear how the current deadlock will be broken. With backbenchers empowered to propose their own plans and amendments, the whole debate could become increasingly chaotic in the days ahead, and it strikes us that the UK government's ability to govern may be called into question, which is why a general election cannot be ruled out, notwithstanding the prime minister surviving this week's confidence vote.

From an EU perspective, a limited extension of the 29 March deadline has always looked possible, but only if there is a clear roadmap to delivering a timely outcome - as could be provided in another referendum.

Ultimately, we feel this could be the direction we travel in, but for now it may be naive to fully discount the 'no-deal' outcome, given that, in the absence of agreement and compromise being found, this will continue to remain the default position.

The clock continues to tick down, and with all involved incented to wait for others to blink first, it may take the very real threat of an accidental hard Brexit to create the momentum needed to move towards a compromise being reached.

Change of tides could result in a meaty catch 

As we look ahead, we take comfort from the recent stabilisation in global financial markets. Having witnessed the machines take control in December, it appears that fundamentals and valuations are now reasserting themselves and a backdrop of respectable economic growth, benign policy and reduced trade worries could see H1 deliver constructive returns.

It also appears that investors are reassured that a 'Powell put' has been seen to exist and that central bankers are listening. This should encourage investors to buy future dips rather than looking to sell into them.

Slowing Chinese data remains a risk factor, but in the absence of a policy error, we remain hopeful that Beijing has sufficient control over the economy to avert hard landing risks.

In this context, it seems that after the stormy conditions of the past month, the sun is starting to come out and conditions may be set to improve. That isn't to say that volatility has gone away, but it is possible that those panicking over recession risks in the past few weeks will live to regret it.

Price action in markets during the fourth quarter was about as irritating as listening to the Baby Shark song non-stop for three months. However, the tide seems to have turned and we look forward to hunting for alpha in the days ahead, doo doo doo doo doo...