Financial markets are confused as uncertainties abound

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When it signalled its shift in strategy last month, the Federal Reserve board’s Jerome Powell said the US central bank was "patiently waiting for clarity". The Fed isn’t the only market participant confused by the context in which they operating.

The Fed, and other central banks – our Reserve Bank, the Bank of England, the European Central bank and even the Bank of India – are all shifting stance pre-emptively, worried about what might happen rather than current conditions.

US President Donald Trump has ruled out a meeting with Chinese counterpart Xi Jinping ahead of the deadline in the trade negotiations that could shape the direction of markets and economies.

US President Donald Trump has ruled out a meeting with Chinese counterpart Xi Jinping ahead of the deadline in the trade negotiations that could shape the direction of markets and economies.Credit:AP

The biggest known unknown is the outcome of the Trump administration’s trade policies – whether it can strike a deal with China and whether the conflict with China is followed by an escalation of its disputes with Europe.

The negotiations with China are rapidly approaching the March 1 flashpoint where, absent a deal, the US will lift the rate of its tariffs on $US200 billion of Chinese imports to 25 per cent, from 10 per cent.

With Trump ruling out a meeting with China’s Xi Jinping ahead of the deadline, and mixed reports about the progress of the negotiations, there is a big and potentially destabilising question mark over the nature of the outcome.

It isn’t, however, just the trade disputes that are causing financial markets to behave peculiarly, although those tensions are woven into some of the other influences.

China’s economy, the growth engine for the global economy for much of the post-crisis era, is spluttering and slowing. The response of authorities – injecting liquidity into their system and embarking on some targeted infrastructure investment – doesn’t appear to be having the same impact that its stimulatory policies have had in the past.

Europe is struggling, with the European Commission cutting its already quite modest expectations for 2019 growth last week. The UK is rapidly approaching the deadline for Brexit without an exit plan.

The Bank of England, the Bank of India and the RBA have either cut their policy rates or, in our case, shifted their bias towards a cut, in the past couple of weeks. For the RBA, it was a combination of the warning signs offshore and tumbling domestic house prices that shifted its bias from raising rates to reducing them.

The anxieties of the central banks are shared by the markets.

After its near 20 per cent decline late last year, the US equity market has rebounded by about 15 per cent this year as the more "dovish’’ tone Fed officials adopted stopped the rout, with the confirmation that US rates are on hold and that the Fed was prepared to also halt its balance sheet normalisation program accelerating the momentum.

Bond markets aren’t, however, as confident about the outlook for the US as sharemarket investors. Bond yields have been easing across the board.

That fits more neatly with the reasons the Fed changed tack, as well as the earnings announcement and guidance coming from the bigger US companies. Earnings growth has slowed and is likely to be quite modest, particularly for those multinationals with exposures to China and Europe.

If the trade relationships deteriorate further, there is a feedback loop for US companies that could magnify the impact of those exposures.

There’s also, of course, the prospect of another US government "shutdown", with damaging impacts on the US economy.

The US dollar’s performance is more in line with the bond market than the equity market. Even though the Fed appears to be suggesting that the tightening cycle of US monetary policy might have run its course, the US dollar has appreciated against its trading partners and has gained nearly 2 per cent on a trade-weighted basis since the Fed’s statement late last month.

The activity in bond and currency markets could suggest that capital is flowing towards the US, not necessarily because investors are confident the US economy will continue to grow solidly, but because they believe the performance of the other major economies will be worse than whatever the outcome might be in the US.

That would mean US rates would still remain higher than other jurisdictions’ (like Australia) even if they didn’t rise any further.

Oddly, emerging markets, which had a torrid 2018, were on something of a tear last month, rising about 10 per cent in January, before the outcome of the Fed meeting saw them track sideways and then, last week, slip back. Perhaps investors in those markets were betting on China’s efforts to stimulate its economy succeeding, or being expanded.

While there is something contradictory and perplexing about the way the various markets have responded to the central bank policy shifts this year, they probably quite accurately reflect the elevated levels of global risks and uncertainties.

There could be considerable volatility as those risks emerge, or don’t, and as the uncertainties are ticked off, or persist.

For the moment, the big risk is a global recession but a positive outcome from the US trade negotiations with China, and subsequently Europe, would produce a positive response from markets and have positive impacts on real economies.