Dealing with volatility. Addressing diversification.

Central banks in APAC are generally leading the way in terms of diversification into equities, while Latin American central banks tend to be the most conservative. Those from the Middle East and Africa tend to be somewhere in between. The Swiss National Bank has a relatively high allocation to equities when compared to other central banks.

The challenge for central banks is how to address the changes that are needed to deal with this new environment. They need to tackle the challenge of volatility related to equities, perhaps allowing greater tolerance to the downside, while also adopting a longer-term mindset, think five years ahead. Perhaps the central banks can learn something from the sovereign wealth funds in terms of separating political goals and investment decisions.

A different perspective: whilst there is consensus that rates in the US look set to be cut the by the US Federal Reserve (Fed) by 50bp, some believe this will be in one go at its meeting in July, whilst others believe there will be a 25bp cut in July followed by another in December.

But trade tensions are the topic of the day and very hard to plan for as the outcome is so binary.

The US economy will bend, not break. Broadly speaking the US economy is holding up well. Growth has come off from levels of 3% of GDP, which were unsustainable, but are still expected to hold around 2% to 2.5% GDP growth. While manufacturing has been hit, the service sector is holding up well. In particular, the US consumer underpins growth and this should continue as incomes are strong and jobless claims are at a 50-year low.

The Fed is in a tricky spot – the market has moved abruptly. It is unprecedented that the market is pricing in a cut so far in advance of a Fed meeting. The market has been priced at a 100% probability of a cut on July 31, well over 85% for September and about 70% for December, as well as once in 2020. Fed policy cannot be considered restrictive but there are downside uncertainties that are building that the Fed is recognizing; financial conditions will be monitored closely and lower equities, wider credit spreads or rising volatility will be looked at closely by the Fed and may generate a response. The Fed must choose between risk management or 'stay the course'.

US inflation has undershot for a decade, hence the Fed's decision to conduct a review of its inflation framework. One possibility is that the Fed switches to a target range around 2% rather than a ceiling of 2%, which would allow for some overshoot of inflation. The Fed has recently pushed out its forecast for core PCE hitting the target again, now expecting it to arrive at 2% inflation in 2021.

RMB internationalization is going slower than expected, but it is nonetheless advancing. There have been some episodes recently when it seemed as though the trend was accelerating, but in fact these have really only turned out to be periods when Chinese assets provided good carry, masking the absence of any underlying structural changes.

Is China an emerging market? When investors begin to reallocate cash towards China, should they pull it from their EM portfolios or from their DM funds? Economic data for China paints a mixed picture, which appears to make China an emerging market in some respects but a developed market in others. In technical and technology, however, China is very clearly ahead of any other emerging markets. It seems likely that the money will come from both.

Chinese bonds are emerging as a safe haven: when volatility increases, yields in China go down. Real rates are attractive and correlation with global markets is low, which supports diversification.

China opened the door to its bond markets in 2018 and whilst there has been rapid growth the overall levels of foreign participation are very low, at just 2.1% of overall market, according to UBS Asset Management. Global bond indexes are gradually ramping up allocations to China and by mid-2020; Chinese bonds are expected to reach around 6% of global indexes, with the inclusion of roughly 300 bonds. That suggests inflows of around 280 billion for the Barclays Global Aggregate bond index alone.

Italy is once again at the forefront of investor concerns about Europe, because the new government has taken a very different and arguably disruptive path. The new government, a partnership between the League and the Five Star Movement, is openly admitting it will no longer seek to reduce the country's extraordinarily high level of debt. Until now, that has always been a goal - even if it hasn't been complied with. Italy's debt service costs exceed nominal growth – this makes it stand out from the rest of the EU and even other heavily-indebted countries such as Japan.

The new government has pushed the country into the danger-zone, as reflected in the spread of BTPs over Bunds. The wrestling with the EU is set to continue and will come to a head in the autumn, when the government will have to present its budget proposals for next year.

UBS Asset Management, June 2019, unless otherwise stated.