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Developed and Emerging Markets
The escalation of U.S. political uncertainty has increased the odds of a correction in risk assets. Bond yields and the dollar have dropped in anticipation of weaker economic activity and the Fed becoming less aggressive, if not sidelined, for a time. U.S. equities had already been struggling to punch out to new highs since cresting at the start of March; the same was true for bond yields and the U.S. dollar. Conversely, many non-U.S. equity markets have decisively broken out in recent months, especially the Euro area and EM Asia excluding China.
The Euro has gained traction versus the U.S. Dollar. Economic and political election-related risks have eased further and the Euro appears undervalued based on the IMF’s Real Effective Exchange Rate model.
Energy and other commodities
Oil investors currently hold widely divergent views and have good reason to be confused. A technological revolution is upending decades-old assumptions about the reaction function of output to price. There is endemic overcapacity, and uncertainties over both demand and supply in the short term.
Illustration (Section “Macro-Economics and Currencies”):
Asset Class Comparison
Global sovereign yield curves remained well supported through the month, in the absence of runaway inflation. The US Federal Reserve is expected to raise rates once again at their June meeting, despite recent economic data showing mixed results. With plenty of commentary from Fed members to this effect and following the released May FOMC minutes, US 2 Year Treasury yields rose. Through May, however, we observed longer-dated US government bond yields lower than where they started the month, indicating a requirement from investors for a more conservative approach to volatility and concern regarding geopolitical uncertainties. In Europe, the core was almost unchanged whilst peripheral sovereign bond yields outperformed, Portugal being the main benefactor both month and year-to-date. The European investment grade bond market has reacted nervously in recent weeks, due to rumors of the European Central Bank possibly announcing a tapering of accommodation or changing forward guidance to a more hawkish stance.
Long duration positioning in USD denominated High Yield credit and local Emerging Market sovereign bonds have continued to post solid gains and should provide some relative cushion, in a hawkish monetary policy environment. A notable downgrade by Moody’s on China by two notches (A1 from Aa3) citing “financial strength as debt mounts and growth slows”, investors had absorbed the news and bonds from within and related to the region withstood any reactionary sell-off, which may have occurred when the news broke.
Illustration (Section «Fixed Income»):
Government Bonds vs. Corporate Debt
Global Equity Markets
A six-week surge in global equities pushed stocks to record-highs but persistently increasing concerns about political instability in Washington have held back U.S. equities and the Dollar.
U.S. equities have looked tired in recent months, in that they have been unable to sustain meaningful new highs. Conversely, the sentiment has improved for European equities on the back of a turnaround in earnings growth, the French election and better economic data. Consequently, Europe is still drawing lots of attention from equity investors. With the exception of Latin America, the overall Emerging Markets Index has managed to rally to new highs in both local currency and U.S. Dollar terms.
Illustration (Section “Equities”): Major Equity Indices
A U.S. politically-induced risk-off phase would hit all markets. However, our expectation is that the budding leadership shift in favor of the Euro area and EM Asia ex-China stock markets (relative to the U.S.) will gain momentum, especially during the next risk-on period as investors will likely become less upbeat on the relatively richer-priced U.S. market and currency. One of the major positive changes from recent years is that the Euro area economy is on much firmer ground.
From an overall global perspective, further choppiness is probable over the near run, but the economic and policy backdrop should remain favorable for global equities over bonds on a 6-12 month horizon.
We expect the U.S. to lead the way, raising interest rates through 2017, affecting only the front-end of the US Treasury curve. Signs of inflationary pressures are not there and geopolitical hurdles on the near horizon will ensure mid-to-longer term rates should be kept from rising higher. Downside risks to the European area are slowly diminishing and it is evident that the ECB will begin to acknowledge this officially, within their forward guidance. The overall environment remains positive for both High Yield and Emerging Markets and as we look to China on the recent downgrade, we believe the response to be muted and credit to remain supported in this region.
Forward earnings have improved in recent months as the economic recovery progresses and related cyclical sector earnings such as Financials and IT deliver above-average readings. We expect absolute and relative earnings to trend higher in the year ahead, to the benefit of regional equities. A more stable political backdrop, combined with an earnings uptrend, also points to both an absolute and relative re-rating in the form of a higher forward P/E ratio.
While it is premature to go long the Euro versus the U.S. Dollar given the widening interest rate gap that still favors the U.S., we advise to reduce or exit EUR/USD currency hedges. We remain overweight the U.S. dollar against a basket of the majors, but are upgrading the Euro to neutral as part of a gradual process to scale back long U.S. dollar exposure.
On a 6-12 month view, fundamental supply conditions will likely remain too plentiful. All the price risks are to the downside, albeit within a broad trading range whose low end is fundamentally defined by current break-evens in the U.S. shale patch.
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