Developed and Emerging Markets
A series of comments from major central banks during the month, reminded investors that accommodative monetary policy is only temporary and a stimulative measure, not for the long term. Throughout the year we have witnessed strong risk appetite in the main, due to improving economic drivers across the developed and emerging regions. Policymakers have maintained an easy tone in their selective forward guidance, so as not to create shocks within global markets and subsequent fallout. However, it is hard to defend such rhetoric as conditions shake off woes of the past. Inflationary pressures may not be evident across the board but there is growth, job creation and relatively cheap money (all of which should force the return of inflation).
In the US this month, we witnessed a strong employment report, healthy output indicators and as expected, a cautiously optimistic FOMC conclusion. Data suggest that the path of rate normalisation-to-date has done little to slow the economy. Mario Draghi of the European Central Bank announced no changes to existing rates and current stimulus. It was also stated that the current level of easing could be increased and also extended, should the single currency region take a downward turn. During a Q&A session, Draghi alluded to expected greater inflation in the coming months and a further debate as to the level of asset purchases at the September meeting. The Bank of Japan set a less positive tone as they struggle to achieve their inflation goals, pushing inflation targets now into 2019. China gave support to the wider emerging market universe, surprising with an outperformance in GDP expectations for Q2 2017. This was based upon fiscal and monetary stimulus, increased investment in infrastructure development and real estate.
The US Dollar has faced selling pressure in response to a marked deterioration related to US politics (e.g. investigation into the U.S. President’s connections to Russia, the failed healthcare bill and rising trade talk tensions) and less than anticipated inflation. Intra-month, the US Dollar traded to levels unseen in almost a year, whilst the Euro rallied against it, to a 2-year high. Broad emerging market currencies also faired well during the month versus the US Dollar, notable outperformers being the Brazilian Real, Chilean Peso, Korean Won and Mexican Peso.
Energy and other commodities
Oil was back in focus as Russia and Saudi Arabia voiced their dissatisfaction towards the governments of producer nations that have failed to meet their share of agreed supply cuts. Fresh concerns have now been raised as to the effectiveness of production cuts in reducing crude oversupply. On a broad-basis, both oil and base metals outperformed all remaining subsectors of the commodities universe.
Global Bond Markets
High quality sovereign yields from the developed markets trended higher through the month. The outliers here were peripheral Europe, where the risks have subsided marginally on news of the ECB reassessing current monetary policy. Optimism is high for the Eurozone despite uncertainties such as over-leveraged banks, countries running debt heavy balance sheets and the ongoing migrant crisis. However, during the month, Greece returned to the primary market and issued a benchmark 5-year bond, S&P raising the troubled country’s rating outlook to positive. Broad European credit spreads tightened, again indicating support for European corporate debt. In the US, the Treasury curve was almost unchanged for most of the month. Janet Yellen made her final scheduled semi-annual monetary report to Congress and the Senate, widely considered by the market as dovish. Her comments indicated the door has been left open for a more gradual rise in interest rates than previously anticipated. The FOMC revealed it’s concentration on the progress of achieving it’s inflation goals. US Investment Grade and High Yield bonds have started the quarter well, credit spreads compressing further with strong appetite for corporates ongoing. Emerging market debt inflows have slowed of late, as investors apply some caution. However, on a performance basis, the current environment is supportive. Our preferred exposure would be in hard currency EMD, although in the short-term due to US Dollar weakness, local bonds have added further gains.
Global Equity Markets
The Euro area equity market rally has stalled as the Euro has broken out to a new rally high. Euro strength should prove to be only a temporary roadblock given solid economic momentum, but is a reminder that monetary conditions must remain accommodative, as the ECB acknowledged. Looking at the U.S. equity market, one can observe that the softer U.S. Dollar has reduced the downside risk for the U.S. economy, which has been reflected in further equity market gains. Also, although still early into the 2nd quarter reporting season, the majority of U.S. corporate earnings so far have topped EPS consensus estimates. Emerging Market Asia is the exception to the recent pattern of strong currency/weak equities. Both have been strong, reflecting the revival of global trade, the relative cheapness of these markets and global investor positioning. As a consequence, we observed further fund flows into European and Asian equities at the cost of U.S. stock exposures.
Investors will need to assess which central banks can follow the Fed in a sustained series of rate hikes over the next couple of years. Indeed, the Fed is already well underway in what should ultimately prove to be a reduced pace of monetary policy adjustment. Global monetary conditions will slowly become less accommodative, as more countries join the US in exiting the great monetary experiment. The bottom line for markets is that the anchor of ultra-low bond yields is lifting.
The outperformance of bonds since the financial crisis has helped create a preference for fixed income. However, equity risk-adjusted returns have now outpaced bonds, a potential trigger in asset allocation favoring of equities. As fund flow statistics show, US retail fund investors are still underexposed to equity markets. More importantly pension funds and systematic traders who measure risk in terms of realized volatility might increase their equity allocations at the expense of bonds.
We are constructive on the asset class and believe that on the course of interest rate normalisation, moderate returns are achievable across both the Investment Grade and High Yield universe. Corporate debt shows strong investor demand. Our focus is mid-spectrum (BBB-B) and our maturity preference is to the out to the mid-point of the curve. We continue with a low duration bias and maintain an overweight in corporate bond exposure, across the developed and emerging markets.
The key to sustaining a generally favorable equity market backdrop in the face of less accommodative global monetary conditions is for corporate earnings to continue to move higher. We remain positive on the earnings outlook, although it will be critical for the leading U.S. economy to maintain a positive growth track. Euro area equity market relative performance has weakened a bit in recent weeks, but underlying fundamentals continue to improve and warrant maintaining an overweight stance in a global equity portfolio.
The US Dollar could face further near-term selling pressure, due to a tightening in monetary conditions elsewhere. We understand this weakness to be short-term however, as few other central banks will be able to keep pace with the Federal Reserve. This is likely to narrow the gap with the Euro and overall G-10 currencies in the months ahead. Selective Emerging Market currencies should also benefit from the current environment.
Commodity prices will remain range-bound with predominantly downside risk. Support for base metals should remain firm as long as there is no immediate slowing in the emerging market region. Gold will remain in demand through periods of volatility. Energy prices are subject to output and supply agreements, which are currently being ignored by some producers. We advise an underweight position.
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