Developed and Emerging Markets
Global financial markets are starting to calm after a volatile first quarter. The non-stop rally in equity prices and narrowing in credit spreads from mid-2016 until early-2018 ended abruptly, as first long-term bond yields spiked and then economic concerns bubbled up as some growth indicators softened and it appeared the U.S. was determined to drag the world into a trade war. Also, the easing in global PMIs (Purchasing Manager Index) and, to a lesser extent, the U.S. Manufacturing index, have raised a potential flag that a meaningful downshift in economic growth might occur. Moreover, some forward-looking measures have deteriorated, especially in Europe. Undoubtedly some of the dip in expectations reflects that economic conditions overheated last year and some slowing was inevitable.
It is possible that protectionist threats and a strong euro would have undermined current economic conditions. If tensions were to worsen, then it is possible that the drop in Euro area expectations would translate into a meaningful downshift in growth. The same holds for most economies around the world. While we remain optimistic on the Euro area and the U.S., China still holds the potential to upset the cart. It could yet escalate trade tensions with the U.S., creating a bearish market and economic outcome. So far, the economy has stayed resilient and is unlikely to suffer a hard landing for the foreseeable future.
The U.S. Dollar managed to consolidated and recover some of its losses earlier in the year. Investors are putting their hopes on a stronger economy and focused their attention on the 10-year Treasury yield, which is expected to cross the 3% level in a sustainable manner. However, the downside risk for the U.S. Dollar remains in place, if concerns about increased national debt take hold again. Elsewhere, currencies linked to oil (e.g. Australian and Canadian Dollars and/or Norway’s Krona) were showing notable gains over the month against the U.S. Dollar and/or the Euro.
Energy and other commodities
Towards the end of the month, Brent oil hit its highest level since 2014, shortly moving above $74 a barrel. Production cuts by OPEC and Russia over the past 16 months along with the latest rise in geopolitical risks to oil supplies/inventories have supported the price rally.
Global Bond Markets
The US yield curve, as measured by the spread between the US 10yr and US 2yr bond yields, has declined to around 44 bps, which is the lowest level in nearly 10 years. This movement reversed towards mid-month as oil prices, driven partly by supply concerns, strong US data indicating robust US growth and market expectations of future inflation have risen, thereby paving the way for rising US bond yields. This reinforces the market’s conviction of 2-3 more FED’s hikes to come this year. Core European Government yields trended also higher. Recent comments from officials of the European Central Bank reinforces its confidence on rising inflationary trend in the medium run. This may suggest that the Goldilocks era of low rates, low inflation, and low volatility is now behind us, and we are transitioning to a new economic regime.
Credit markets outperformed throughout the month on the back of better outlook for the global economic growth and reduced geopolitical risks related to trade wars and tensions in the Middle East. Our portfolio maintains a larger allocation to High Yield and Emerging Market debt, as generally improving credit metrics and accommodative monetary conditions support investments in bonds with lower credit quality. Such bond positioning should deliver positive returns in absolute and relative terms for the rest of the year and help to mitigate eventual losses from higher government yields.
Global Equity Markets
Global equities have been forced to digest several credible threats this year, including a sharp drop in the U.S. Dollar, a spike in U.S. and G7 government bond yields and an escalation of trade tensions. The potential for a trade war has diminished as of late, and the widening in the Libor-OIS (Overnight-Index-Swap) spread has paused. At the same time, the selloff has unwound overbought conditions and taken some of the froth out of equities that existed earlier this year. Global equities are now attempting to bottom, although we expect any renewed advance will prove choppy. The dynamics between equities and bonds has changed materially this year, where yields will now rise much more meaningfully during risk-on phases than earlier this cycle. This will keep underlying equity volatility heightened and restrain as well as narrow further rallies.
U.S. growth stocks have dramatically outpaced their value counterparts this cycle. A major call will be in timing a reversal in this multiyear relative performance trend. We expect this to occur alongside a persistent souring in FANG-type* stocks, which will likely require a sustained risk-off event. One noteworthy caveat is that relative valuation for the overall growth/value trade is not as stretched as during past turning points, suggesting it still may have further to run over the next few months before reaching a turning point.
Global growth is cooling after last year’s mini-boom, but a sizable slowdown is unlikely, provided trade tensions do not escalate. Thus, although the recent digestion in stock prices and bond yields could persist, we expect an upside breakout in both beyond the near run. Our investment stance is positioned for trade threats to not escalate, but one needs to monitor developments given the uncertainty regarding the U.S. administration’s trade intentions.
In terms of positioning, the investment cycle is maturing and will prove more challenging heading forward. Aggregate monetary conditions remain accommodative, but will slowly become less supportive, and many of the other economic risks we have been monitoring in recent years have appeared. Investors will need to be more tactical and/or selective in their pro-growth exposure, especially in terms of global trade bets.
Central Banks should be poised to tighten monetary policy in 2018, with the US Federal Reserve leading the way. Three Federal Funds Rate increases have been suggested with rumors of a fourth, should the US economy surprise to the upside. Government bond yields will continue to rise in response to solid growth and higher inflation expectations. We expect this trend to continue. We maintain a bias to short-duration and continue to overweight credit risk from the Developed and Emerging economies. We see the current environment as positive for credit market, despite likely muted returns and greater volatility than in previous years. The allocation to high yielding bonds should offset losses experienced from higher government yields.
Equity markets will remain volatile as economic growth momentum moderates and the gradual cyclical build-up of inflationary pressures persists. Fundamentals are shifting in favor of value versus growth, although timing the turn in relative performance will prove challenging. Once these issues are digested, stock prices should undergo another upleg given the positive earnings backdrop. Accordingly, we remain committed to a moderately pro-growth portfolio construction stance.
Bearish longer-term trends for the dollar are being brought to the forefront by protectionist rhetoric from the Trump administration. Even aside from this drag, a solid global trade cycle will steadily encourage global investors to look elsewhere for opportunities. We keep a neutral stance on the U.S. Dollar, favoring developed commodity-importer currencies over their commodity-exporter counterparts.
Any further spike in oil prices is likely to be short-lived due to resurgent U.S. shale output.
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