Despite robust economic indicators, inflation under control and still largely accommodating central bank policy, most bond and equity markets are now in negative territory year to date. Sharply positive returns have been rare and volatility has rebounded. After the sigh of relief on Emmanuel Macron’s presidential election victory in Spring 2017, political risks have made a strong comeback, reviving or creating new uncertainties. This situation will probably persist in coming months due to the election schedule so it would make sense to remain highly vigilant. Nevertheless, the US economy has re-accelerated, China’s economy is still strong and there is high visibility on monetary policy in the second half of the year, all of which justifies maintaining an upbeat outlook.
Political clouds are gathering
The global economic recovery continued in the first half of 2018 but at a slightly reduced and less synchronised pace. The US economy went it alone by accelerating, thanks to the tax reform approved at the end of 2017, while Japan and most European countries slowed. In the emerging zone, China has continued on its controlled moderate slowdown trajectory while a minority of more fragile countries like Brazil, Turkey and South Africa suffered significant capital outflows. The Fed has resumed its monetary policy normalisation by raising rates by 25bp in each The first half of 2018 is good illustration of the dilemma facing investors after an exceptional 2017 across the board. Despite robust economic indicators, inflation under control and still largely accommodating central bank policy, most bond and equity markets are now in negative territory year to date. Sharply positive returns have been rare and volatility has rebounded. After the sigh of relief on Emmanuel Macron’s presidential election victory in Spring 2017, political risks have made a strong comeback, reviving or creating new uncertainties.
This situation will probably persist in coming months due to the election schedule so it would make sense to remain highly vigilant. Nevertheless, the US economy has re-accelerated, China’s economy is still strong and there is high visibility on monetary policy in the second half of the year, all of which justifies maintaining an upbeat outlook. quarter. The ECB managed to announce it will stop asset purchases at the end of 2018 without sending the euro higher but at the cost of giving very strong indications that its current interest rate policy would remain in place for more than a year. Even so, market sentiment has changed markedly from 2017 and equity returns in the first six months of this year were up and down as investors alternated between considering the glass as half full or half empty. The first spell of turbulence at the end of January and beginning of February looked like the end of the fairy tale conditions that we had flagged 6 months ago. Upbeat macroeconomic news triggered a rise in bond yields and caused valuations to fall and volatility to rise.
But the increasingly uncertain mood in place since March is primarily down to political risk. In our view, the subsequent rise in the oil price is partly due to increasingly influential hawks in the Trump administration and the US exit from the Iranian nuclear agreement. The 50% rise in prices over 12 months1 constitutes a mini oil shock and almost certainly had some part in the economic slowdown outside the US. Italy’s parliamentary elections resulted in an unprecedented 5-star/Lega coalition government, showcasing the strength of populist movements and the European Union’s persistently fragile foundations. And then Donald Trump, fresh from pleasantly surprising business leaders with a sweeping tax reform bill, decided to focus on the protectionist side of his programme, reviving fears of a trade war not only with China but also with the traditional allies of the US.
Equities: underpinned by upbeat results
Faced with mounting political risk, investor optimism was mainly fuelled by strong company results. Upward earnings revisions have maintained strong momentum year to date on major developed markets (although Japan has lost a little steam in the last 3 months). The trend is particularly strong in the US and not only because of reduced corporation tax: consensus expectations for S&P 500 companies are for average 2018 sales to rise by close to 10%2! Europe's improvement is probably due to a slight fall in the euro’s effective exchange rate in the second quarter. At the sector level, energy unsurprisingly leads the field in estimated growth rates and upward revisions but global sectors as a whole are seen growing this year; only some defensives (consumer staples, telecoms and utilities) and financials saw revision momentum turn negative in the second quarter. Note that emerging markets have also seen downward earnings revisions, essentially due to countries with sharply depreciated currencies tightening monetary policy in an attempt to reverse the trend.
We need to be cognisant of the current optimistic assumptions, especially during the summer earnings season as cautious statements from companies, and even profit warnings, have started rising in June amid mounting threats over a trade war. Most markets in the first half posted mixed returns while earnings rose further, thereby helping multiples to fall and assuaging one of our worries back in January. Our analysis of investor positioning also makes us think that equity market optimism/complacency has fallen sharply. The momentum approach, i.e. overweighting outperforming stocks, has, just like 2017, delivered excellent stock picking results but failed completely in 2018 as a guide to equity market exposure.
We have scaled back our preference for European rather than US equities
As a result, our geographical differentiation is getting less marked. We remain cautious over emerging country equities due to externally fragile cases like Turkey, Argentina, Brazil and South Africa where monetary and financial conditions have turned very negative but also because of US-China tensions which seem pivotal to the ongoing rise in protectionism. But we have scaled back our preference for European rather than US equities. UK, German, Spanish and Italian government fragility and the political instrumentation of the migrant crisis have highlighted weak aspects of the European Union’s construction, put the brakes on timid efforts to move forward and complicated talks over a post-Brexit agreement. And although the ECB succeeded in its Quantitative Easing (QE)3 exit communication, expectations for bank sector earnings will be hit by its decision to prolong negative deposit rates for 5 more quarters. In the US, we prefer technology (in its post-September 2018 sector revision definition) as it will benefit from a strong investment recovery. We also like the financial and energy sectors for their earnings growth and reasonable valuations.
Still selective on bonds
As we expected, long yields rose at the beginning of 2018 but only briefly for German bonds which then rallied to last autumn’s levels. The upward trend in US yields also slightly fell back at the end of the first half as risk aversion rose. This historically high Bund/Treasury spread is due to the sizeable lag between the ECB’s monetary policy cycle and the Fed’s and is, in any case, completely wiped out by the cost of currency hedging. The situation for European holders of corporate bonds has been less favourable. Sales by nervous investors in the run-up to the end of the ECB’s quantitative easing, a programme which also includes corporate bonds, caused spreads to widen from their very tight levels at the end of 2017, even if fundamentals remained strong. And spreads tightened even more for hard currency emerging country issues as the US dollar returned in force. We continue to believe that interest rate risk in core eurozone countries offers very poor rewards and that investors should steer clear. Even if the ECB has decided to move very cautiously towards monetary normalisation, the process has begun and will gain traction in the second half. Real interest rates and the term premium do not, in our view, accurately discount the ECB’s apparent readiness to be behind the curve. Credit markets are now looking less expensive so we are minded to be a little more optimistic on spread assets up to the end of the year and focus on segments which lost the most ground in the first half despite their good fundamentals.
Finally, given low carry levels4, at least for European investors, we continue to prefer equities to bonds and are sticking with our tactical and contrarian management of exposure.
1 Source: Bloomberg
2 Source: Factset
3 The term «quantitative easing» refers to an unconventional type of monetary policy that central banks can use in exceptional economic circumstances.
4 The carry strategy consists in holding the securities until maturity in order to benefit notably from coupons.
Chief Investment Officer
This analysis is an extract from the first House View published by Edmond de Rothschild.
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