Overall, equity markets had a mixed week. Meanwhile, bond yields generally continued to decline as investor concerns eased over the pace at which major central banks may remove monetary accommodation. ECB president Draghi’s comments following the bank’s monetary policy meeting on 20 June was interpreted hawkishly by currency markets, and the euro’s subsequent gains undermined a number of European bourses. European bond markets were more dovish in their interpretation of Draghi’s comments. The slight softening of some US data reinforced the growing perception that the FOMC may be more restrained than previously thought in the pace at which it withdraws monetary accommodation.
The implied change in the relative stance on monetary policy between the US and the Eurozone underpinned a further bout in euro strength against the US dollar and other major currencies.
Draghi turns dovish for bond markets, hawkish for FX markets
At the ECB press conference on 20 July, Mr Draghi stressed the continued strength of the Eurozone’s economic recovery, but he also indicated that the ECB had scope to further support the economy if needed and was ambiguous about the symmetry of inflation in the ECB’s reaction function.
European bond markets were biased towards a dovish interpretation of Mr Draghi’s comments, with 10-year Bund yields declining by six basis points. However, FX markets focused more on the relative rather than the absolute stance of monetary policy and were thus more hawkish in their interpretation, bidding up the euro on a trade-weighted basis, a move that hit European equity markets. In our view, it will also test the ECB’s commitment to the symmetry of its inflation target within its policy framework as it will tend to lead to a greater undershoot of inflation versus its target of 2%.
Equity and bond markets: Economic outlooks still differ
A feature of financial markets for most of this year has been the dichotomy between the economic outlook discounted by equity markets and by fixed-income markets. Equity markets had tended to be more optimistic on the prospects for the global economy and had rallied strongly, while bond markets, more cautious in their outlook, had also rallied strongly. More recently, though, concerns about the ability of central banks to tighten policy despite weaker inflation data, some tentative softness in European economic data and stronger evidence of softness in the US economy, started to lead to weakness in a number of equity markets and a sell-off in bond markets, suggesting that both were starting to discount a similar economic outlook. However, after a brief pause, equity and bond markets both appear again to be discounting differing economic outlooks.
Asset allocation: No major changes
In fixed income, we continue to be broadly neutral duration on a tactical view. Longer term, we expect to move back to an underweight duration position, particularly in European bonds, as we expect the ECB to be one of the first major central banks to adopt a less symmetrical reaction function and place greater emphasis on prudent management of financial markets.
For our other strategies, we see US equities as more overvalued than European ones. We are overweight Eurozone equities versus US and UK equities. This also reflects the fact that our forecasts for UK corporate earnings are much lower than consensus expectations and, as such, we expect UK equities to underperform those in most other major equity markets.
On real estate, European stocks have rallied significantly this year, while US real estate has lagged. This encourages us to maintain our overweight in US real estate as we expect this divergence to reverse over the coming months amid a pick-up in demand for US real estate.
We do not believe high-yield bond markets have adjusted sufficiently to the recent drop in oil prices and the risk of rising default rates in the US energy sector. In emerging markets, we prefer local currency debt, which should allow us to benefit as emerging currencies appreciate.
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