Hopes were so high. At the start of the year, the ‘Goldilocks’ environment — characterised by above-trend global growth, contained inflation, and moderate volatility — looked set to continue, if not quite as strongly, in 2018. Importantly in 2017, we saw better-than-expected eurozone growth, and economic stimulus from the Trump administration thanks to tax cuts. This year, however, eurozone momentum has faltered and Trump has escalated trade tensions. A global trade war looms. It is important to recognise, however, that Trump’s measures are not merely protectionist — if his objective was only to raise tariffs he would have done that already and dispensed with any pretence of negotiations. Instead he has raised tariffs to force America’s trading partners to lower their own, or additionally in China’s case to change how it treats American companies that operate there. This distinction may be irrelevant if the result of American demands is a trade war, but it does illuminate that if the current tensions are to recede, America’s trade partners will need to offer concessions. Given how febrile the atmosphere has become, however, there is certainly no guarantee that they will.
The original Goldilocks scenario predicted continued outperformance of risk assets, that is, equities and credit outperforming government bonds, and emerging market assets outperforming developed market assets. Midway through the year, investors have reason to feel disappointed, if not exactly misled. Emerging market assets in particular have disappointed, and credit has underperformed government bonds (see Figure 1).
Figure 1: Market returns, 2018 (annualised) vs 2017
Note: Equity indices are MSCI IMI total return indices in local currency terms, except emerging markets, which are in US dollar. Fixed income index returns are local currency except for emerging market debt. *Returns through 21 June 2018 at an annualised rate. **Emerging market debt portfolio composed of one-third US dollar sovereign debt, one-third local currency sovereign debt, and one-third US dollar corporate debt.
Sources: MSCI, Bloomberg, BNP Paribas Asset Management, as at 21June 2018.
For US equities, at least, returns so far this year have not been so bad, and not far different from the prior year’s pattern. For all the volatility the second year of Trump’s presidency has brought (the VIX has averaged 16.3 this year vs. 11.1 in 2017), equities have still outperformed government bonds, and at a rate not significantly less than a year ago: the MSCI All Country World Index (which includes small cap stocks) has beaten the Bloomberg Barclays Multiverse (which includes high-yield bonds), by 6.0% (in US dollar terms year-to-date at an annualised rate) compared to an outperformance of 15.7% last year. The US is again outpacing Europe and Japan.
The disappointing performance of emerging market assets is due to the strength of the US dollar as well as the rise in US interest rates. Since the beginning of February this year, the dollar has recouped all of the depreciation accumulated over the previous 13 months (see Figure 2).
Figure 2: Emerging market currency index
Note: Index is the J.P. Morgan Emerging Markets Currency Index.
Sources: Bloomberg, BNP Paribas Asset Management as at 11 June 2018.
This rebound has not only reduced returns for investments in local currency debt and equity for hard currency investors, it has also prompted several central banks to raise interest rates to defend their currencies, threatening the domestic growth outlook. Those who opted for US dollar-denominated securities had to contend with an 80bp increase in US Treasury yields by mid-May compared to just a 20bp gain in 2017 (for 5-year Treasury bonds, which have similar duration to the US dollar emerging market indices).
Developed market credit index underperformance relative to government bonds is somewhat more surprising, though in fact not quite as bad as it might at first appear. To use the US as an example (because it has more data available), we find that when government bond interest rates are rising, credit generally outperforms. High-yield credit has done so consistently, and investment-grade credit more often than not (see Table 1).
Table 1: US interest rates and credit index relative performance
*Yield-to-worst for the Bloomberg Barclays US Aggregate Treasury index. Investment grade index is the Bloomberg Barclays US Aggregate Investment Grade Corporate index. High yield index is the Credit Suisse High Yield Index II until 1995, and the Bloomberg Barclays US High Yield Corporate Index thereafter.
Sources: Bloomberg, Credit Suisse, BNP Paribas Asset Management, as at 21 June 2018.
One could explain the underperformance in the first two periods shown in the table by the higher rate of inflation at the time. The comparatively poor performance this year is likely due to far higher valuations than we have seen in the past. For example, the spread on the investment-grade index at the end of last year was just 93bp compared to an average since 1989 of 133bp, and for high yield it was just 343bp versus 521bp on average since 1995.
We would nonetheless anticipate continued outperformance of high-yield debt from here and a recovery in investment-grade credit performance. Spreads remain low but are above the levels we saw earlier in the year. The strength of the US economic recovery suggests corporates should have little trouble meeting interest payments, and although there have been some disappointing growth figures over the last few months for Europe, credit conditions are still supportive. For example, the upgrade/downgrade ratio for European investment-grade debt date is at 0.9 versus a long-run average of -1.4 (according to data from Bank of America Merrill Lynch). While the current level is lower than the peak in February, it is still near the highest level since the global financial crisis began.
The outlook for emerging market assets in the short term will depend on the path of the US dollar and US interest rates, as the fundamentals remain relatively strong (if not as strong as earlier in the year; the emerging market composite PMI has dropped from 53.6 in January to an estimated 52.3 in May, but the recent increases in interest rates in some countries is likely to drag further on growth). We do foresee US interest rates continuing to rise, but not significantly from current levels. We expect the US 10-year Treasury yield to end the year between 3.0% and 3.25% as inflation rises slightly and the term premium remains suppressed (despite the Fed’s balance sheet runoff and increased issuance from the US Treasury Department). US dollar emerging market sovereign spreads look attractive at these levels after having widened by 75bp from the lows early this year.
The path for German Bund yields should follow that of US Treasuries upwards as the ECB plans its exit from quantitative easing. Inflation is moving back towards the ECB’s target of 2%, though this is more visible in the headline rather than in the core rate, thanks to the fairly steady upward march in the price of oil over the last year. Of course, political developments in Italy could yet drive another rally in Bunds like we saw at the end of May. While we remain cautiously optimistic that the more extreme scenarios in Italy will be avoided, the path for both core and peripheral eurozone government bond yields is likely to be stony.
As we noted, equity market returns have been more consistent with a Goldilocks outlook and similar to those of 2017, with the exception of emerging markets. Even the poor performance of EM equities can be blamed partly on the dollar. While the return in the MSCI Emerging Market IMI index has been -5.9% this year through 21 June in US dollar terms, it has been -2.2% in local currency terms and -2.7% in euro terms. Nonetheless, returns across most markets have been lacklustre. For the 24 countries in the index, only six have positive USD returns year-to-date, and the bulk of the positive return is from China; without China, the return would be -9.4% instead of -5.9%. The returns for China are dominated by the technology sector, however. The sector accounts for a large part of the country’s total return, as in the US.
While most valuation metrics for equities show the asset class still to be on the expensive side, one change since the beginning of the year is the disappearance of the premium that US equities had versus European equities. For the last several years, US equities (excluding the technology sector), have been trading at an above-average premium to European equities (the premium is normally about 10%). Recently, however, that premium has dropped back to the average level (see Figure 3). While there are still reasons to be overweight European equities (primarily higher and rising interest rates in the US), the argument that European equities are notably cheaper no longer holds.
Figure 3: US forward P/E relative to Europe
Sources: FactSet, IBES, BNP Paribas Asset Management as at 21 June 2018.
Equity market returns remain highly dependent on the technology sector, followed by energy. While we are less confident in the prospects for oil prices, technology sector revenues look like they will continue to rise faster than those in other sectors of the market. With rising Treasury yields in the US, interest-rate sensitive sectors are likely to continue to lag, but the earnings outlook for the other parts of the market remain fairly good and valuations, while above average, are not extreme. Barring a reversal in investor sentiment (from escalating trade tensions, Italy, or other causes), equity markets should continue to move upwards, albeit at a restrained pace. Retreating central banks will lead to rising core interest rates, but with economic growth steady, the income from credit markets ought to generate outperformance. A return to sustained gains from emerging markets will likely have to wait on a reversal in the dollar. With the Fed still on track to raise rates several more times over the next 18 months, this may happen later rather than sooner.
 The CBOE Volatility Index, known by its ticker symbol VIX, is a popular measure of the stock market’s expectation of volatility implied by S&P 500 index options, calculated and published by the Chicago Board Options Exchange