Growth throttles down, in line with inflation and inflation expectations

For yields: emerging market debt in local currency and US real estate

26 Jun 2017

  • Time to buy oil?
  • Central banks do not stand in the way of the equity rally
  • A delicate balancing act in China
  • Asset allocation: overweight in eurozone equities versus the UK and the US

Equity markets have remained quite unexciting, with volatility at a record low in the US and close to it in Europe. Volatility in US government bonds is also at record lows. The big story of the past few weeks has been the steep decline in crude oil prices. On the data front, surprises have started to roll over and there are indications that robust ‘soft’ data, such as sentiment surveys, are converging with more modest ‘hard’ data. We do not see any strong catalysts for big changes in markets any time soon though, so what phenomena are we watching for?

HAVE OIL PRICES FOUND A BOTTOM?

Oil prices have dropped by a sharp 18% from late May, dragging down oil-related assets including some emerging currencies and US high-yield corporate bonds, but passing by broader risky assets. We think these market moves are consistent with the view that the oil price correction has been driven by excess supply rather than a drop in demand. The likely culprits? For one thing, US crude oil production continues to rise and inventories remain high. The US shale oil sector has fundamentally changed the supply curve, with elastic supply at a break-even price that was low two years ago and is probably even lower today.

There has been other news on supply: production surged in Libya and news on the royal succession in Saudi Arabia has probably shaken market confidence that OPEC can sustain cuts in production. But even if those cuts can be extended further, investors may be coming around (again) to the view that US production can expand to fill any void left by others. Prices may drift higher, but they will likely struggle to defy the irresistible drag of (rising) supply. Given the negative carry on the asset class, we think it is too early to go overweight oil or commodities now. But we are also looking for oil-related assets which could benefit from price rises.

DEALING WITH CONFLICTING GROWTH AND INFLATION OUTLOOKS

Survey data have been strong recently and we doubt that hard data can live up to their ‘promise’. Meanwhile, the latest economic data is no longer offering up positive surprises in the US and the Eurozone; data has also turned in Japan and the emerging markets. The purchasing managers’ indices for June for the US and the Eurozone fit this pattern. In the Eurozone, the composite PMI fell to its lowest since January, although its current level still points to robust growth and the German Ifo index rose to its highest in decades. So, we think it is too early to worry about Eurozone growth.

In the US, the composite PMI slipped to its lowest since last September. Data released so far in the second quarter indicates that the rebound from the modest pace of growth in the first quarter may be more subdued than thought. The pace of growth of commercial and industrial loans by banks has fallen significantly and this slowdown appears to be demand-driven. If the corporate sector decides to borrow less, dividends or share buybacks look set to suffer.

Meanwhile, inflation and inflation expectations have come down. Central banks appear to see this as temporary. In the US, the Federal Reserve has some flexibility in its monetary policy, but the ECB could be forced to taper its asset purchases next year amid a shortage of eligible bonds, which would limit its room to manoeuvre. Lower oil prices will likely push down inflation further, which may in turn further suppress inflation expectations.

For now, equity markets do not appear to worry too much. As long as economic growth holds up reasonably well and company earnings momentum and analyst earnings revisions stay positive, markets may treat this environment as a goldilocks scenario with strong enough growth and inflation to sustain earnings growth and low enough yields to not upset equity markets. While we are worried about the high valuations of equities and the elevated earnings expectations, we have maintained our neutral asset allocation view on equities.

HOW WILL MONETARY TIGHTENING AFFECT THE CHINESE ECONOMY?

Monetary policy has clearly been tightened in China when looking at short-term interest rates. Growth in the M2 money supply is at its slowest pace on record, while growth in domestic credit has decelerated sharply. We think slower credit growth is a necessity from a longer-term perspective, but balancing tighter credit and a 6.5% target for GDP growth will be a challenge for Chinese policymakers. Sales and construction activity in the residential housing sector has slowed significantly, even if the recent monetary tightening was only modest.

Given the size of the Chinese economy, any such shifts can meaningfully impact the global economy and financial markets. So far, the process has been gradual and benign enough not to cause any concerns. But data on trade and industrial production in some Asian countries shows that the recent growth impulse from China is fading. We think the authorities are sharply focused on stable growth and we do not expect China to rock the markets any time soon.

ASSET ALLOCATION: UNCHANGED

While equity markets look tranquil and unexcited at first sight, there are some interesting developments under the hood. US equities have managed to grind higher, but Eurozone equities have settled into a modest downtrend. This is largely due to differences in sectoral composition. Information technology makes up 22.6% of the US S&P500, but it accounts for only 6.5% of the EuroSTOXX 600. Healthcare, another sector that has supported the overall equity market performance, also has a much bigger share of the US market index than it has in the Eurozone. Financials generally have suffered from the decline in bond yields, but US financials have had some support from market speculation on financial deregulation.

However, we think valuation, the earnings outlook and earnings momentum matter more in the medium term. We regard US equities as more expensive than Eurozone equities. For us, our overweight in Eurozone equities versus the UK is essentially also an overweight versus the US. One notable positive factor for the Eurozone is the recent improvement in the political climate.

Eurozone equities rallied on the back of a bank rescue in Italy. After the ECB warned Popolare di Vicenza and Veneto Banca were ‘failing or likely to fail’ and the EU resolution authority ruled the banks were not big enough to justify resolution, Italian bank Intesa Sanpaolo stepped in to buy the banks’ good assets for a token amount, while the bad assets were shifted to a ‘bad bank’. The Italian government paid EUR 5.2 billion to Intesa and provided an additional sum of up to EUR 12 billion in guarantees for future losses on the assets that were transferred. Senior bondholders and large depositors appear to have been spared being hit.

In government bonds, US 10-year yields appear to have found a bottom, while German yields are still heading towards the lower end of the range they have traded in since late last year. We think for yields to break out of that range on the downside, political risk needs to re-emerge or there would have to be more evidence of an ECB policy mistake. Both do not look likely at this point. Structurally, German yields still look low, hence our structural short duration position.

We think spreads are too low on US high-yield corporate bonds given the worsened balance sheets of many US companies and even thinner financial buffers for US high-yield issuers. We prefer to look for yields in emerging market debt in local currency and in US real estate.

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