Markets have plenty to discuss, but act on little

Strategy: now overweight local currency emerging market debt

10 Apr 2017

  • Economic surprises have rolled over, in the eurozone
  • Fed turns its attention to bulky balance sheet
  • ECB clarifies: the order is taper-pause-hike

Overall, economic data has had a strong, positive impact on financial markets in recent months. Positive soft data has supported equities as well as analysts’ upward revisions of company earnings expectations, but these expectations have also been driven by a perceived brighter economic outlook. Bond markets have leaned towards the more muted hard data. Indeed, we do not see an imminent acceleration in growth. And while economic surprises have on the whole remained highly positive in the US, they have rolled over in the eurozone, Japan and the emerging markets.

Basically, we think equities are slightly expensive and earnings expectations are plentiful. There are other lingering risks. Geopolitical tensions have risen recently with the US military strike on Syria as well as the stepped-up rhetoric around North Korea. The latest polls for the French presidential elections led to spread widening on French, Italian and Spanish bonds, although we see this as temporary. The meeting of US president Trump and his Chinese counterpart Jinping looked less confrontational than may have been assumed. Still, the summit showed that there are open issues with trade and investment, North Korea and maritime security.

So, financial markets have been fairly quiet, without much conviction for up or downtrends. US equities have continued to drift lower, while the uptrend in eurozone equities seems to be losing steam. In Japan, equities have lost around 5% since mid-March after the Japanese yen strengthened. Emerging equities have slipped from a peak in March.

US LABOUR MARKET: THIS IS THE ANNUAL HICCUP

Non-farm payrolls growth in March disappointed, but we have seen the occasional weakness in other years as well and the poor numbers ultimately proved to be red herrings. We suspect the same will happen again, particularly as the headline number does not gel with all the indicators of a healthy (and indeed, increasingly tight) labour market. Strong job growth combined with a steady labour force participation rate led to a cyclical low in the unemployment rate of 4.5%.

Also encouragingly, the broad unemployment rate, including marginally attached labour market participants as well as part-time workers seeking full employment, has fallen notably and now appears to be consistent with full employment. Wage growth has basically stalled, but at some point, the labour market will have tightened by enough to generate faster wage growth.

In general, the Federal Reserve has sounded more hawkish on interest rates this year, but the focus is also on its balance sheet. Most FOMC participants now expect a change to the bond reinvestment policy to be appropriate this year, which is not far off market expectations. This likely explains the relatively muted market reaction to this news. New York Fed staff assume a baseline of USD 500 billion in excess reserves at the end of balance sheet normalisation. This would mean about USD 1.5 trillion of Treasuries and agency MBS being run off within four years.

ECB: IT’S TAPER-PAUSE-HIKE

There has been confusion about the order in which the ECB would taper and ultimately remove monetary policy accommodation. The eurozone economy now looks strong enough, but core inflation is just 0.6%. So, there is work to be done by the ECB to lift inflation. In addition, wage growth has so far hardly materialised. When the time comes for the ECB to exit quantitative easing (QE), it will taper the asset purchases before increasing the (now negative) deposit rate. President Draghi and chief economist Peter Praet confirmed that a) monetary policy must remain loose for now because there is no convincing evidence of a pickup in inflation, and b) that the ECB council is committed to executing the taper-pause-hike exit strategy.

On the political front, the rise of the French far-left’s Melenchon reminds us that euroscepticism is more widespread across much of Europe than many believe and that a run-off of Melenchon and the Front National’s Le Pen would certainly give financial markets palpitations. We still expect the centrist Macron to make it through to the second round and then win the presidency decisively. He could benefit from tactical voting if Melenchon looks like posing a serious threat.

There was a glimmer of hope for those waiting for a more realistic approach to the Brexit negotiations from the British government. Prime Minister May hinted that it might take longer than two years to agree a trade deal (alongside the terms of the exit) and that a post-Brexit UK might have to continue to respect the free movement of labour and the sovereignty of the European Court of Justice until a deal is done. However, with control of borders and control of immigration seen as crucial, tough negotiations and a ‘hard’ Brexit cannot be ruled out.

ASIA: NORTH AND SOUTH DIVERGE

While PMIs improved in southern countries such as India, Indonesia and Vietnam, they fell in Japan, China and South Korea. We think the discrepancy is mostly due to differences in economic structure. Japan and China in particular are relatively large and closed economies, while Indonesia should benefit from higher commodity prices. India is recovering from ‘demonetisation’ where large banknotes suddenly stopped being legal tender.

Japan saw a pretty steep decline in the Economy Watchers’ Survey. Nominal wages growth was neutralised by energy-driven inflation, which explains the sluggish domestic economy. In China, the Markit services PMI fell, dragging down the composite index.

NOW OVERWEIGHT EMERGING MARKET DEBT IN LOCAL CURRENCY

We think progress on fiscal consolidation and structural reforms has generally been limited, which is the main reason behind our underweight in hard currency emerging market debt, where we regard spreads over US Treasuries as unattractive. We believe local currency bond valuations are more attractive. Moreover, we expect the recent upward momentum of emerging currencies to continue to benefit local currency bonds. Falling inflation has enabled central banks in Brazil and Russia to cut interest rates, which should support local currency bonds in these countries.

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