Strategy: Risky assets signal steadier nerves, but safe havens remain crowded

07 Jul 2016

  • Dichotomy between risky and safe-haven assets persists
  • Global PMIs point to subdued growth
  • How strong is growth in the US?
  • Challenging environment for risky assets

The current level of most equity markets would suggest that nothing has happened over the past few weeks. US equities have returned to the levels seen before the UK voted to leave the EU and emerging equities are trading near the top of their recent range. Why are UK equities at their highest since August 2015 and Japanese equities down almost 8% from the pre-referendum average? Currencies. The British pound has not recovered from the referendum outcome-induced slump and the yen has continued to strengthen in line with gains by other safe-haven assets such as government bonds and gold.

PMIs: ANY SIGNS OF A ‘BREXIT IMPACT’?

June’s PMI data should be interpreted with some caution since the surveys of the purchasing managers were held before the UK vote. Nevertheless, there are some clues. The manufacturing PMI jumped by two points, possibly on the prospect of a weaker pound, but the services sector PMI, which better reflects the shape of the domestic economy, fell. We expect the UK economy to slip into recession. We expect the combination of slowing business investment and consumer spending plus economic and political uncertainty, plus the negative impact of Brexit on real estate markets, to take a heavy toll. Already, several UK real estate investment funds this week froze withdrawals due to their inability to meet investor redemptions. This could potentially lead to a fire-sale of assets.

On a global scale, the composite PMIs remained relatively unchanged. The global GDP-weighted composite is positive, but its subdued tone is caused mainly by developed economies. In emerging markets, the improvement has stalled under heavy pressure from the weakness in Brazil. Admittedly, the PMIs for Brazil have started to recover. However, any bounce in the economy is likely to be slow. In our view, fiscal austerity and a central bank which wants to see lower inflation before it starts to cut interest rates constrain the potential upside. In China, the ‘super’-composite PMI which weighs all of the four available PMIs advanced, but, worryingly, three of the four employment components were below 50, pointing to a weak labour market.

In the US, the main questions now are how strong the second-quarter growth rebound has been and what growth will look like in the second half. Consumption data points to a robust rebound, but GDP growth could be held back by factors including weak business investment. Our nowcasting index points to growth of 1.8% QoQ annualised. Higher New York and Atlanta Fed estimates of 2.1% and 2.6% respectively would still reflect a modest recovery after the slow first quarter. For the second half of the year, weak business investment, modest leading indicators and cracks in the positive labour market story point to growth of around 2%, which is roughly the level we have seen in recent years.

The eurozone economy looked quite resilient going into the UK referendum, but the strong growth of the first quarter is unlikely to be repeated. Eurozone retail sales and industrial production and German manufacturing orders point to slower growth, but enough of an expansion to leave room for the labour market to gradually improve further.

In emerging Asia, our nowcasting index points to growth at just below 6% YoY, which suggests no acceleration. In South Korea and Taiwan, the manufacturing PMIs and industrial production have gained some steam, but things look less bright in India, Indonesia, Malaysia and Thailand.

For Japan, our nowcasting index indicates negative YoY growth in the second quarter. That would extend a slowdown since the third quarter of 2015 and fit with the latest PMI data. Overall, the composite PMI has now been below 50 for four straight months.

MARKETS: RISKY ASSETS vs. SAFE HAVENS

In equity markets, the mood soured again, but safe-haven assets have behaved much more consistently. Government bond yields have been falling, even in the US, which should be relatively sheltered from any economic impact from the UK vote. US 10-year yields have dipped to a record low, while German and Japanese yields are negative. Gold has gained almost 30% this year. Risk spreads on ‘peripheral’ sovereign bonds and corporate bonds have been quite stable, with yields falling in tandem with the slippage in government bond yields.

We view the investment climate as challenging for risky assets. Growth is on the whole modest and the risks have increased. Inflation is low in many parts of the world despite massive monetary stimulus. Meanwhile, equity valuations are stretched, in our view. In the eurozone, investor concerns over the shape of the Italian banking sector, where non-performing loans are high, have grown. Portugal and Spain are struggling to comply with EU rules on fiscal deficits, which may now have to be interpreted flexibly, creating another source of tensions in the eurozone.

Monetary policy is providing some counterweight to the market uncertainty and geopolitical tensions. Market expectations for a rate increase in the US have been pushed further into the future, while in the UK, futures markets are assigning a high probability to a rate cut as early as this month. The Bank of England has already acted by telling banks they can pause in the building of a special capital buffer. This pause should free up capital for more lending. More monetary stimulus can also be expected from the ECB and the Bank of Japan. Meanwhile, while everyone was preoccupied with Brexit, the Chinese authorities have let the yuan slip to its weakest level since 2010.

Dovish monetary policy and lower inflation expectations are depressing bond yields, but should also support equities. However, we think that the relative strength in equities will not hold. Hence we remain underweight in global equities as well as emerging market debt in hard currency.

The muted growth outlook and the market uncertainty in general have started to weigh on oil prices. Furthermore, supply is coming back on stream in Nigeria and Canada. Given that we expect oil prices to retreat, we have maintained our underweight in commodities.

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