Are equities discounting too much of a good thing?

Worries include high political risks and possible protectionism

06 Feb 2017

  • Equities react positively to US labour market data
  • Eurozone: tapering discussion negative for equities?
  • PMIs diverging between developed markets and emerging markets
  • Asset allocation: complacency?

Global equities were roughly flat after a sell-off following the temporary bans on travel into the US for people from a number of Middle East countries ended as markets rallied on last Friday’s US labour market news. In addition, reports on fourth-quarter company earnings have shaped up positively in the US, Europe and Japan. European equities lagged despite upbeat economic data. Still, we think a lot of the good news is now discounted.

US LABOUR MARKET: GOLDILOCKS

The latest US jobs report just fits into a Goldilocks scenario where economic growth is strong enough to support earnings growth, but not too strong to generate inflation and result in monetary tightening. The 227 000 new jobs mark the strongest monthly gain since last September. Growth in employment was steady after having slowed for three straight months.

A rise in labour participation points to more slack in the labour market, as was also signalled by weak hourly wage growth. Indeed, the Federal Reserve’s (the Fed) latest policy statement did not do much to change views on monetary tightening. That said, market expectations for the Fed’s rate increases this year fell marginally and equity markets reacted favourably to the jobs data.

The ISM and Markit surveys of sentiment among companies continued to point to improving GDP growth in the months ahead, while the Atlanta Fed index has moved from indicating 2.3% QoQ annualised GDP growth in the first quarter a week ago to now signalling 3.4% growth. Our own nowcasting index points to 3.0% growth.

Goldilocks may be close to our main scenario, although we believe growth may be too slow to be really positive. The longer-run US labour market trend points to slower employment growth, while the Fed’s broad Labour Market Conditions index has slipped back into negative territory. Moreover, inflation has slowed the rise in real wages significantly. For faster consumption growth, consumers would need to dip into their savings or leverage up. But consumers may have become wary of cutting savings or taking on more debt since the financial crisis.

EUROZONE: STRONG DATA RAISES PRESSURE ON ECB

Strong German manufacturing orders did not immediately excite European equity markets. The data fits with a range of broadly positive numbers, especially leading indicators, but this may not support equities since it could feed the market discussion about the timing of the ECB’s tapering of its asset purchases. Tapering central bank quantitative easing (QE) in the US caused short-lived volatility in global financial markets, but tapering in the eurozone may have a longer-lasting impact. When the Fed started tapering In January 2014, the ECB and the Bank of Japan had their own QE programmes running, but when the ECB starts tapering, there will be no other central bank around to compensate for this.

Tapering in the eurozone may have a different impact on government bonds in the eurozone since this is a heterogeneous market. Here, quantitative easing suppresses both bond yields and credit risks. Just look at the range of developments recently. As the amount of eligible bonds the ECB can buy in Portugal is becoming more limited, Portuguese risk spreads have risen by almost 200bp from their 2016 lows. Spreads have widened by 50bp in France due to political risks. In Italy low growth and high levels of non-performing loans in the banking sector are the main risk, pushing spreads 100bp higher. But in Spain the strong economy has limited the spread widening to 34bp.

Thus, the mere discussion about ECB tapering has led investors to reassess government credit risk in the eurozone. We think this argues for cautious tapering. Tapering will come, but only when the ECB thinks inflation is close to its target or approaching the target on a sustainable basis and when growth is strong enough.

PMIs: GROWTH ACCELERATING

Interpreting purchasing managers indices (PMIs) on a global scale can be tricky. Our global GDP-weighted composite PMI was up in January, with a gain in developed economies, but a decline in emerging markets. But the average manufacturing and services PMIs were up in both regions. The average emerging market manufacturing PMI covering 19 countries was still at a fairly modest level historically. In the four BRIC countries, the manufacturing index was up in India and Russia. A slowdown in Brazil and China was bigger than the improvement on the services side, explaining the decline in the emerging market composite PMI.

The overall message of the PMIs is still that the global economy has gained momentum, driven by developed economies. The gap between developed economies and emerging markets has widened further. We are closely watching recent developments in global trade to see whether emerging markets can catch up. However, we think there are structural impediments to global trade and the possibility of rising protectionism is not making us more optimistic.

ASSET ALLOCATION: COMPLACENCY?

We are underweight developed equities since we think currently rich valuations discount a positive scenario amply and equity investors may have become complacent. Volatility in equity markets has been exceptionally low since late last year and volatility in US government bonds has fallen recently. Given the high political risks, possible protectionism and the risk of higher inflation and bond yields in the US, we feel there is enough to worry about.

The strong US dollar is a headwind for the US manufacturing sector and US earnings. President Trump has stated that the dollar is too strong, but we do not expect such remarks to change the course of the dollar. Policy initiatives such as a border tax where imports are no longer deductible would directly push up the dollar, as would the increases in inflation, interest rates and yields resulting from a large fiscal stimulus programme implemented in an economy at close to full capacity. We do not have a position in the US dollar at the moment though.

We remain underweight in US high-yield bonds and emerging market debt in hard currency where we think the weakening fundamentals do not justify the narrowing in risk spreads.

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