Strategy: Low yields elbow out growth and inflation concerns

Rotation in investment-grade from Europe to US

14 Jul 2016

  • US: better growth without rate hike pushes equities to all-time high
  • Eurozone: is disappointing data a harbinger of slower growth?
  • Emerging markets: stuck in low growth
  • Japan: what form could stimulus take?

After May’s weak labour market report, the US Federal Reserve did not argue with the low probability the market attached to a policy rate hike anytime soon and again, its lack of comment after June’s strong jobs report had no impact on market expectations. The market’s assessment of a rate hike in July has hardly changed, perhaps reflecting the Fed’s warning that labour market data is often volatile. Overall, the view appears to be that monetary policy will remain stimulative.

That perception, in combination with fading investor concerns over the outlook for growth, has boosted equities, driving US equities to an all-time high. We are wary of this optimism since we do not believe global growth is strong, while low inflation makes boosting company profits a challenge.


June’s jobs report was strong and helped to turn around the gloomy sentiment about the shape of the labour market, and by extension the US economy, after the slowdowns in employment growth in April and May. The Fed’s Labor Market Conditions Index, which tracks 19 job market indicators, remained negative for the sixth straight month, but less so than in the previous four months. Average hourly earnings growth remained modest, but other indicators have shown faster growth.

Sentiment among small business owners improved in June, mimicking an improvement in sentiment among bigger companies. But adjusted for volatility, the ISM manufacturing index is only just above its long-term average, while the NFIB index is still below. Adjusted for volatility, the two main measures of consumer confidence appear to have plateaued lately. Thus, GDP growth should be positive in the US, but at a somewhat subdued level, in our view.


US equity markets appear to be discounting a ‘goldilocks’ scenario with growth high enough to increase corporate profits, but inflation remaining subdued, keeping the Fed on the sidelines. For the short term, this looks reasonable. Even with the recent improvement in the labour market, the uncertainty is too high for the Fed to consider raising the fed funds rate any time soon. Recent comments by Fed officials have not indicated any willingness to do so.

The short-term implications for markets are clear: bond yields should stay low. Equity markets have reacted positively, especially in the US. The reaction in Europe has been more muted: European equities are down by 7.7% year-to-date. We remain underweight global equities, with a preference for an underweight in Europe. As for the still-nascent US earnings reporting season, analyst expectations are low and earnings revisions have swung from positive to neutral. Net earnings revisions are also negative in Europe and Japan. While we are relatively positive on growth in Europe, there are downside risks, while political uncertainty is high.


In Germany, exports and industrial production fell unexpectedly sharply in May. Month-on-month, production also fell in France, Italy, Spain and the Netherlands. As in Germany, the weakness in France, Italy and the Netherlands follows earlier strength. For the eurozone as a whole, the decline practically reverses April’s strong gain. Thus, a second-quarter slowdown in eurozone GDP growth looks inevitable and the main question is whether the economy can hold on to its 0.3% to 0.4% QoQ growth rate. Private consumption and a gradually improving labour market should provide some counterweight, so we do not see this as the start of a sustained slowdown, but low growth, low inflation and low inflation expectations should still push the ECB towards more easing later this year.


Japan’s economy could also use policy support. In the Economy Watchers’ Survey, the assessment of the current economic situation and the outlook have now fallen to close to the lows after the 2014 consumption tax hike. Lower industrial production and capacity utilisation in the manufacturing sector signal that there is not much need for business investment. We think the economy barely grew in the second quarter and may even have shrunk somewhat.

With the ruling LDP winning Sunday’s Upper House elections, expectations for a fresh stimulus package have grown. We think significant fiscal stimulus is on the cards, but it is unclear how and when the Bank of Japan will react. Prime Minister Abe thanked voters for their endorsement of ‘Abenomics’, his structural reform and cyclical stimulation programme, but with the focus now on short-term stimulus and changes in Japan’s pacifist constitution, the reform arrow of ‘Abenomics’ may remain somewhat blunt.


In China, exports and, even more so, imports have struggled to gain traction after the traditional Chinese New Year slump. This data points to weak growth in China’s export markets and in the country itself. Weakness in trade was also still visible in Russian data.

In India, data signalled strong GDP growth at 7.9% YoY in the first quarter, but industrial production growth lingered at a disappointing pace for an emerging economy such as India’s. The composite PMI does not point to strong growth. The economy could do with more easing, but inflation – sticky above the Reserve Bank of India’s 5% target – is limiting the central bank’s room to manoeuvre.

In Brazil, an improvement has started to become visible in the YoY growth rates of indicators including the PMIs and industrial production. But in May, retail sales contracted further as higher unemployment and rising personal default rates held back consumption. High real interest rates and the need for fiscal austerity should limit the pace of any recovery. Meanwhile, swift rate cuts are off the table since the new central bank governor wants to see further improvement in inflation first.


Investment-grade corporate bond spreads over government bonds are about 50bp higher in the US than in Europe and yields are close to 250bp higher. In Europe, we see higher political risk after the UK referendum, while there are more banking sector problems, looking, for instance, at non-performing loans at Italian banks. The need for these banks to recapitalise may become clear after the ECB’s stress test results, due on 29 July. Officially, any recapitalisation should include a bail-in from equity and bondholders and could impact the European investment-grade credit index, which has a large financial component. We expect lending conditions in Europe to worsen given the pressure on banks. US conditions could improve as fewer and later Fed rate hikes are discounted.

WSU 14July16

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