Investment Outlook 08.2017
Thomas TrauthEconomist, Dr. rer. pol., CFA, FRM
Equity markets performed well in July. Emerging markets equities clearly outperformed, rising by 5.5%, while developed markets rose 2.3%. The performance of emerging markets was driven by China, up 6.1%, India up 5.8%, and Brazil up 4.8%. Asia Pacific, excepting Japan, performed strongly, up 4.3% in July and 16.5% year-to-date. Among developed markets the US S&P500 and the Swiss SMI outperformed in July, gaining 1.9% and 1.7%, respectively. Both markets were supported by depreciating currencies. The EuroStoxx50 index rose 0.2%, while the Nikkei225 fell 0.5% in July.
The European yield curve steepened. Short-term yields fell 11 basis points while 10-year yields rose 8 basis points. Meanwhile, the US yield curve remained almost unchanged month-over-month.
Despite softer headline inflation in major economies, break-inflation inflation rates rose somewhat after falling since the end of February.
Emerging markets bonds outperformed within fixed income. Local currency bonds were up by 2.07% in July. Also, high-yield bonds performed very well, up by 1.66%. Inflation-linked bonds fell by 0.23% in July and underperformed nominal bonds, which were slightly up.
Commodities rebounded in July. Energy prices were up 4.6%, industrial metals by 4.1% and gold by 2.2%. Oil markets were driven by falling inventories, disciplined OPEC producers and falling US shale production.
REITS had a bad month falling 1.6%. Investors seem to be concerned about rising discount factors more than they appreciate the potential for rising leases in a better economic environment.
The macro environment looks almost too good to be true. We recently read the headline “better than goldilocks” written by a leading bank analyst, who described the very favorable macro environment we are currently enjoying: a period of steady economic growth coupled with low inflation.
Having said this, both the US and the European PMI weakened somewhat, though remaining very solidly in the growth area above 50. The US ISM index fell to 56.3 in July after 57.8 and the EMU manufacturing PMI fell to 56.6 after 57.4. In contrast, the Chinese Caixin manufacturing PMI rose to 51.1 in July from 50.4. This was helped by a solid increase in new business, with growing numbers of new orders and rising export demand.
Inflation figures fell across the board, driven by falling energy prices in recent months. Fed chairwoman Janet Yellen recently stated quite emphatically that softness of inflation will be only transitory. Markets seem to be confirming this view, since break-even inflation rates, as a measure of expected inflation, have recently risen.
On 20 July, the ECB kept key interest rates unchanged and maintained its net asset purchase program unchanged at EUR 60 bn per month until at least the end of December 2017. ECB chairman Mario Draghi was very dovish saying that “… inflation is not where we want it to be and where it should be …” and “… that interest rates will remain unchanged for an extended period of time and well past the horizon of our net asset purchases.” Despite the soft rhetoric the EUR continued to strengthen, which was a surprise to us. We expect that at its policy meeting on 7 September the ECB will announce a reduction of its bond-buying program to EUR 40 bn per month starting in January 2018.
The US Fed held its policy meeting on 24-25 July and left rates unchanged. The Fed believes that the current inflation weakness is only transitory. Chairwoman Janet Yellen said the Fed would start reducing its bond holdings “relatively soon”. Despite the more hawkish Fed statements, the market currently prices only a 6% probability for a rate hike at the next policy meeting on 20 September and a 42% probability for a rate hike by December. We think that the market is currently underpricing the Fed’s willingness to hike further. Firstly, the real effective Fed Funds Rate is still negative at -0.3%, while the Fed’s neutral rate, given current conditions, should rather be at 0.3%. Secondly, the weaker USD has loosened monetary conditions in the US, which may warrant the Fed hiking sooner to prevent the economy from overheating.
While Bank of England’s (BoE) Monetary Policy Committee members Ian McCafferty and Michael Sanders have been in favor of a rate hike to address rising UK inflation, the Bank of England decided on 3 August to keep rates and the asset-purchase program unchanged. The vote came in at 6-2, with the above-mentioned members voting for a rate hike. The BoE lowered its forecasts for economic growth and wages. The weakening GBP is driving inflation, which is outpacing wage growth and, in turn, lowering real wages and purchasing power. The BoE continues to assume a smooth Brexit scenario and said that the benchmark interest rate may need to rise somewhat more than the market currently anticipates. The market has fully priced a rate hike by the third quarter of 2018. The GBP dropped further after the policy announcement.
Meanwhile, the Bank of Canada raised its benchmark rate to 0.75%, its first rate hike in almost seven years.
The most dovish central bank remains the Bank of Japan, which revised down its inflation forecast and put forward its expectations for inflation to reach its 2% target to 2019. However, it did not decide on new or changed policy measures.
We stay positive for equity markets in general and for Japanese and European equities, in particular. US earnings growth and a high likelihood for US tax cuts will support US equities. While the rotation into European equities, which we discussed back in April, has lost momentum in recent months, we remain overweight in European equities. This thinking is based on solid European growth, a softer ECB than many anticipated, and relatively attractive valuations.
Japanese equities are supported by Bank of Japan’s policy measures, including direct buying of domestic equities.
Depressed commodities prices, especially energy prices, have some upside from current levels. We remain overweight in energy but are prepared to take profit when oil prices move towards USD 55, since higher levels may trigger additional production, most noticeably in the US.
We have been caught off guard by the strong rally of EUR-USD. We think the move is exaggerated and not sustainable. It seems to us that the market expects more aggressive tapering than the ECB is prepared to deliver and underestimates the Fed’s willingness to hike rates and reduce its balance sheet. The recent USD weakness by itself has softened monetary conditions in the US and gives the Fed more leeway to move.