Investment Outlook 10.2017
Thomas TrauthEconomist, Dr. rer. pol., CFA, FRM
Is inflation back?
Developed equity markets rebounded in September as geopolitical worries started to abate. The Trump administration revealed its long-awaited tax reform plan, which includes significant tax cuts for corporates and more moderate personal tax cuts. This has led to a rally of tax-sensitive US stocks and could be a positive growth driver for the US and the global economy.
A more hawkish Fed pushed rate-hike expectations, global rates, and the USD up. The USD strengthened clearly against most major currencies. This helped European equities to outperform in September. The EuroStoxx50 rose by 5.1% in September, followed by the Japanese Nikkei225, which rose 3.6%, and the US S&P500, which was up by 1.9%. Meanwhile, the stronger USD was less welcome among investors in emerging markets equities, which had a difficult month with the MSCI Emerging Markets index and fell 0.5%.
US government bonds sold off. 2-year yields rose 16 basis points and 10-year yields 22 basis points. US break-even inflation – the difference between nominal and real 10-year rates – rose 8 basis points to 1.85%. The steepening of the yield curve and rising break-even rates clearly indicate that the market expects inflation to pick up, albeit rather moderately. European bonds also sold off, but to a much lesser extent.
High-yield bonds outperformed other fixed-income markets in September. The high-yield index was up by 0.85%. Emerging market bonds suffered from a correction after very strong gains in previous months and fell by 0.3%.
The hurricane season caused significant damage on the east coast of the US. A large portion of insurance-linked, i.e., catastrophe bonds, are exposed to insurance losses in relation to US wind. The market for insurance-linked bonds therefore sold-off significantly. The Swiss Re cat bond index lost 6.5% in September. It is very likely that some cat bonds will be affected and investors will have to forego coupon payments. We assume that the mark-to-market losses exceed the expected event-related losses and we are taking the opportunity to increase our cat bonds allocation.
Gold continued to sell off on the back of the benign risk environment. The Gold price fell from USD 1,350 beginning of September to USD 1,280 end of September. Industrial metals retreated in September and fell 3.8%. The price for Brent oil rose by 7.7% and passed the USD 50 mark.
The general macro situation we have depicted remains valid. Growth indicators clearly indicate that the economy is moving on a very robust globally synchronized growth path.
Most manufacturing PMIs we observe in this publication increased, with the notable exception of the Chinese PMI, which fell slightly but remained above the crucial 50 mark, indicating that the Chinese economy is still growing.
US non-farm payrolls fell into negative territory. The US labor market slashed 33,000 jobs in September. This can, however, be explained by weather-related disruptions and does not change the robust labor- market picture overall. The unemployment rate, for example, fell to 4.2% from 4.4%.
Average hourly earnings rose 2.9% year-on-year, the strongest increase since 2009. We monitor this indicator closely as a measure of potential wage pressure, which would translate into higher consumer price inflation. The September figure is, however, distorted to the upside due to bad weather conditions. Utility workers’ overtime pay was boosted while lower paid workers, for example in leisure and hospitality, have been more vulnerable to weather-related disruptions. It is still reasonable to assume that wage pressure will start to accelerate, since earnings growth figures were revised upwards in the previous two months.
Inflation in most major economies remains moderate. But we see early signs of US inflation picking up. Firstly, the economy has approached full capacity, and wage pressure – as mentioned above – has started to increase. Secondly, if the US tax-reform package were to be implemented, the US economy would receive an additional fiscal stimulus when it is already running close to full capacity.
China’s National Party Congress
China’s 19th National Party Congress, which takes place every five years, will be held 18-25 October. The major purpose is to rotate the leadership. President Xi Jinping will receive a second term but is likely to re-shuffle his leadership team. Very often, after the party congress, the new leadership will focus on structural reforms, which can potentially have far-reaching consequences for the domestic economy but also internationally. Comments by key policy makers close to president Xi suggest that major areas of concern are shadow banking, property bubbles, high leverage in state-owned enterprises (SOEs), and elevated local-government debt.
This suggests that the new leadership may focus on de-leveraging the economy. Most likely, this is associated with cutting back on aggressive infrastructure investments, a shift towards more domestic consumption and internal growth instead of export-led growth. In addition, private entrepreneurship may be encouraged more and state-owned enterprises may be rather cut back.
These reform plans are likely to reduce credit growth and slow the economy, before leading to a more sustainable growth path. In addition, Chinese demand for commodities, especially industrial metals, is likely to fall. This may also reduce growth in other emerging economies.
We try to take advantage of mark-to-market losses in the insurance-linked securities sector and tactically increase our allocation to this asset class.
Finally, and as we expected, the USD rebounded, when the market readjusted its Fed rate-hike expectations. The GBP, which recovered strongly in September, weakened again in early October after May’s speech regarding her Brexit strategy and doubts about the stability of the UK government. We remain USD overweight and GBP underweight.
We also remain slightly overweight in equities in general, and Europe as well as Japan in particular. We increased our Japan overweight and are now underweight in developed equity markets in the Asia Pacific region.
What are the major risks we see? Firstly, the US Fed could fall behind the curve. This could especially be the case if president Trump were to elect very dovish and possibly inexperienced central bankers, who would remain accommodative for too long. A too loose monetary policy in combination with a tax-cut-induced fiscal stimulus could lead to an overheating economy with accelerating inflation. History shows that when central banks react too late, interest rates need to rise above the equilibrium level, which usually triggers a recession.
Secondly, as mentioned above, after the Chinese National Congress there is the possibility of structural reforms in China, including measures to deleverage the economy. While this would move China to a more sustainable growth path in the long run, it could slow Chinese growth in the short-term, with negative spill-over effects especially to emerging markets.