Volatile end to the quarter for global equities as markets rattled by mixed central bank messages
As we move into the second half of 2017, factors influencing financial markets have continued to shift on a weekly basis. Over the second quarter, we have seen political risks in the Eurozone ease and continued evidence of a cyclical rebound in the region’s economy. This has underpinned the continued strong performance of Eurozone equities. On the other hand, hopes for Donald Trump’s fiscal stimulus plans providing a boost to the US economy have continued to fade. This comes when the US economy has been showing signs of losing momentum. The UK’s domestic political strains are likely to continue to dominate the headlines, and have added a further layer of complexity to Brexit negotiations. Sterling is likely to remain the bellwether of political concern for investors going forward.
Towards the end of Q2, markets have been rattled by mixed messages from central banks globally. Recent speeches from Bank of England Governor Mark Carney and European Central Bank (ECB) President Mario Draghi have been interpreted by markets as a shift to a more hawkish stance; both speeches hinted that an end to the era of ultra-accommodative monetary policy could be drawing near. Bond yields (which move inversely with prices) have spiked higher in recent weeks in response to higher interest rate expectations and the possibility of a tapering of asset purchases, particularly in the Eurozone. This has caused comparison with the ‘Taper Tantrum’ of 2013 (where US treasury yields spiked to 3%), although we are unlikely to see moves of that magnitude.
The volatility in bond markets has begun to spill over into equity markets with bond proxy sectors (those with similar characteristics to bonds such as telecoms and utilities) initially hit the hardest.
Looking ahead to the second half of the year, despite the recent central bank commentary, we don’t expect a notable shift in policy. Although the Federal Reserve (Fed) raised rates again in June, we suspect the Fed will assess the incoming data over the coming months and are unlikely to consider moving again until the end of the year. It is hard to see the Fed moving to tighten again purely on grounds of financial stability, particularly with US inflation still below target, and real growth weak.
The IMF recently downgraded its 2017 US GDP growth forecast (to 2.1%), citing the diminishing prospects for fiscal stimulus this year. With expectations low, equity markets could respond positively should we see a concerted effort from the Trump administration to revive fiscal stimulus plans over the summer. However, this seems unlikely given the amount of political capital already spent attempting to (unsuccessfully) push through healthcare reforms.
US equity valuations continue to look relatively stretched, something Fed Chair Yellen referred to this week, on “standard metrics” like price/earnings ratios. With the Fed looking to gradually withdraw stimulus and share buybacks, another key driver behind US equities in recent years, on the decline, corporate earnings will need to replace QE as the main driver, if share prices are to maintain current high levels.
The Eurozone’s economic recovery remains encouraging and we remain relatively positive on the prospects for the region’s equity markets. Analysts continue to upgrade corporate earnings forecasts and valuations remain relatively attractive. Despite recent efforts to stem contagion risks from Italy’s troubled banking system, the health of much of the region’s ailing banks remains a risk going forward. With much of the positive news in the Eurozone now priced in, looking ahead the danger is that the data undershoots higher market expectations. Moreover, should data remain positive, Mario Draghi is likely to come under further pressure to remove monetary stimulus. Focus will now be on the ECB’s next meeting in September. Mr Draghi is likely to give the ECB’s hawks more recognition, but a change in policy seems unlikely at this stage.
In the UK, the political uncertainty may already be weighing on corporate and consumer confidence. UK Purchasing Manager’s Indices are likely to deteriorate further and feed through into lower growth forecasts. This comes when real disposable incomes are being squeezed and the household savings ratio is at a 50 year low. Against this backdrop, we are likely to see the government’s zero public sector deficit target be pushed further out and some shift back towards fiscal stimulus.
For the Bank of England, a shift towards a more expansionary UK fiscal policy would reduce the onus on monetary policy to prevent a recession during Brexit uncertainty. However, that does not mean an early monetary tightening would necessarily make sense. Raising base rates prematurely, when inflation is likely to peak in the third quarter, risks tipping the UK economy into recession by deepening the squeeze on household incomes and importers’ margins. Given the ‘stagflationary’ backdrop (higher inflation and lower growth), we believe Mark Carney’s dovish influence will ultimately prevail, despite some members of the MPC recently taking a hawkish turn.
It seems the UK is set for an extended period of stagflation, which presents the central bank with difficult choices. With sterling likely to remain on the weaker side and given the headwinds facing the economy, we continue to favour the overseas earners of the FTSE 100 over more domestically focussed companies. Within the fixed income space, the ‘stagflationary’ environment favours index-linked bonds over conventional gilts. However UK index-linked bonds continue to look relatively expensive. We feel there is better value in US TIPS for those seeking some inflation protection.
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