Geopolitics dominated the headlines over the summer as conflict escalated in both eastern Europe and the Middle East. Nonetheless, the drumbeat of monetary normalisation in the US and UK is getting progressively louder, even if central bankers and bond markets choose not to hear it.
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US economic data and corporate earnings continued to point to brighter times ahead: second-quarter GDP growth came in above expectations – at an impressive 4.2% – buoyed by a brisker outlook for capital expenditure. Meanwhile, unemployment data showed further signs of durable improvements within a much-scrutinised labour market. US stocks, across the market cap spectrum, led the equity market recovery in August following a brief period of uncertainty earlier in the summer. Second-quarter earnings provided plenty of support as analysts continued to boost full-year revenue and earnings forecasts.
The yield on the 10-year US Treasury fell by 21 basis points last month1, dragged lower by falling European government bond yields, which saw the bund plummet to all-time lows. Geopolitics and falling supply, to some extent, played a part. With the fixed income complex looking increasingly distant from the underlying economic reality, the scope for a more violent wake-up call – as monetary normalisation looms larger – is increasing. We continue to suggest that investors tread carefully within the fixed income space.
The euro zone economy enjoyed a considerably less encouraging summer. An already anaemic recovery ran into the sand, with the German economy suffering some payback for a strong first quarter. This was compounded by continued nervousness around eastern Europe, while the French economy continued to choke. Euro zone inflation hit a five-year low in August with the headline rate printing at 0.3% – some way below the European Central Bank (ECB)’s target.
There were further signs that credit markets in the region have begun to thaw. The ECB’s targeted liquidity operation, due in September, alongside some catharsis from the end of the in-depth audit of European bank balance sheets, should help this process at the margin. With policy rates likely to remain accommodative for some time – a clear divergence from the UK and the US – European government bonds may continue to outperform their developed-market peers. August saw government bond yields in Europe – both core and peripheral – reach historical lows with investors starting to bet more confidently on ECB quantitative easing (QE), following hints from President Mario Draghi.
European equities suffered significant volatility over the summer, buffeted by the worsening situation in Ukraine as well as soggy incoming economic data. However, the same QE hints from President Draghi allowed the region’s stocks to recoup much of the summer’s lost ground. Although we do not see QE as immediately likely, we see good reason to continue to favour European equities. Continued warming of the credit markets and potential upside for earnings are central to this positive view.
In line with expectations, the booming UK economy moderated over the course of the last month as the economy moved towards a more sustainable growth profile. However, the gradual reduction in economic slack and initial signs of a rebound in earnings still suggest that the Bank of England may be the first of the major western central banks to raise interest rates. Unsurprisingly, both gilts and UK equities remained range bound as investors grappled with impending interest rate rises.
US economic data and corporate earnings continue to point to brighter times ahead…
After signs of renewed strength earlier this year, Japanese equities were the worst-performing regional market – in both local currency and dollar terms – as the correlation between stock markets and the yen collapsed. Faith in the near-term success of Abenomics faltered and the economy has continued to weaken following the consumption tax hike in April. In July, industrial production rose less than expected, while household spending slumped and inflation remained unchanged.
As bottom-up reform and liberalisation – the third of the three arrows aimed at revitalising the economy – remains largely absent, Prime Minster Shinzo Abe has until the end of the year to decide whether to raise the consumption tax rate further, from 8% to 10% in October 2015. This could lead to a further distortion of economic activity. Should data continue to disappoint, the Bank of Japan may be forced to provide an interim solution and step-up the pace of money printing. The central bank is already expanding its monetary base by 60-70 trillion yen each year, in an attempt to break the prolonged deflationary cycle, but this may not be enough to meet their price stability target.
Emerging markets equities reached an inflection point in February of this year, with much of the strong performance attributed to Asia and Latin America. The region’s stocks have shown resilience in the face of geopolitical headwinds, passive global trade and the prospect of higher US interest rates. Positive election results in India, Indonesia and Mexico have, to some extent, supported capital flows to these countries.
In contrast, emerging market debt has been losing steam since the end of July. The asset class showed considerable strength earlier in the year as policymakers in the developing world took steps to circumvent the impact of the Federal Reserve (Fed)’s tapering of asset purchases. However, in the past month, tensions in the Ukraine sparked a notable sell-off, particularly in emerging European assets. Recent strength in the US dollar – on the back of improving US economic data – has also contributed to weakness in local currency emerging market debt. In early July, we cut our recommended weightings in high yield and emerging market bonds to a strong underweight, while raising the weighting in cash to a strong overweight. If the days of easy money in developed markets are numbered, so too are cheap ‘carry trades’ financed by such money.
Commodities fared poorly this summer, with the broad index dropping by more than 8%2 since their peak at the end of June. The near-perfect weather conditions for harvesting grain, corn, and soybeans in the US meant that many agricultural goods saw supply constraints ease, and prices decline. Coffee prices, however, remained high as investors speculated on the impact of the Brazilian drought earlier this year. Industrial metals stood out within the commodity complex, benefiting from a pick-up in global manufacturing activity during the second quarter – a trend that could continue over the coming year. Precious metals and oil remained volatile throughout the summer, spiking periodically on the back of geopolitical risk events.