We believe that the rally in equities can continue, although decent earnings results will be needed to maintain momentum. Earnings growth expectations have come down sharply already, but the early days of the Q2 season have been mixed. We are more focused on guidance given the uncertain trade and growth outlook, which so far isn’t pointing to a significant deceleration. Valuations are not cheap, especially in the US, but there is still a lot of cash on the sidelines. Indeed, flows are still absent, a welcome technical support.
The bond rally has faded somewhat and sovereign yields have stabilized. We believe that yields below 2% in US 10-Year Treasuries are too low, pricing in too much easing from the Federal Reserve. Nonetheless, with an even more dovish European Central Bank (ECB) readying itself for a rate cut in September, and the possibility of further bond purchases pulling German Bunds and other European yields down, there is little risk of a sharp backup in yields in the coming months.
Global growth concerns persist and have contributed to lower yields but, for now, we do not see data pointing toward a recession. Indeed, while manufacturing remains weak and will likely continue to be so given ongoing trade disputes, service sectors are strong and consumers healthy across major economies. Labor markets are also showing resilience and the US housing market should benefit from lower rates.
Gauging Political Risk
Politics will remain in the spotlight. The US may have averted a fiscal cliff by agreeing to a new budget deal, but tensions between Italy and the European Union, as well as difficult Brexit negotiations under new British Prime Minister Boris Johnson, imply ongoing headwinds. Investors may continue to shy away from European equities, which have not benefitted from expected ECB stimulus as much as bonds yet, but the threshold for upside surprises in Europe is low.
Geopolitical tensions in the Middle East are on the rise, with the Iran-US-Europe situation bringing underlying support to oil prices. We do not expect a military escalation, and Iran has struggled to close the Strait of Hormuz in the past, but energy prices are likely to remain supported in the short term, though a spike in prices appears unlikely given global growth concerns.
ASSET CLASS DETAILS
We expect equity markets to remain supported by the US-China trade truce and accommodative central banks. However, we believe that decent earnings growth will be necessary for the next leg up. We also look to corporate guidance for the rest of the year, which so far has not pointed to a sharp slowdown. At the same time, earnings expectations had already been slashed, leaving room for announcements to surprise on the upside. Political and geopolitical headlines are also likely to add volatility, whether in Europe with Brexit and Italy, or with US-China-Japan-Europe trade developments.
Valuations remain high, particularly in the US, and could cap the rally if earnings disappoint significantly. Nonetheless, we expect the US to outperform over the medium term, as stronger growth and earnings support performance.
In Europe, valuations are more attractive and a lot of bad news is already priced in. In addition, the ECB is back into easing mode, which should support markets. One hurdle remains the euro, which might have only limited room to depreciate from here, given the renewed currency war. Emerging markets will go along for the ride, as long as Chinese growth stabilizes and the dollar does not strengthen too much.
The fixed income rally has slowed, with sovereign yields retreating and spreads widening somewhat in recent weeks. We believe that yields below 2% in US 10-Year Treasuries implies too many interest rate cuts by the Fed, and too negative a growth outlook. At the same time, with the ECB set to be even more dovish than the Fed, Bund yields are likely to remain close to the deposit rate, dragging down bond yields everywhere. Negative yielding debt now tops USD 13 trillion, and includes some European high yield bonds, a trend that is unlikely to reverse for some time. We believe a sharp backup in yields is unlikely given central bank support, muted inflation expectations, and global growth concerns. We favor shorter durations, but maintain some exposure to core assets as protection.
Credit spreads have stabilized, though high yield spreads widened in recent weeks. We expect spreads to range-trade from here, unless a much more negative growth scenario materializes, with carry providing most of the performance going forward. The current environment remains supportive of emerging market debt, which still offers attractive carry - and should remain in demand as long as the US dollar remains stable.
Despite a dovish Federal Reserve, the US dollar isn’t winning in the currency (depreciation) wars. Indeed, a new battle has started, where the Japanese Yen is the clear loser, as JPY remains supported by safe haven demand. The ECB looks to exceed the Fed’s dovishness, ensuring the euro doesn’t appreciate too much. As such, we expect broad range trading across major currencies.
One exception is likely to be sterling, which remains under pressure, given Brexit woes and a deal or no-deal exit Prime Minister. At current levels, downside is more limited, but it cannot be excluded during a difficult negotiation period. Emerging Market currencies should do well in the current environment, as long as risk appetite holds up and the US dollar doesn’t strengthen too much, but idiosyncratic risks remain.
Oil prices are balancing between worsening geopolitical tensions in the Middle East and ongoing concerns about the global growth outlook. For now, growth concerns have prevented a spike in prices, but oil should still find some underlying support. Over the medium term, we expect shale production to keep prices capped. Gold continues to see safe haven demand amid lower real rates, expectations for further rate cuts, and a stable USD. With ongoing growth fears and trade uncertainty, this trend can persist.
We continue to see a place for alternatives in portfolios as we look for de-correlating and diversifying strategies to complement traditional asset classes, particularly with liquid alternatives.
Fixed income securities may carry one or more of the following risks: credit, interest rate (as interest rates rise bond prices usually fall), inflation and liquidity.
Commodity-related investments, including derivatives, may be affected by a number of factors including commodity prices, world events, import controls, and economic conditions and therefore may involve substantial risk of loss.
Currency exchange rates between the US dollar and foreign currencies may cause the value of the investments to decline.
Alternative investments involve unique risks that may be different from those associated with traditional investments, including illiquidity and the potential for amplified losses or gains. Investors should fully understand the risks associated with any investment prior to investing
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed may change based on market and other conditions.
All investing involves risk, including the risk of loss. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments.