Global Weekly: An uncertain situation

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With yields on certain long-term bonds having fallen below short-term yields, bond markets seem to indicate that the future is more certain than the present. It surely looks that way. With the trade dispute intensifying, total chaos in British politics and some European economies edging closer to a recession, the current situation is very uncertain.

Nevertheless, equity markets are heading towards new highs, with the Dow Jones, the S&P 500 and the Euro Stoxx 600 now trading only a few percent below recent highs. The reason for these index levels is what investors would call ‘TINA’ (there is no alternative). The bond market hardly offers any expected returns. In addition, interest rates on savings accounts are extremely low and possibly moving towards negative territory.

Alternative assets are either weak (commodities) or have rallied (gold). Investors therefore look at ‘safe’ areas in the equity markets. Historically, these safe areas are consumer staples, health care, utilities and telecom sectors. Telecom is in a miserable situation (kill-your-enemy competition and high investments) but the other three are in good shape albeit somewhat expensive.

Sector rotation charts of the Euro Stoxx 600 index reflect that relative strength for these sectors is increasing and that they are outperforming the index. At the same time, these charts point at weak relative strength and underperformance for sectors such as financials, energy and materials. Indeed, it looks like investors are putting their money in ‘safe’ sectors or are not investing at all.

How uncertain is the current situation? In our base case scenario, we do not expect a disorderly Brexit – if there is one at all. As things stand at the time of writing, we expect British elections of which the outcome may well be very close. The trade dispute between the US and China will not be resolved anytime soon and in the end everybody loses. PMIs (purchasing managers indices) in Europe show signs of weakening and central banks will do whatever it takes to prevent a recession. Our current base case scenario does not include a recession. That said, the combination of economic weakness and political upheaval does warrant an underweight stance towards equities.

Postponed escalations

Bond markets had no clear direction this week, stuck between recession fears and political developments, including the shift of power in the British Parliament and the conciliatory news from Hong Kong, where the risk of escalation has decreased. German Bund yields faced a moderate upward pressure, but remained close to the historical low levels under 60 basis points. In the US, the yield curve, i.e. the difference between two-year and ten-year yields, which when negative is regarded as a recession indicator, turned positive again.

In Italy, now that the new government between the Five-star-movement and the social democrats has been successfully implemented, Italian government bonds showed an impressive rally. Risk spreads for ten-year bonds dropped to 1.5%, which is again in pre-election territory, representing a yield below 1%. At least for now, an escalation in the form of new elections while Matteo Salvini’s Lega party is leading the polls appears to be postponed.

European corporate bonds showed some weaknesses, now that the summer is over and significant new supply is entering the primary market. It appears that the positive signals from the European Central Bank regarding a new corporate purchasing programme are becoming more essential. Emerging markets had a rough time last month, caused by political fears in Argentina and the unpredictable development of the trade dispute. Emerging-markets bonds saw some relief in the first week of September. US high-yield issuers were also able to defend their spread levels, profiting from the tiny ‘risk-on’ movement in the market.