Global Weekly: Digesting Trump's latest announcements

News item -

Over the past weeks, equity markets had difficulties to take direction. Investors were weighing the potential impact of the US trade tariffs and the departure of the US Minister of State, Rex Tillerson. The resignation of Gary Cohn as Chief of the National Economic Council earlier in the week, also made investors somewhat uncomfortable. US stock markets, however, outperformed European market in the last weeks.

The earnings season has gradually come to an end. On balance, the fourth quarter earnings season will go into history as one of the strongest on record - up to 70% of the earnings reports in developed markets came in ahead of expectations. The solid fourth quarter earnings season combined with robust macroeconomic momentum has resulted in an upward acceleration in earnings revisions by investment analysts. The momentum in US earnings revisions has been even more pronounced, due to the announced US tax reforms. This might as well have been one of the reasons why the US equity markets have outperformed Europe in recent weeks.

Another important driver for the recent performance difference between the US and Europe is the larger weight of IT in the US equity market. When looking year-to-date, the IT sector has again been by far the strongest performing sectors, with an absolute return of around 10% in US dollar terms and the Nasdaq moving back to an all-time high. This is in sharp contrast to energy, the weakest performing sector year-to-date, with a negative return of almost 7% in US dollar.

Another striking feature of the market dynamics of 2018 so far is that traditionally defensive sectors such as consumer staples, telecoms and utilities have underperformed, despite rather lacklustre market conditions. One could draw the conclusion that the consensus amongst investors is still to be risk-on positioned.

Signs of Goldilocks?

Fears that dominated markets in February, when investors suddenly woke up to the perspective of rising inflation and even more growth, are waning. Macro numbers from the US, Europe have been lukewarm, tempering expectations, whereas developments in emerging markets indicate a continuation of the uplift (numbers early in the year were somewhat distorted by the timing of the Chinese Lunar New Year. As a consequence, markets appear to be seeing signs of ‘Goldilocks’ again – a situation where economies are growing at their potential, with inflation remaining low.

Interest rates, as a consequence, have come down off late. Inflation expectations, derived from inflation linked bonds, declined as well. The steepening of the yield curve – long-term rates rising faster than short-term rates – witnessed during the start of the year has partly reversed, with the reversal being more prevalent in the eurozone than in the US.

The upward movement of risk premia on corporate bonds have ushered in an ‘end of the cycle’ debate. This to us seems a bit early, as we see no overwhelming signals indicating that the end of the cycle is imminent. This would require a rise in inflation and a mismatch in corporate investments. With economies at full capacity, companies need to invest in additional capacity to meet increasing demand. Due to competition, however, they will try to postpone these investments to avoid losses if demand does not grow any further. A mismatch in corporate investments will cause inflation to rise even further. Company profits will therefore start to come down. In order to keep equity investors happy, companies resort to bond-unfriendly measures, like debt-funded dividends or share buybacks. Disappointed corporate bond investors will part ways.

For such a scenario to become reality, we first need to see inflation creeping up again. In that case, we would have to say goodbye to ‘Goldilocks’.