Global Weekly: Divergence between emerging and developed markets

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Up until the middle of the week, most developed equity markets have been grinding higher with the S&P 500 Index reaching new highs and the Euro Stoxx 600 approaching its old highs from October 2018.

Markets took a breather after the Federal Reserve policy meeting on Wednesday, as the Fed sounded seemingly less dovish than in the recent past. Meanwhile, emerging markets have lately been lagging developed markets a little bit. Year-to-date, absolute returns in emerging markets are at double-digit levels and as such encouraging. Developed markets, however, have been outperforming. When looking deeper into the composition of emerging markets, it is striking to see that China is the clear outperformer – doing even better than the US. Main detractors within the emerging markets’ block are countries like India, Brazil and Mexico. This underlines the fact that although China is a large component of the emerging market segment, it is not a given that if China outperforms other emerging markets do the same.

The first-quarter earnings season continued on a relatively positive note. Both in the US and Europe, the majority of companies surprise on the upside, with regard to both revenues and earnings. This week, US bellwethers like Apple, McDonald’s and Mastercard have updated markets on their quarterly results. All were at the high-end of expectations and provided positive guidance for the remainder of the year. Especially for Apple, this was a comforting sign as iPhone sales have been slowing in recent quarters, particularly in China.

Alphabet, the mother company of Google, was an exception to the rule: although Alphabet’s earnings came in clearly ahead of expectations, revenues lagged behind consensus. The revenue miss was largely related to foreign currency headwinds. Note that 19% net revenue growth is still a very strong number. When analysts expect revenues to grow by more than 20%, a reality check is not necessarily a bad thing. On balance, long-term analyst views continue to be very positive on Google being one of the leaders in the internet advertisement space.

Bonds: tranquillity to continue?

It has been a very strong start of the year for fixed income markets. In a near-zero rate environment, eurozone government bonds and investment-grade corporate bonds have returned between 1.5% and 3.5%. If we go a little higher up the risk ladder, we see a 5% return for emerging market debt and 7% for global high yield. These returns are in stark contrast to what we saw in the last quarter of 2018, when financial markets were starting to price in an recession. This fear was eventually countered by global central banks taking a more dovish stance. The Fed paused its hiking cycle and the ECB pushed back its rate hike plans even further.

This caused a two-sided reaction from the market: risk premiums came down, pushing up prices of riskier debt – a response in line with a growth scenario. At the same time, interest rates came down as well, reflecting a scenario of lower growth and lower inflation. Although declining interest rates are good news for bond holders (as bond prices move inversely to yields), the question is how long this situation can be sustained. Markets are now pricing in lower growth and lower inflation, but no recession in the near future. However, if growth turns out even a little lower than currently expected, it would be approaching near-recession levels. The room for error has become smaller.

We believe the current state of relative tranquillity can continue for quite a while, allowing for a more risk-on approach towards bond investing. We remain watchful of developments that could trigger higher volatility, including renewed fears of China becoming unstable, rising populism in the eurozone with upcoming European elections in mind, US President Trump intensifying his trade dispute with Europe, disappointing earning numbers and a further deterioration in eurozone growth.