Global Weekly: Equities - Market review

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In this article, we address three topics: fallout from the G20 meeting, Christine Lagarde being nominated to be the next President of the European Central Bank (ECB) and market fragility.

The G20 summit in Osaka caused a small relief rally in stock markets. Just before the US Fourth of July holiday, the S&P 500 Index ended up 1.8% higher than last Friday’s close. The Euro Stoxx 50 rose by 1.9%. The much anticipated meeting between the US President with Chinese leader Xi Jinping resulted in trade negotiations being resumed and the threat of a full-blown trade war having been averted – at least for now.

The trade dispute is part of a much larger secular trend, where China is becoming an increasingly dominant world player. Just as the British Empire and Europe dominated the 19th century and the US dominated the 20th century, we may have to acknowledge that the 21st century will be dominated by China. Supporting this view are China’s new Silk Road plans, activities in Africa, actions as a parallel monetary fund (a sort of International Monetary Fund) for South Asian countries and its major purchases of US Treasuries. We believe that the trade dispute is a symptom of this trend -- a push-back in the clash of empires, which may dominate markets for longer than might be wished.

The second topic is Christine Lagarde’s likely new Job. Currently, the ECB is failing to reach its inflation target. Central banks have been pumping money into the financial system like there is no tomorrow and are willing to continue to do so. In Europe, the total amount of monetary stimulus provided by the ECB has skyrocketed to a staggering EUR 2,600 billion, which is the equivalent of EUR 7,500 per person in the eurozone. So, by now, it should be apparent that increasing the money supply is not leading to inflation. This is because there are two major deflationary factors in play: very high debt levels and demographics in the form of a decline in population. An aging population and declining birth rates cannot be fought with monetary stimulus. Very high debt levels lead to spending restrictions. So this policy is not working. One of the first things Christine Lagarde may want to do as the president of the ECB is to reconsider the inflation target.

So, where did all that money go? Assets and cash

We currently see that most assets are at high levels, which has been partly helped by the trade dispute pause. The S&P 500 Index is at an all-time high; the Euro Stoxx 600 Index is nearing its all-time high (392 vs 415) and gold has risen above USD 1,400. Moreover, non-US fixed income markets are at extreme levels, as global accommodative central bank policies result in rock-bottom interest rates.

Art markets, including a record USD 110 million for a Monet painting in May, and housing prices in popular areas also seem to be beyond realistic levels. So, in part, the money is flowing to assets which may be overvalued. This is recognized by people and institutions holding the vast amount of uninvested cash waiting for an entry point. In our view, there is not a lot of substance that backs these high valuations, apart from the view that the Federal Reserve may be considering interest rate cuts. There are also many headwinds, not the least of which is Chinese deleveraging. Our conclusion is that all of this leads to fragile market circumstances, where not much would be needed to ignite a correction.

Bonds – uncertainty continues

Last weekend’s G20 meeting did little to lift the uncertainty that is gradually choking an increasing part of the global economy, especially in the manufacturing sector, which is relatively more exposed to global trade. While the trade conflict was neither resolved nor escalated, markets reaction was mildly positive. Investment-grade spreads moved sideways, while risk premiums in high-yield bonds and emerging-markets debt tightened a bit, in line with equity market sentiment.

Investors will have to continue weighing the benefits of strong support from central banks versus the impact of the risks these central banks are trying to fight. The gradual escalation of global trade tensions since 2018 is increasingly depressing business sentiment, which has already led corporates to postpone capital investments and is now threatening to make consumers more reluctant to spend given that weakness could spread to labour markets.

Central banks are well aware of these risks and ready to act. European Central Bank (ECB) President Mario Draghi lowered the bar for ECB action, saying that only a clear improvement of economic conditions could still stop a reduction in rates and a restart of bond buying. Christine Lagarde, probably the new ECB president starting in October, is not expected to change this dovish course.

In anticipation of rate cuts, US 10-yearTreasury yields have already moved below 2% and 10-year Bund yields fell towards -0.4%, the current level of official central bank rates. Yields are expected to grind even lower, although investors have now priced-in much of what can be expected from central banks. Still, long duration positions seem pretty secure for the rest of this year, as central banks are expected to keep to their dovish course with rates staying lower for longer.

The return of the ECB to the bond market as a massive buyer is still expected to make an impact. Corporate bond spreads should tighten, certainly as long as an outright recession can be avoided. Peripheral spreads should also be supported, allowing Italy to consolidate the gains made this week. The threat of new actions by the European Commission on the Italian budget was easily avoided by pointing to better-than-expected tax returns so far this year, despite a struggling Italian economy. However, after this summer, the 2020 budget is due, with could still trigger action from Brussels.

Plans to introduce mini-BOT’s — government IOUs that could be considered a parallel currency next to the euro — have also resurfaced and deserve a strong response from the rest of the EU, including the ECB. Italian spreads are still relatively high for a reason, while Spanish spreads have now hooked up with the semi-core of Europe, lining up right after France, Belgium and Ireland.

Inflation-linked bonds continue to struggle and remained quite volatile and vulnerable in a period where markets are anticipating ‘Japanification,’ that is a prolonged period where low-growth expansion is accompanied by low levels of inflation. Inflation-linked bonds have become very cheap compared to nominal bonds, pricing at less than 0.7% inflation over the next 10 years. This is while inflation has been around 1% over the last five years and central banks are determined to push it higher. Over the next few quarters, however, slowing growth may challenge these efforts and make it difficult to convince investors, which will keep inflation expectations low for longer.