Global Weekly: Markets waver between fear and hope

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The surprising move towards a ‘more traditional’ government in Italy was welcomed by a strong rally in Italian bonds, indicating how much investors would appreciate a broader normalisation of global politics. Apart from Italy, however, geopolitical tensions have only increased further.

Last weekend’s G7 could have been worse, but still did little to lift the uncertainty that is gradually choking off an increasing proportion of the global economy, especially in the manufacturing sector that is relatively highly exposed to global trade. The US-China trade conflict is continuing to turn into a trade war, Macron picked a fight with Brazil’s Bolsonaro and Boris Johnson moved closer to a hard Brexit with the announcement that the British parliament will be shut down until five sitting days before the Brexit deadline on 31 October.

Markets are ever more torn between fear of a recession and hope, the latter provided by central banks turning aggressively to policy easing. Lower US Treasury yields reflect the market’s anticipation of a series of rate cuts, to support the economy and financial markets. US Treasury 10-year yields have already moved below 1.5% and 10-year Bund yields have dropped below -0.7%. While most of any future rate cuts now seem to have been factored in, the risk of economic slowdown and recession they are supposed to cushion may be less clearly priced in. We therefore advise reducing the proportion of more risky bonds in the portfolio, such as emerging market bonds, and taking some profit on their excellent performance year to date, as these gains may be eroded by wider risk spreads in a deteriorating economic environment. We continue to advise caution on high-yield bonds, which are even more vulnerable.

We expect central banks to ease monetary policy even further than already anticipated, with the ECB buying a much greater number of bonds than many currently expect, pushing yields even lower. As lower yields mean higher prices, even bonds with negative yields could show positive returns for a while. Longer-dated bonds are more sensitive to lower yields (duration) and thus more attractive, especially if risky assets disappoint. We therefore advise buying more bonds with long maturities (increased duration) but little or no credit risk, as recession risks in Europe are rising. Government-related bonds, with banking group KfW and the European Investment Bank being the main issuers, still have attractive spreads of up to 0.5%, but covered bonds and government bonds of Spain, France or Ireland are also worth considering. Inflation-linked bonds are still very cheap historically, but have become less attractive as inflation risks continue to fade into the distant future.

Equities – Geopolitical tensions again take centre stage

Over the weekend, the Jackson Hole press takeaways focused on the limits of central bank policy. Fed Chair Jerome Powell commented that monetary policy cannot provide a settled rule book for international trade, a sentiment echoed by other central bankers, including the Bank of England’s Mark Carney in his remarks about managing Brexit uncertainty. In essence, the overriding conclusion was that central banks cannot solve all the world’s economic problems and that more fiscal stimulation is potentially needed to restore growth.

Meanwhile the US-China trade war escalated yet again, as Trump last Friday announced to hike tariffs on approximately USD 550 billion of Chinese imports by 5% (up from 25% or 10%). As China indicated it would retaliate, the US move on tariffs caused markets to nosedive just before the weekend. Additional uncertainty was fuelled by Trump expressing his intention to block US companies from having supply chain connections into China. On Monday morning, however, with fresh signals from the US that China was willing to talk and Trump striking a more emollient tone, equity markets recouped some of their earlier losses and they edged gently up further throughout the week.

In other developments, France hosted a G7 meeting at which President Macron tried to bring the US and Iran closer together and funds were committed to help Brazil stem the spate of fires in the Amazon. These funds were promptly rejected by President Bolsonaro, who demanded an apology from Macron for what he saw as state interference. Meanwhile in Germany, confidence indicators hit post-crisis lows, Italy continued to struggle to find a way out of its government crisis, and Boris Johnson attempted to renegotiate the Brexit deal and arranged to shut down parliament until 14 October. On top of all this, the yield curve inverted somewhat further, signalling another reason for a degree of investor caution.

On balance, then, and with limited significant company-specific news – except for the announced intention of Philip Morris and Altria to merge into the world’s largest tobacco company – equity markets were largely driven by geopolitical events, without taking any decisive direction.