Investment Outlook 06.2016
Thomas TrauthEconomist, Dr. rer. pol., CFA, FRM
Brexit and FED rate-hike expectations weigh on markets
In May developed equity markets consolidated after the recovery in March and April. The US S&P index continued to outperform European equity markets, which in our view at least partly reflects the Brexit risk premium. We continue to believe that UK voters will finally not be ready to take the major risks associated with a Brexit. We also think that bookmakers’ odds, which clearly indicate a win for Remain, show a more unbiased picture than the opinion polls, which suggest a 50-50 chance.
If the Brits were to decide to leave the EU, we would expect a sell-off of the GBP, British and more broadly European stock markets. A no-vote, in contrast would lead to a recovery of the GBP and European stocks, which could probably even make up for the underperformance vis-à-vis the US since the beginning of the year.
European government bonds rallied in May, on the back of the ECB’s bond-buying program, while US Treasuries at the short end of the yield curve sold off – though then recovered in early June – and longer dated treasuries remained almost unchanged. Break-even inflation represented an increase from very depressed levels, which reflects fading deflation concerns.
The risky part of fixed income has performed very well since mid-February, with a significant spread tightening. However, emerging markets in local currency experienced a sharp correction in recent weeks.
Commodities continued to rally. Oil prices reached 50 USD/bl. In recent months market participants associated rising oil prices with macro normalization, regarding them as a pro-growth indicator, which lifted equity prices. Usually the correlation between equities and oil tends to be negative as higher oil prices are seen as a growth brake.
Gold sold off in May and lost 6% of its value. However, it strongly rebounded in June, probably on the back of heightened macro uncertainties.
Despite Brexit fears the EUR managed to appreciate against the USD by 3.6% year to date. This can be explained by the low valuation of the EUR after the strong depreciation in 2014, disappointing US growth indicators, and a dovish US Fed. Recently, whenever US rate-hike expectations rose, the USD appreciated, and when expectations declined, it fell.
On 3 June the ECB unsurprisingly did not change its policy stance. It announced, however, that it would start its corporate bond-buying program on 8 June. The market impact was moderate, especially because credit spreads had already tightened significantly. Furthermore, the ECB said it would start its targeted refinancing program on 22 June, the so-called TLTRO II. As the conditions are very attractive, it will be interesting to observe to what extent banks participate.
On 6 June Fed Chairwoman Janet Yellen, in a speech that gained close attention, pointed out that she would be very mindful of the weak labor market report, watching a potential growth slowdown very carefully. It has become very unlikely that the Fed is going to hike rates at its next meeting on 15 June. The Fed could, however, still raise rates on 27 July, but this would clearly require a strong June non-farm payroll figure. The market-implied probability of a July hike is currently only 17%.
The big macro event in May was the very disappointing US non-farm payroll figure. The US economy created only 38,000 jobs, clearly below expectations. Since this figure tends to be very volatile and is subject to major revisions, we need to wait for the upcoming data points. The US unemployment rate fell to 4.7% from 5%. This drop was primarily due to a decline in the labor-force participation rate, which fell to a 2016 low of 62.6 percent. Meanwhile the University of Michigan consumer sentiment index recovered strongly in recent months, although preliminary estimates for June show some slight softening.
The European manufacturing PMI has been moving sideways for a number of months, remaining in a near stagnation area. The May figure was 51.5 after 51.7.
The Nikkei Japan manufacturing PMI fell to a 40-month low of 47.7 after 48.2. Especially worrying was the rapid drop in the output and new orders sub-indices.
The Chinese manufacturing PMI was also weaker at 49.2 after 49.4, and thus remained at contraction levels (below 50). It is expected that the Chinese authorities will apply further fiscal and monetary expansion measures.
As far as inflation is concerned, US inflation trended upwards in recent months, certainly due in part to rising wage costs. On the one hand this reduces deflation fears, but on the other it may make the Fed more concerned about inflation risks, despite mixed growth indicators. Meanwhile inflation trended lower and into negative territory in the Eurozone as well as in Japan. Swiss consumer prices clearly fell less than in previous months. The consumer price index fell by 0.4% YoY in May, while it had fallen by 1.3% in January. This may reflect the weakening of the currency and rising energy prices.
As growth remains subdued, growth indicators are close to stagnation, and at times they can fall into negative territory due to normal fluctuations. While markets may react negatively to such events, it is important to keep an eye on the underlying trends. It is also worth noting that when the US economy approaches full employment, it is very normal for job growth to decline. It will be important to keep an eye on upcoming US hiring intentions for small businesses and the US manpower reports. If those reports should confirm weak US labor-market conditions, we would not exclude more pronounced market reactions.
As discussed previously, anemic growth coupled with high valuations does not bode well for large equity-market returns. On the other hand, positive growth and negative bond yields will continue to pressure investors into equity and riskier credit markets. We continue to be positioned for that. We are neutral in our equity market position and slightly overweight in high-yield bonds.
In our base case, British voters will vote against the Brexit. In that case, we expect the GBP to recover and European equity markets to make up for their significant underperformance in 2016. We therefore remain overweight on European equities.
When it comes to commodities we do not see much upside for oil prices above 50 USD/bl. In recent weeks we have observed some supply disruptions and easing inventory figures. Oil prices above 50 will, however, lead to the buildup of additional supply, most notably in the US but also in Saudi Arabia, and push oil prices lower again.
Big uncertainties are keeping up the demand for safe-haven or portfolio insurance assets, like high-quality government bonds and gold, while the pricing for such assets has become punitively high in our view. Therefore, and since we still believe in a non-catastrophic outcome, we are staying away from the mentioned assets and would rather recommend selling gold and government bonds into strength.