Whatever it takes

More central banks joining the easing camp

In most superhero movies, we know that the villains will be defeated in the end and their evil plan foiled. The audience buy tickets to find out “how?” and “at what cost?”. 

There is no doubt that global growth momentum is slowing. The global Purchasing Managers’ Index eased to 49.3 in July. The 2Q U.S. GDP number was better than expected, but this shows the divergence in strong consumption and weak corporate spending. China’s economic growth also decelerated in 2Q, to 6.2%, as investment remained subdued. There are some tentative signs of improvement in June’s data, such as pick ups in fixed asset investment and retail sales. Yet, it is too early to call a turnaround. The latest salvo from U.S. President Donald Trump to impose a 10% tariff on another USD 300billion worth of Chinese exports on 1 September is likely to renew downward pressure on corporate sentiment and global growth momentum.

Given the threat from global growth, the Federal Reserve (Fed) delivered its first rate cut since the global financial crisis in its July Federal Open Market Committee meeting. It delivered a 25bps rate cut, as expected, and moved forward the end of asset reduction to August from October. However, Fed Chairman Jerome Powell’s comment that this is not the start of a rate cutting cycle disappointed the market. We believe the Fed’s reluctance to commit to more aggressive easing is justified by strong consumption, but could be tested by renewed trade tensions.

Meanwhile, the European Central Bank’s President Mario Draghi sees the euro area’s outlook as “getting worse and worse” and hinted that more stimulus could be on its way to achieve its inflation target. There are few conventional tools available to the Bank of Japan to ease monetary policy, but it remains determined to support the economy if the global environment jeopardizes Japan’s recovery.

Beyond the big three central banks, other central banks around the world are also engaging in monetary easing, especially in Asia and emerging markets (EM). In July, Australia, Indonesia, Russia, South Korea and Turkey were amongst the 11 central banks that opted to cut rates. A more dovish position by the Fed certainly helped. Despite a stronger U.S. dollar in July against major currencies, high yield EM currencies (Brazil, India, Indonesia, Turkey) gained against the U.S. dollar, permitting their central banks to loosen monetary policy. 

Paying for the privilege to lend

As a result of the latest round of monetary easing, bond yields, especially in Europe, are falling below zero again. This also spread to selected corporate debt in the region. 34% of developed market government bonds now have negative yields. Investors are paying the German or Japanese governments to give them a 10-year loan. While this may seem bizarre, this is the investment landscape that investors may have to accommodate in the medium term. This would imply that investors would have to continue to seek carry by either taking on higher credit risk with high yield corporate debt, or they can shift to EM fixed income, earning additional yield by taking on EM currency risks in local currency papers. Given the rich valuation in some fixed income assets, active management to manage risks becomes critical.

2Q earnings beat expectations, but the 2020 outlook seems too optimistic

We are now 70% of the way through the 2Q U.S. earnings report season, and overall earnings per share (EPS) growth still managed to grow by 2.0% (as of July 31). 76% of companies managed to beat EPS expectations. Health care has been a huge contributor to headline EPS growth, while financials, utilities and communication services also made modest contributions. However, revenue growth has been offset by profit margin contraction. This leaves share buybacks as the key driver to EPS growth. We believe that the current market expectation for low single digit EPS growth in 2019 is realistic. However, double digit earnings growth for 2020 seems too optimistic given the easing growth momentum and potential profit margin pressure facing U.S. companies. This could be a factor pushing back on U.S. equities to reach new highs in months to come.

Back to shopping in an expensive mall

Back in 2017, we noted that both equities and fixed income were richly valued. We compared this to shopping for a birthday present in a high-end shopping mall. There are still some good deals, but you need to know where to look. Many investors feel the same now, and they are struggling to decide on the next step.

In equities, value stocks have underperformed in recent years, but some of them do provide high dividends. In fixed income, investors have been cautious over EM fixed income given the strong U.S. dollar environment in recent years. Given the U.S. dollar’s rich valuation, structural deficits in its current account and fiscal position and President Trump’s dislike for a strong U.S. dollar, the greenback’s upside is likely to be limited. This would create an opportunity in EM fixed income. 

Global economy:

• The Fed delivered its first rate cut since the Global Financial Crisis as expected. The fed funds target rate has been cut by 25bps to 2.0%-2.25%, and the end of asset reduction has also been brought forward to August from October. Chairman Powell reiterated that this is not the start of a rate cutting cycle. Meanwhile, a number of EM central banks continue with their monetary easing to support growth. (GTMA P. 30, 31)
• China’s economic growth slowed to 6.2% yoy in 2Q on the back of weak investment, while consumption remains a pillar to growth. The story is similar in the U.S., with 2Q GDP expanded at 2.1% annualized. Strong personal and government spending offset weakness in inventory correction and corporate spending. Meanwhile, U.S.-China trade negotiations restarted in Shanghai, but with limited progress. (GTMA P. 8, 19, 20, 25)

Equities:

• July started strong for global equities but earnings and a lack of fresh positive news weighed on sentiment. The S&P 500 was up 0.5% in the month, while the Euro Stoxx 50 was down 0.9%. U.S. 2Q earnings was slightly ahead of expectations due to share buybacks, as revenue growth was offset by the squeeze in profit margins. Investors will soon focus on 2020 earnings growth. The current forecast of double digit growth could be too optimistic.(GTMA P. 33, 35)
• Softening global growth is weighing on market sentiment across Asia. The CSI 300 was down 3.5% in July, with the rest of Asia down in the range of 3%-4%. India has underperformed the region (Sensex was down 5.6% in the month) due to renewed pressure on the currency and also questions surrounding the next growth driver. (GTMA P. 39, 40)

Fixed income:

• The 10-year U.S. Treasury yield was stuck in a 1.95%-2.1% range in July as investors waited for the Fed’s decision. In contrast, government bond yields in some European markets and Japan pushed further into negative territory because of their central banks’ dovish stances. 34% of developed market government bonds now have a negative yield. (GTMA P. 44)
• Despite a stronger U.S. dollar and weaker economic data, both EM fixed income and U.S. corporate credit continued their positive return streak in July. U.S. investment grade and high yield corporate credit both saw a credit spread tightening of 7-8bps in the month. Hard currency sovereign and corporate debt also saw a 17bps spread tightening in July. This reflects the hunt for yield by both institutional and retail investors as cash return falls. (GTMA P. 52-55)

Other assets:

• The price of oil moved in a narrow range, with the NYMEX West Texas Intermediate Crude ranging between USD 56-61pb. Two opposite forces are at work. Geopolitical tensions between Iran and the west, in particular around the Strait of Hormuz, should have added a risk premium to oil prices. 17% of global oil output moves through this stretch of water. This was offset by the fear on weaker demand. In contrast, falling real yields are supporting gold prices, breaking above USD 1,400/oz. (GTMA P. 64, 65)
• More dovish positions by global central banks drove the U.S. dollar stronger in July. The USD index rose 2%, largely reflecting a weaker euro and British pound. A less dovish Fed is likely to boost the U.S. dollar in the near term, but currencies with high yields should remain well supported.   (GTMA P. 61, 62)

Market Bulletins - July: 

• Keeping a LID on portfolio volatility for Asian investors
• Yield curve inversion: Understanding the fire alarm
• 2Q19 Earnings bulletin: Threading the needle