Esty Dwek

Macroeconomic overview

• Recent macro data has been somewhat mixed – stronger than expected in the US, weaker in the Eurozone and disappointing in Japan. But, although disruptions from the coronavirus outbreak are likely to impact incoming data, particularly in Asia, we believe that the global backdrop remains supportive. US consumer sentiment has improved, the labour market added 225k new jobs in January and the ISM manufacturing PMI for January jumped back into expansionary territory. Japan’s GDP shrank an annualised 6.3% following the VAT hike, and could see a technical recession as the impact of the outbreak poses an added risk to the economy. Growth in the Eurozone remains sluggish as the Area grew 0.1% in the fourth quarter – the slowest pace since the crisis seven years ago. Germany’s economic sentiment dropped sharply due to expected consequences of the outbreak on exporters. Factory orders and manufacturing production were also weaker in both Germany and France, which might only be exacerbated by the outbreak and slower Chinese growth.
  
• The recent coronavirus outbreak is likely to have a significant impact on Q1 Chinese data. In an effort to cushion the blow, China has halved tariffs on USD75 billion of US goods, the People’s Bank of China cut by 10bps its reverse repos rates as well as its medium-term lending facility rate and injected liquidity – and more stimulus is expected.
• The US dollar is up more than 2.5% in the first six weeks of 2020, benefiting from safe haven demand, better growth and high demand for US Treasuries. We believe that recent strength is likely to continue as concerns surrounding the outbreak’s effects persist.
• German domestic politics got messier as Merkel’s chose successor, Annegret Kramp-Karrenbauer, announced she was stepping down from the CDU flowing a regional alliance with far-right anti-immigration AfD party. While early elections are not expected, questions are likely to continue to surround Merkel’s succession plan in the coming months. This could also limit the potential for fiscal support, though slightly more expansionary policies are expected.
• The beginning of negotiations between the UK and the EU are off to a rocky start as the UK is showing signs of wanting a ‘harder’ Brexit than hoped by the Europeans. We expect tensions to remain over the coming months, but believe the worst case no deal will be averted. The change in the Chancellor in the UK suggests fiscal stimulus will be announced at the 11 March budget to help support a fragile UK economy.

Market outlook

• Equity markets have continued to advance despite the coronavirus outbreak, helped by stronger than expected earnings and abundant liquidity. Major central banks stand ready to ease policy further, but we do not expect further rate cuts in 2020. Given this backdrop, we expect equities to continue to advance in 2020, though rich valuations could eventually cap returns.
• EM equities have bounced back from their selloff at the beginning of the year, boosted by the Chinese market recovery and they are on track to consolidate their 2019 advance. However, a stronger dollar remains a headwind and idiosyncratic stories suggest selectivity remains key.
• With over 75% of the Q4 earnings season completed, profit growth has so far beaten expectations. Earnings have increased 1.2% YoY, prompting analysts to expect robust profit growth from US companies in 2020, despite the potential impact of the coronavirus. We believe that earnings growth can show upside surprises in the coming quarters, helping markets higher.
• Sovereign yields remain at very low levels, as concerns about the outbreak’s impact on global growth and inflation expectations linger. Indeed, recent flows into bond funds were very large, suggesting investors do not expect price pressures to pick up. US 10-year yields are around 1.55%, Bunds are at -0.4%, and Italian and Greek 10-year yields are both below 1%. We believe yields will take time before drifting higher given still weak growth and low inflation, as well as accommodative central banks. While we believe yields should be somewhat higher in 2020, we maintain some exposure to core segments as protection. We maintain our preference for credit, both in the US and Europe, over sovereign debt, as sovereigns remain overvalued.
• Credit spreads in the investment grade space have continued to tighten, and, after widening at the beginning of the month, HY spreads have followed. We expect spreads to remain broadly range bound for now, and even absorb some higher yields, and still see little systemic risk. We continue to see opportunities in HY, though the further along we move in the cycle, the more likely we are to see demand for IG rise. We continue to see attractive opportunities in EM hard currency debt, where spreads have continued to tighten as well.
• Without a clear view yet on the effects of the coronavirus outbreak, we expect a challenging road ahead with higher short-term volatility, though we continue to expect risk assets to grind higher over time. We nonetheless continue to add absolute return, flexible strategies such as liquid alternatives for diversification.

By Esty Dwek, Head of Global Market Strategy

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Etsy Dwek

Macroeconomic overview

• Recent data points towards a moderate rebound in activity. Consumption has remained strong, the labour market is holding up at historical low unemployment levels, the housing market is starting to tick up and the manufacturing sector should benefit from the US/China trade truce. Europe has been surprising on the upside; Germany has continued to show signs of improvement, with manufacturing picking up, though PMIs remain weak. Chinese data is also pointing towards stabilisation, with improvements in money supply and credit growth. The trade truce, together with the recent PBoC’s monetary easing should help support growth above 6%.
• US/Iran tensions heightened after Iran launched more than a dozen ballistic missiles at US forces in Iraq in retaliation for the killing of military commander Qassem Soleimani. Although both countries have backed down since, we may see the risk premium remain elevated. For now, oil prices have responded calmly, as have equity markets, while gold has soared. At the same time, the Democratic-controlled House of Representative has passed a resolution to limit President Trump’s ability to take military action in Iran without Congressional approval.
• The US and China’s ‘Phase one’ trade deal will be signed tomorrow. Both sides have strong incentives to avoid renewed escalation, especially President Trump in a re-election year. Thus, we are much less likely to see reversals moving forward, which should help confidence, but we believe an all-encompassing deal is likely to prove illusive.
• Following the Tories’ win, Brexit should be done by the end of the month so we will move on to the transition period. However, we believe a trade deal by the end of 2020, as PM Boris Johnson has stated, will be difficult. In the meantime, the UK continues to show signs of fragility, and the BoE might need to act, as early as at the end of the month.
• After months of discussions, Spain finally has a government as Prime Minister Pedro Sanchez managed to form a coalition with the unit-austerity United We Can party. The road is unlikely to be smooth however, as in Italy, where the coalition is holding but friction is building. For now, we believe that both coalitions will hold.
• The US dollar benefited from the recent Middle East flare up, but has since stabilised. We believe that some weakness could materialise with improved risk sentiment, but expect broad range-trading for major currencies.

Market outlook

• Equity markets continue to advance on the trade truce and better economic perspectives. Accommodative central banks continue to be an added support, as is recent economic data, which keeps suggesting the global economy may have turned a corner. We expect equities to continue to advance in 2020, though rich valuations could cap returns.
• European assets should benefit in the current environment, and we maintain our overweight allocation for now. Over the medium term, we expect better growth and earnings in the US to support that market. EM equities sold off at the beginning of the year due to the risk off sentiment because of rising geopolitical tensions and a stronger dollar. We believe that selectivity remains key given idiosyncratic stories.
• The Q4 earnings season kicks off, with expectations for a decline in earnings to finish the year, though investors are more focused on 2020 expectations, which should see a bounce from the Q4 2019 low. We believe that earnings growth should show upside surprises in the coming quarter, which should help markets to move higher.
• Sovereign yields fell on Middle East fears, but they soon reversed as Iran’s foreign minister stated the country did not seek an escalation in its dispute with the US. US 10-year yields are around 1.85%, while 10-year bonds are at -0.22%. We believe they can drift a bit higher still in the short- term, but we do not expect a sharp back up given still weak growth and low inflation, as well as accommodative central banks. While we believe yields should be somewhat higher in 2020, we maintain some exposure to core segments as protection.
• Credit spreads in the investment grade space have continue to tighten, and HY has continued to follow, so that the widening we saw in December in the lower credit ratings in the US has reversed. We expect spreads to remain broadly range bound for now, and even absorb some higher yields, and still see little systemic risk. We continue to prefer credit, both in the US and Europe, over sovereign bonds and we prefer investment grade over high yield as we approach the later stages of the cycle, though we still see HY opportunities for now. We continue to see attractive opportunities in EM hard currency debt, where spreads have continued to tighten as well.
• With ongoing uncertainty and market sensitivity to headlines, we expect a challenging road ahead, and we continue to add absolute return, flexible strategies such as liquid alternatives for diversification. We expect risk assets to grind higher and we maintain our exposure for now, but higher volatility and short-term corrections should be expected.

By Etsy Dwek, Head of Global Market Strategy.

The post A moderate rebound in market activity but a challenging road ahead appeared first on AdviserVoice.

Esty Dwek

What happened?

The Federal Reserve, as expected, cut its benchmark interest rate by 25 basis points for the second time this year, lowering the federal funds rate to a range of 1.75% – 2% as a response to the ‘implications of global developments for the economic outlook as well as muted inflation pressures’.

Mr. Powell stated that the committee will continue monitoring both macroeconomic data and potential risks and that they will act as appropriate to sustain the expansion. However, the tone was interpreted as hawkish as he mentioned only “moderate” support should be enough to support still-solid US growth. Moreover, the latest ‘dot plot’ showed no more cuts for 2019. Indeed, markets were disappointed by the lack of future measures, and President Trump criticized the Fed’s announcement within minutes.

There were three dissents on the Committee, two favouring no cuts, and one favouring 50 basis points. In addition, the new ‘dot plot’ showed increasing uncertainty in FOMC’s next moves, with wide dispersions among expectations.

The Fed will continue to roll over all principal payments from its holdings of Treasuries and reinvest all principal payments from the Fed’s holdings on agency debt and agency MBS, as announced over the summer.

Following some pressure on the repo market, the Committee also lowered the interest rate paid on required and excess reserve balances to 1.8%, setting the rate 20 basis points below the top of the new target range for the fed funds rate.

Since the announcement was in line with expectations, but offered less easing for the future, equity markets were muted, the US dollar strengthened (but has retreated since) and 10-year- US treasury yields drifted higher to 1.8%.

What’s next?

The announcement was in line with our expectations, and we believe a third cut before year end is still likely, even if core CPI and average hourly earnings have picked up. Indeed, overseas softness and ongoing uncertainty surrounding trade are likely to keep some pressure on the Fed, as seen with weaker manufacturing and investment data. Additional headwinds from rising geopolitical tensions in the Middle East, weakness in Europe and a stronger dollar persist.

Markets may need to adjust some of their expectations to a less aggressive easing scenario, and yields can continue to drift higher, but given ongoing easing elsewhere around the world, we do not expect a sharp back up in yields.

We believe that the Fed will continue to watch trade developments, core inflation gauges as well as external growth factors in the coming months.

Investment implications

Yields are likely to remain in a broad range, though they may continue to drift somewhat higher as markets re-price rate cut expectations. However, growth concerns, trade uncertainty, central bank easing and low inflation pressures suggest a sharp correction is unlikely.

We maintain some exposure to core debt for protection, but continue to favour credit allocations.

Risk assets should remain supported by accommodative policies, and should continue to grind higher in the coming months, though valuations and low earnings growth are likely to cap returns. Nonetheless, we still believe that while it may be too late to add much risk to portfolios, it is too early to take it all off.

By Esty Dwek, Head of Global Market Strategy, Dynamic Solutions

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