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When good economic news may no longer be good financial news

Pascal Blackburne & Luc Synaeghel 2018-05-01

An important milestone was reached on April 24, when the US Treasury 10-year yield topped 3%, threatening to undermine the form of “equilibrium” that equity markets had settled into during the past few months.

In effect, equity markets have gone nowhere year-to-date – with much volatility. Valuations and expectations were so elevated entering 2018 that a strong economic and earnings environment was required just to deliver flat index performance. Within indices, dispersion in performance has increased. Companies that reported disappointing first quarter results were severely punished. Even companies matching expectations tended to see their stock price drop slightly. Expectations really had to be surpassed by a wide margin in order to generate strong returns.

Are interest rates likely to continue to trend up, beyond the psychological 3% threshold? Monetary policy normalization would certainly argue so. Before the era of zero interest rates and massive quantitative easing, long-term government yields used to be aligned with economic growth: 5% nominal GDP growth implied 5% rates – a far cry from the current level.

Inflation prospects also suggest that rates will move higher. Headline inflation is admittedly more muted than traditional Phillips curve theory would suggest, perhaps due to measurement issues, but we are now starting to see workers attempt to secure a larger share of the pie in some highly industrialized and very labour-tight regions of Europe. Whatever the reason, in this cycle, unemployment has needed to quasi-disappear for labour protest movements to take hold. Adding to inflationary pressures are, of course, commodity prices.

Rising interest rates will be a headwind for equity markets, both because of the discounting mechanism (a higher discount rate implies a lower present value of future earnings) and because of the impact on the cost of credit. As such, rather than holding broad index positions, likely to continue – at best – to go nowhere, we feel that investment should focus on sectors/segments with promising perspectives and still reasonable valuations. In our view, these include shale oil, gold mines, dry bulk shippers and European small- and mid-cap companies.

The forthcoming market environment should also be more auspicious for stock picking. In order to limit company-specific risk, however, we strongly suggest adopting a basket approach. As we wrote last month, developments over the past decade have contrived to make earnings predictions much more difficult. The risk that any one company misses expectations is thus always marked – rather be invested in a basket of companies active in a similar space.

As for the bond segment of portfolios, a short duration definitely remains warranted, as interest rates revert to more normal levels.

Why the flattening of the US yield curve does not herald of recession

Yield Curve US

Source : Bloomberg

Hitting the 3% mark on the US 10-year yield may have made the headlines, but it should not mask the fact that short-term rates are also rising, at a faster pace even. As a result, the US yield curve – particularly the 2-year to 10-year segment – has flattened substantially over the past year.

Given the yield curve’s historical ability to predict turning points in the economic cycle (all nine US recessions since 1955 were preceded by an inversion of the yield curve), its flattening is raising concern among investors.

We do not share these worries for now. Not only should the massive fiscal stimulus underway in the US prevent an economic downturn in the near- to medium-term, but we also view the flattening of the US yield curve as somewhat artificial. Ongoing monetary easing by the European and Japanese central banks is having spillover effects in the US Treasury market, with the liquidity that continues to flood the financial system pushing up demand for long-dated US paper.

The crucial test will come when the ECB ends its quantitative easing. It has committed to continuing asset purchases – at the current pace of EUR 30 billion per month – through the end of September. Speculation is that the purchase program will then rapidly be tapered down to zero, possibly already by the end of this year.

At that point, long-term US yields will no longer be capped by artificial demand, and odds are that the US yield curve will revert to a more normal (i.e. steeper) shape.

Rising US-Europe rate spread

spread US GEr

Source : Bloomberg

Core European bonds did not follow the same path as their US peers during the month of April. As a result, the spread between US and German 10-year sovereign rates now stands at a historically high 2.4%, prompting some greenback appreciation.

Here again, the ending of ECB asset purchases should prove a game-changer. Heading into 2019, we expect the spread between US and German rates to begin to wane, alongside an upward shift of the entire European yield curve.

A lessening US-Germany spread in turn suggests that US dollar exposure in portfolios be gradually reduced. Notwithstanding President Trump’s protectionist ambitions, the fact remains that the US currently runs a deficit with virtually all of its trade partners – not just China. This lack of competitiveness argues for depreciation in the long-run, even of the world reserve currency.

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