Summer time and the thinking is not easy

Summer time and the thinking is not easy

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A welcome relief from the usual sardine-packed commute can only mean one thing: summer holidays have arrived. I bid adieu to my two Americans this morning as they flew back to New York to see family and friends. Meanwhile, for markets there’s plenty of fodder for deeper contemplation until August vacations end.

Asset prices have risen handsomely so far this year, leaving many portfolios looking a lot healthier from their late-2018 score. That said, the FTSE All-World index is only up 1.9 per cent over the past 12 months. Lower bond yields and expectations for a lot more central bank easing only goes so far, and at the back of investors’ minds is the nagging feeling that there’s not much more upside left. A look at bond yields and currencies shows they’re stuck in narrow ranges. 

But what really sticks out in this environment is how flows are tilting in favour of corporate credit and also higher yielding currencies, a strategy known as the “carry trade”. Borrowing for next to nothing in one currency and ploughing the proceeds into assets that pay a lot more on paper is great when central banks are keeping a lid on volatility. 

And this backdrop is likely to continue. Both the European Central Bank and the Federal Reserve hold policy meetings this month, where their message should be so soothing as to keep carry and credit-risk trades humming along. The Bloomberg Carry Trade index for eight emerging market currencies has bounced nearly 5 per cent from its low in May, leaving this measure sitting at a 14-month high. Low market volatility leaves the index with a lot more room to rally, although its January 2017 peak still requires a further 7 per cent rise.

But don’t rule that out. In a world where interest rates are perceived to being stuck in a “lower for longer” trend, credit risk and carry trades stand out as attractive strategies. These work unless there is a shock such as a recession, which remains a low probability at the moment.

Katie Nixon at Northern Trust says “dovish central banks around the world” represent “a constructive backdrop for risk assets”.

She adds:

“Central bank liquidity will find its way into the market” and will support “the global search for yield” which “favours strategies like Global Listed Infrastructure, Global Real Estate, and US High Yield bonds. A key to this foundation is that we avoid a global recession.”

Of some note on Monday was how “positive talk” between the US and China did not spark much of a market reaction. Clearly, markets have endured plenty of examples of false dawns over trade, but beyond “trade war fatigue” there is another factor for the inaction — namely, the China-US impasse has already hurt the global economy.

Monday’s news from South Korea, a canary for global trade, was hardly reassuring. The country reported trade data for the first 20 days of July that showed a year-over-year contraction in exports of 13.6 per cent, while imports slid to minus 10.3 per cent year-on-year. This comes after the Bank of Korea cut rates last week for the first time in three years. 

There is little doubt that the global economy is slowing, but for deep thinkers the key is whether this represents a temporary soft patch or a harbinger of a something worse. Citi’s Economic Surprise index for the global economy shows this measure stuck in negative territory, a situation that has existed since April 2018.

Similar gauges for the US, UK and China along with EMs place them near their weakest or most negative levels in the past five years. On Monday there was another lacklustre US data point as the Chicago Fed National Activity index for June was minus 0.02 versus an expected read of 0.08. Yep, lots of good news here. 

In contrast, data for the eurozone has been far less disappointing of late, providing a glimmer of hope among the gloomy outlook. (The Citi Eurozone Surprise index has improved to minus 8.8 from January’s nadir of minus 88.6.)

But that will not stop the ECB — with its one mandate focused on inflation — from going down the easing path, most likely in September. At this juncture, the futures market is split as to whether the ECB will cut its current overnight rate of minus 0.4 per cent to minus 0.5 per cent. The general view among traders is that a dovish statement locking in a September rate cut and other easing measures (such as buying more bonds) should keep markets rangebound.

Then there’s the Fed to consider. All eyes will turn to the US central bank at the end of the month. While there is some trepidation that policymakers may disappoint dovish expectations, such thinking misses the point. Whether the ECB or Fed are aggressive in the coming weeks is not really the story; rather, it’s whether central banks will match market expectations over the rest of 2019. Over the next fortnight their message will no doubt suggest they are leaning in that direction, mainly because the last thing policymakers want to see is a brutal August when liquidity thins and there’s a pronounced shift in asset prices.

This all provides a bit more for thinking about how markets behave once September beckons and there are hopefully clearer signs for what direction the global economy is heading.

Quick Hits — What’s on the markets radar

A busy week for corporate earnings — The pace of companies’ quarterly earnings steps up this week, with 145 S&P 500 companies on tape while banks set the pace in Europe. Expectations for S&P 500 earnings season have improved a touch as companies have beaten estimates. The run rate has shifted from a year-over-year drop in quarterly earnings of minus 3 per cent to minus 1.9 per cent, so the market is looking at a final figure that should be narrowly positive. 

A market trading at a lofty forwards-earnings multiple of 17 times can hang in while bond yields remain low and analysts expect a bounce in earnings during the fourth quarter, with forecasts of year-on-year growth of 6.4 per cent. That has edged lower from 7.7 per cent at the end of June, but still looks toppy. 

Lori Calvasina at RBC Capital Markets highlights the big issue with an S&P 500 sitting at valuation extremes previously seen in December 2017 and September 2018:

“The big problem in the minds of many investors we’ve spoken with in recent months has been the sharp rebound anticipated in 4Q19 estimates.”

She adds:

“Our chief concern is 4Q19 estimates, which are still embedding a strong rebound in 4Q that seems at risk as the impacts of tariffs and the trade war with China are baked in.”

Eurozone bank earnings and the ECB — The Euro Stoxx Banks index is up just 1.8 per cent this year but down nearly 20 per cent for the past 12 months. In terms of value, the index trades at a price-to-book value of 0.55 times, the lowest annual estimate since 2011.

That may look enticing, but forecasts for all of 2019 and 2020 suggest little change, with the market clearly not trusting the balance sheets of eurozone banks. Not only are eurozone banks among the worst sector for the Stoxx Europe 600 (although, telecoms hold the wooden spoon), in contrast, the S&P 500 financials index has risen 17 per cent so far in 2019. 

This week, as banks start reporting quarterly results, the ECB may offer some relief from negative interest rates via a tiering of deposit costs. That may spark a bounce in bank shares, but misses a bigger point: Europe needs fewer and stronger banks, a point often made by Mario Draghi, outgoing ECB president, and unlikely to occur given political pressure and of course low book values that only elicit a big question mark. 

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