Italian stress has subsided as parties agreed on a last minute compromise. This is not to say that all is well, but at least there is a government. There has been some backtracking on spending plans and markets have again concluded that Italy is back to its usual problem. How to get structural growth in a higher gear. Clearly an issue, but not one that is of immediate concern. Hence the spotlight is back on trade deals with the US and the nuclear deal that Trump and Kim are supposedly agreeing on. We will see what geopolitics brings next. We can be sure that markets will remain volatile. More than they would be if one would simply look at the fundamentals which are progressing as we have expected to. Growth is stable and above trend, inflation slowly picking up and interest rates are slowly trending higher. Markets are taking the tightening in liquidity in stride. Yes, there are some pockets of weakness in certain parts of the credit markets, but that is mostly idiosyncratic. Until it isn’t. Given the back up in Italian yields we feel that value has emerged and we advise clients with a more shorter term time horizon to take benefit and close shorts or add some tactical longs via EMU bonds at the expense of core.
US economy outperforming
One of the major surprises recently has been the weakening in European leading indicators. This is in stark contrast to what we see in the US where leading indicators are strong and picking up. While a strong growth rebound is expected in the US in the second quarter, the growth slowdown in the eurozone looks more sticky. We had thought that the growth dip in the eurozone would be only temporary, but it now looks like the earlier appreciation of the euro, rising oil prices and political unrest in Italy may have a more sustaining impact. We are therefore a bit less positive on the eurozone growth outlook. Emerging markets have faced a triple whammy of higher oil prices, a strong US dollar and rising US bond yields, which have wreaked havoc on some emerging market currencies. But with the three causes mentioned now abating and leading and economic indicators showing hardly any impact on Asian economies, we still look favorably to the economic cycle in emerging markets. Overall, leading indicators are still above the expansion level and global trade – as witnessed by EM exports – is also strong.
“However, with the Italian stress we can understand that investors became a bit more skepticaland need more evidence to add to risk.”
EU contagion contained
However, with the Italian stress we can understand that investors became a bit more skeptical and need more evidence to add to risk. On the equity side we stick to our positions. With a strong economy and equities trending higher, US equities may look attractive, but valuations are higher. A positive cycle is largely discounted in our view. If emerging economies hold up, equity performance should improve, so we have kept our overweight versus European equities. Peripheral bonds are look interesting from a medium term perspective. With contagion contained now is as good a time as any to move back to neutral in our allocation core bonds vs EMU bonds. Clearly this is not without risk and there will be bouts of volatility along the way.
Fed hikes, ECB will taper
Fed-chairman Powel had an easier job this month than ECB-president Draghi. With growth strong and inflation around 2%, the Fed hiked rates as expected. The Fed even felt confident enough to remove the forward guidance of low interest rates and looks set to hike rates two more times this year. The ECB announced that it will taper its asset purchases to EUR 15 billion after September and to fully end its asset purchase program after December. But with growth in the eurozone slowing and Draghi admitting that the slowdown could continue into the second quarter, Draghi did not look overly convincing on this point. But this was compensated by the dovish forward guidance of no rate hikes at least through the summer of 2019. Thus, the knee-jerk market reaction was that equities rose, German yields and Italian spreads fell and the euro weakened.
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