Fed continues to raise interest rates, but outflow from emerging markets is an overreaction
Firstly, there is the difference in growth between the United States and the Eurozone. Secondly, the calm behaviour of US and German government bonds. The third theme we identify involves events surrounding Italy’s budget plans and, finally, there is the turbulence on emerging markets. The strong growth and corporate earnings in the US have led to a corresponding outperformance by US equities versus other regions, which confirms our positive outlook. With many indicators at or close to record highs, we are closely monitoring whether we need to take profit here. Our contrary outlook for emerging markets, whereby we believe the drop in the equity markets in particular to be an overreaction, has not yet materialised, however. In general, we are seeing the investment climate shifting more towards inflation, which makes us positive about commodities and real estate. We still hold a negative outlook for government bonds and credits.
Strong growth in the US versus the Eurozone
Almost all indicators in the US are pointing to robust growth. Consumers have not been as confident as they are now since 2000. Even sentiment at small businesses is more positive than ever. Furthermore, in August the ISM manufacturing index, which measures sentiment at large industrial companies, reached its highest level since 2004. The positive sentiment has decreased slightly at housing construction companies and in the service sector, but it remains well above average. Leading indicators are depicting a less robust picture in the Eurozone. The German Ifo remained strong in August, but the PMI for industry fell slightly and the Economic Sentiment Index – an important indicator published by the European Commission – declined for the eighth month in a row. In Germany, industrial production and exports were also worse than expected in August. A clear contrast can also be seen in the orders for capital goods, which are accelerating in the US but in fact slowing in Germany. It is therefore possible to explain the sharp rise in US equities from an economic perspective. Moreover, corporate earnings are growing at a considerably faster rate in the US than in the Eurozone. Some caution is due from an investment perspective, however. The robust US economy and the tight job market – a large number of jobs was again created in August and hourly wages were up by 2.9% on an annual basis – mean that the Fed will continue its interest rate hikes. The Fed itself says it will raise interest rates on a further two occasions this year and three times next year. Markets are sceptical, but 2018 is the first year in this economic cycle in which the Fed has kept to its plans and market forecasts had to be adjusted upwards. Furthermore, it won’t get much better for the US economy and corporate earnings than it is now. For the time being, we retain our positive outlook for US equities versus Europe.
“Almost all indicators in the US are pointing to robust growth.”
Little movement in capital market interest rates
In spite of the robust growth and growing inflationary pressure in the US, 10-year government bond yields are still just below 3%. Yields have moved within a fairly narrow bandwidth of between 2.7% and just over 3% since February. We believe that after years of very low inflation bond investors want to see more signs of inflation before they push up yields. Yet temporary factors may also play a part here, such as the repatriation of corporate earnings following changes to US corporation tax and the corresponding deposits into company pension funds. In Germany, capital market interest rates have not managed to exceed 0.5% since May this year. This is also extremely low in an economy that is nominally growing at a rate of close to 4%. Yet in the Eurozone as a whole there is considerably lower inflationary pressure, the ECB continues to buy bonds and there is turmoil surrounding Italy’s budget. Now that the Italian government seems to be slightly more cautious with respect to spending and a clash with the European Commission is less likely, spreads on Italian government bonds have also tightened slightly again. We assume that a solution will ultimately be found that reassures the bond markets, but the next few months could continue to see periods of higher volatility.
Outflow from emerging markets an overreaction
With a drop of 20% from the high at the end of January, emerging market equities are now officially in a bear market. We believe that this correction has gone too far. Firstly, the decreases in both bond and equity markets are concentrated in a small number of countries. Interest rates have rocketed in Argentina and Turkey, but less so in countries such as South Africa, Brazil, India, Russia or Indonesia. In equity markets listed in local currency there are only two countries with a drop of about 20%: Turkey and China. This is not that surprising in the case of Turkey given its structural problems, but the Chinese economy is reasonably stable and corporate earnings are growing strongly. Cyclical markets such as Korea and Taiwan are displaying widely differing pictures: -7.5% this year in Korea and almost unchanged in Japan. In India and Russia, the markets stand at a plus of over 10%. Secondly, economic indicators are in reasonable shape. The PMI for industry has declined slightly on average for all emerging markets, but it still stands at a reasonable level. Industrial production is showing stable growth and no clear slowdown is visible in export trends. Finally, more technically, the volatility of emerging market currencies is extremely high compared to the volatility of US equities. This points to a fairly negative scenario being priced in. Of course there is a risk of a trade war and emerging markets could be adversely affected by the Fed’s interest rate hikes, but stability in US capital market interest rates and more recently a stable US dollar ought to help stabilise financial markets in emerging economies. We therefore maintain our positive outlook for emerging markets.
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