Risk assets disconnect from fundamentals
The exuberance in risk asset markets did not spill over to government bonds, which seem to price in a much more pessimistic scenario. In the US the ten-year interest rate fell to 2.37% towards the end of March, a level not seen since late 2017when the Fed policy rate was 100bps lower. In Germany ten-year yields dipped into negative territory for the first time since October 2016. There is not only a disconnect between risk asset markets and government bonds, but also between risk assets and fundamentals. There were some green shoots in leading indicators, but the broad economic outlook remains weak. This makes us cautious on equities, where we hold our neutral stance. Bond yields have fallen against our expectations for some time, but as we think the current move is excessive given the somewhat better outlook, we remain negative on government bonds.
Green shoots in Asia insufficient for a more positive view
A number of leading indicators has shown signs of bottoming. Most notably the PMIs in China, and other Asian economies. The Ifo-index in Germany, the ISM-manufacturing index in the US and consumer confidence in the US and in the eurozone all came in stronger than expected. However, leading indicators for the manufacturing sector in developed economies have continued to decline. Furthermore, new orders for the industrial sector in the developed world dropped at an alarming pace. Trade data have also stayed weak. The improvement in the manufacturing PMIs in Asia in general and in China in particular may reflect the fiscal and monetary stimulus that the Chinese authorities have implemented. The actual Chinese data on credit, retail sales and industrial production however,have hardly improved. The consensus is that the growth slowdown was caused by temporary factors like the trade war between the US and China, Brexit and one-offs in the German car industry. Once these issues have been solved, the global economy is expected to rebound. But we think these factors may have caused some lasting damage. Especially to the industrial sector, trade and business investment, which are reflected in the continued fall in capital goods orders. We also see some spill over into labour markets. Sure, financial conditions have eased since the end of last year, but no additional stimulus has been announced in the US, the eurozone or the UK. Stimulus in China will be offset by fading fiscal stimulus in the US and some signs that the tightening by the Fed is starting to bite.
“Equity markets incorporate a significantly more positive view than bond markets.”
Who is right, the bond or the equity market?
Above we pointed to the disconnect between the equity markets and bond markets. Equity markets incorporate a significantly more positive view than bond markets. The decline in bond yields makes sense. The Fed and the ECB have turned more dovish, inflation is going nowhere and inflation expectations derived from swap markets have fallen. Still, we think that ten-year yields below 2.5% in the US and especially negative yields in Germany are excessively low. So we do not agree with the bond markets. Equities have rallied against weak economic data and earnings. With the exception of the US, where the corporate tax cut is still in the numbers, trailing earnings have flatlined in all regions. Earnings downgrades have continued. Earnings expectations for the first and second quarter are generally modest, but imply an acceleration in the second half of the year. We think companies may struggle to meet those expectations. A strong argument in favour of equities is TINA, short for There Is No Alternative. With low bond yields this makes sense and valuations and sentiment in equity markets do not look excessive. We therefore prefer a neutral stance on equities. So in fact, we currently think the equity market is a bit more right than the bond market, but we are not overly convinced. Regionally, we prefer the US, where the cycle is stronger and emerging markets where we have seen some green shoots. We are more cautious on Europe, where growth is weaker and policy makers have less room to stimulate. We do see eurozone credit as a viable alternative for equities. The carry may be low, but we do not think default rates will increase.
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