In May, developed market equities stagnated (in euros). They fell slightly by -0.10% in euros due to the depreciation of the USD during the period. Overall, the European markets were the strongest performers of the developed markets.
On the fixed income side, the markets were rather undecided. The US 10-year bond yield fluctuated around 1.65% to finish the month at 1.60%, while the German bond yield on the same maturity remained between -0.20% and -0.10%.
At present, the markets are experimenting with a phase of hesitation due to the debate surrounding inflation and the support of central banks.
The latest US consumer price index reached 4.2% in April on an annual basis, its highest level in 13 years. This has raised concerns amongst market analysts of an aggressive rise in bond yields, threatening to make the equity markets relatively less attractive.
There are many indications that the observed inflation would be more temporary than sustainable. Let us not forget: a year ago, inflation had fallen due to the pandemic.
In addition, it is the most cyclical components of the inflation basket that push the index upwards. When we look more closely, core inflation (excluding food and energy) is 3%, a level that is already less worrying.
On the issue of inflation, the US Federal Reserve is in the less worried camp. Indeed, according to many economists, the deflationary factors that have persisted for several decades are still in effect: the globalisation of trade, digitisation, the decline in the unionisation rate and the bargaining power of employees are all factors that reduce inflationary costs and pressures.
The issue of rates is tied to the issue of inflation. If inflationary pressures are sustained, the central banks may be forced to raise key rates or limit asset purchase programmes.
In short, there is a lack of evidence to address the issue of uncontrolled inflation. This is why we favour the scenario where inflation remains at a higher level than in previous years (>2%) for several quarters. Indeed, the bottlenecks in the supply chain suggest that the issue of inflation will still be on the table. Furthermore, this context leads us to give further consideration to the management of duration risk in portfolio construction by questioning the added value of this risk.
For the time being, real bond yields remain mostly negative in developed countries, and we continue to favour equities over bonds. From a sector perspective, we continue to favour sectors that promise strong long-term growth while adding a degree of cyclicality, a combination offered for the past several months by Industrials and Materials.
As vaccination campaigns continue in the developed countries and health restrictions are gradually lifted, markets have maintained their strong performance since the beginning of the year, but with significant geographical and chronological disparities. Volatility remains, and markets wobble, trapped between hopes of recovery and fears of inflation.
In Europe, financial markets continue to be driven by the scenario of a rebound in economic growth and accommodative monetary and fiscal policies, not to mention sustained consumption. Once again, it was the European indices that posted the best monthly performance, at +2.14%, while the MSCI World ended the month close to equilibrium, at -0.41% in EUR. After the good performances of recent months, the US market consolidated and posted a performance of -1.09% (in EUR). For the time being, this performance gap is mainly due to a catch-up effect, with the US being farther along than Europe in the health and economic cycle. At the end of the month, the Chinese market lost 1.10%, faltering in May due to the slowdown in industry (difficulties with supply and weak global demand).
For equity markets as well as for consumers, the summer reopening will be the moment of truth in terms of inflationary and health risks. Thus, in the last earnings season, investors focused on cost increases for companies, and the term inflation has never been invoked more often over the past 20 years. Particularly in the United States, these fears weighed on the prices of a market that lacks new catalysts, and each session of rate pressures automatically resulted in deflation of valuation multiples, particularly on the most expensive stocks.
It is true that, in addition to rising commodity prices and logistics costs and semiconductor supply disruptions, companies are now having to absorb additional fixed costs, particularly in the US. Thus, despite a much higher unemployment rate than before the pandemic, hiring difficulties are becoming an issue, particularly in the low-wage segment. For example, McDonald’s had to announce an average wage increase of 10% in order to address this problem. In Europe, European companies want to be more reassuring about the effect of cost increases on margins: as for the ECB and the Fed, they believe that inflation should normalise once supply disruptions have stopped and that this should not have a lasting impact on the price system.
From a sector perspective, we continue to favour Technology, which continues to offer great growth opportunities, despite high valuations and sensitivity to one-off inflationary pressures. We would also like to reiterate our favourable opinion on the Communication Services sectors, which encompass Internet and communications companies, and should continue to benefit from the digitisation of the economy and the growth in data exchange volumes. We also remain positive on the healthcare sector (R&D investments and attractive valuations) and the industrial sector, which should benefit from the economic recovery expected for this year and also benefit from the digitalisation and automation of industrial processes in the longer term.
In addition, we maintain our negative view on the Energy sector, as we remain sceptical about the ability of various players to remain disciplined.
Sovereign rates
In May, the bond market showed signs of nervousness in the absence of a press conference from the European Central Bank and the US Federal Reserve in particular. Admittedly, over the past month, 10-year US and German Treasury bond yields barely moved, which did not prevent a temporary rise in the Bund from -0.20% to -0.10%, where it was two years ago. In reality, investors’ fears of a rise in inflation are penalising high-quality sovereign bonds.
In Europe, May inflation reached 2% year-on-year for the first time since 2018. Admittedly, the figure seems impressive at first glance, but it is the tree that hides the forest. Ultimately, in our view, this figure should be interpreted cautiously because temporary factors are playing a major role, with slowdowns in the production and transport of goods, on the one hand, and the surge in oil prices reflecting a significant base effect, on the other.
Core inflation, which excludes more volatile goods, such as food and oil, came to 0.9% year-on-year, in line with its 10-year average.
On both sides of the Atlantic, investors fear a “tapering” of monetary stimulus policies. Nevertheless, the ECB assures us that it is still too early to discuss a slowdown in the asset purchase policy.
The credit market
The month of May revealed a disparity between Europe and the US in terms of performance. Indeed, while risk premiums widened slightly in Europe, leading to a slight underperformance in credit, the opposite occurred in the US, where private debt posted a robust monthly performance.
Inflation fears remain at the heart of the debate these past months and are the main reason for the rise in rates since the beginning of the year. In recent weeks, however, there have been a number of central bank announcements seeking to reassure investors about the temporary nature of these increases in inflation.
In the US, private debt risk premiums reached their lowest level in nearly 14 years at the end of May. This can be explained the strong recoveries of many economies and the easing of Covid-19 restrictions around the world. Issues remained stable as companies continue to take advantage of low rates to obtain financing, while central banks continue to support them.
In Europe, the very slight widening in risk premiums was mainly due to concerns over the slowdown in the European Central Bank’s asset purchase programme, which the institution denied. Nevertheless, the risk premiums of the Old Continent remain at historically low levels, and credit remains robust.
Against this backdrop, we maintain our positive view on the asset class, but remain attentive to inflation forecasts and their influence on rates. We believe that credit will continue to be robust in this low interest rate environment, as credit yields are more attractive than government debt yields.
EUR/USD
In May, the dollar’s downward movement against the euro continued. The month started at a parity of 1.20 and ended at 1.22. In the US, economic data confirms the economic recovery despite a labour market that is still performing below its potential. As a result, bond yields have risen for several months without making the greenback much more attractive, however. Indeed, inflation remains a source of concern for investors who may therefore fear that negative real bond yields will continue. Moreover, the renewed relative momentum in the eurozone may be another factor behind the depreciation of the USD. Ultimately, the downward pressure on the USD is likely to remain in place, with the twin US fiscal and trade deficits increasing. We therefore maintain our view on the euro/dollar, which is expected to remain above the level of 1.20.
Gold
In May, gold returned with a vengeance, as the price per ounce rose from USD 1,770 to USD 1,900, a jump of more than 7%. Gold is an asset that allows investors to diversify their portfolio, especially in periods when real bond yields are suffering from spikes in inflation, as they are currently. Volatility is expected to remain in terms of inflation, and therefore rates as well, which are likely to be a positive factor for gold. With central banks’ asset purchase programmes likely to continue to compress rates, high inflation figures (although these effects should be transitory) should make gold an attractive asset for the rest of the year. That is why we will not be surprised if gold remains at high levels until the end of the year, namely between USD 1,800 and USD 2,000 per ounce.
Disclaimer
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This document was produced by the Private Banking Unit and BCEE Asset Management. The drafting of this document was completed on 12 March 2021 at 2:00 pm.
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