After a quite difficult month in May, during which hopes of a possible agreement between the US and China abruptly dissipated, stock markets seemed to be recovering. Geopolitical tensions in the Middle East also created a major risk, given the unpredictability of the diplomatic issues they raised.
In order to calm the markets, central banks committed to an accommodative stance in the coming months. At the beginning of June, Jerome Powell announced that the Fed could cut its key rates if the trade tensions affected economic activity, and the FOMC was on the same page. It emphasised that uncertainties regarding economic growth had increased and, given “muted” inflation pressures, said the Fed would “act as appropriate to sustain the expansion”.
The European Central Bank implied that its unconventional monetary policy would remain in place, having revised inflation expectations downwards. It could go further in its negative key rates or even launch another asset purchase programme after TLTRO III which involves providing liquidity at low rates to banks so that they can fuel the economy through loans. In his speech on 18 June, ECB President Mario Draghi stated:
In the absence of improvement, such that the sustained return of inflation to our aim is threatened, additional stimulus will be required
Contrary to the prevailing situation a year ago, it's time to redeploy unconventional measures against the backdrop of worsening economic indicators. Overall, economic growth is expected to fade this year according to forecasts by supranational institutions.
For several months now, global trade and industrial production have deteriorated. In the first quarter of 2019, for example, China’s exports to the US dropped 26% in volume year-on-year for the products subject to additional tariffs by Donald Trump.
Looking to the near future, the confidence indicators that give an idea of economic activity also point to an economic slowdown, particularly in the manufacturing sector. In Germany, both the purchasing managers’ index and the Zew, which measures investor confidence in Europe, were weak. Similarly in the US, the paths of the purchasing managers’ index and the Philadelphia Federal Index, which measures variations in business growth, were identical – while job creation levels were below expectations, at 75.000 instead of 175.000. In China, the slowdown in the industrial sector was more pronounced than forecast, and also affected imports more than expected.
As a result, given the risk factors that weigh on the current environment and the existing economic slowdown, we maintain a cautious stance in our investments by underweighting equities and fostering a neutral approach to the bond markets.
We maintained our cautious bias on the stock markets in June. As such, we recommend reducing portfolio exposure to the more cyclical sectors and segments of the market. Consequently, our view remains negative on commodities, as the sector is highly exposed to the health of emerging countries, particularly China, and utilities, which are suffering from weak growth in electricity and gas consumption and the development of intelligent decentralised networks. Similarly, we have some reservations about the semiconductor segment due to valuations that we believe do not reflect the current economic slowdown.
Conversely, we are much more positive about real estate, which is well positioned because of the sector’s diversity, increasing complexity of supply chains, data-centre requirements, private consumption that remains healthy and valuations that remain reasonable. Our view of the communication services sector is also positive, as it is meeting the growing needs for both networks and content.
This cautious stance, justified by the deterioration in most economic indicators and by political risk, did not pay off in June. The equity markets performed very well overall and made up for their weak performances in May. This dynamic is justified by the ever-more accommodative message from the main central banks. Falling rates and the expected increase in liquidity are pushing investors to seek yield. Furthermore, the equity markets are considered to be the solution. For the first time since the beginning of 2019, equity funds had a positive net inflow in recent weeks.
Reporting season for the second quarter begins in July. As is generally the case, the consensus over expected earnings has been gradually downgraded. However, investors attention is likely to focus on third quarter guidances. The question of a rebound in the second half is a key topic keeping investors in suspense. They are generally under-invested in equities. If guidances for the second half of the year seemed positive, or better than expected, there would likely be a vacuum effect that could drive equity markets to a new high. Some companies, particularly in the semi-conductors sector, are starting to announce that this rebound should happen at the end of the year or even in 2020. Ultimately, equity-market performance over the next six months will depend heavily on the extent of these revisions.
Sovereign yields and bonds
In their recent presentations, the European Central Bank and the US Federal Reserve adopted a more accommodative tone. We expect the ECB and the Fed to stimulate their respective economies again in the medium term. Yet although market expectations of monetary easing from the ECB may appear reasonable, expectations from the Fed seem to be excessive. There is no doubt that US Treasury bonds are still acting as crucial stabilisers in strategic portfolios against a background of growing macroeconomic uncertainty. However, in the short term, we remain cautious about long-term sovereign bonds on the US rate curve.
European and US money markets reacted differently to this change in the central banks’ tones. Whereas in Europe the very short part of the curve hardly moved at the end of the month, in the US, rates fell by more than 25 basis points. This is mainly due to extremely low rates in Europe with the German Bund's 1-year rate standing at -0,58%.
On the credit market, June was mainly characterised by a pronounced narrowing of risk premiums. This is due to the fact that the market was expecting a new round of monetary easing in Europe, and an even more accommodative stance from the Fed in the US. European Central Bank President Mario Draghi suggested that, if need be, the ECB would use the flexibility of its mandate to bring extra stimulus using the tools available.
In this context of relaunching the central banks’ asset purchase programme, the European credit market is becoming more attractive. We believe that risk premiums will tighten at levels similar to those during the first round of quantitative easing. However, as we are in an advanced credit cycle, we prefer high-quality securities that are also eligible for the CSPP programme.
Broadly speaking, in Europe, sovereign yields are at low levels. This makes credit more appealing as insurers and other managers are seeking yield, driving lasting demand and keeping the spread from widening.
In June, the euro gained some ground against the US dollar. In the US, some macroeconomic data was rather underwhelming compared to expectations, leading investors to expect rate cuts. Additionally, Federal Reserve Chairman Jerome Powell stated that the central bank was open to interest rate cuts this year if trade disputes with China and Mexico slowed US economic growth.
Thus, yields on the short end of the US sovereign curve fell more than those of the German Bund. This tightening of the spread between US and German rates caused the euro to rise against the dollar.
We do not expect a drop in the Fed’s key rates in July. Consequently, the euro's upside potential should be limited in the coming weeks.
However, we are still keeping a close eye on the speeches and decisions of the European Central Bank and the Fed, which could affect the exchange rate. Investors expect a more pronounced rate cut in the US than in the euro zone, which is why the euro should see a limited rise over the medium term and not fall below the 1,12 threshold.
US President Donald Trump announced that he would impose new sanctions on Iran, as he plans to strengthen pressure on the country's leaders and restrict the Iranian economy even further. These geopolitical tensions therefore led investors to look to gold. Gold soared and exceeded USD 1.400 per ounce.