“If adverse contingencies were to materialise, the Governing Council stands ready to act and use – as I’ve said many times – all the instruments that are in the toolbox”. (Mario Draghi, Vilnius, 6th June, 2019)
There was a time, barely a decade ago, when central bankers spoke in code and it seemed as if an entire industry had grown up around the analysis and interpretation of cryptic pronouncements from Chairman Bernanke, President Trichet and Governor King. Not so today! Happily (for everyone other than those analysts), the heads of the western world’s monetary authorities are about as explicit in their communications as it is possible to be and the financial world is certainly a better place for it.
In many ways, the quarter under review typifies the market climate that we have witnessed throughout the past three or four years, reflecting a pattern with which we have become familiar and arguably even conditioned to expect: a shift in investor sentiment that is a response to evidence of a mature and slowing global economic cycle is reversed by the words and / or actions of the world’s senior policy-makers. In that respect, the transparency that characterises today’s Central Bank chiefs is also emblematic of a shift in their institutions’ expanded role as keepers of the flame of asset price stability. For proponents of a free market system at least, this interference in the natural order is a far less palatable aspect of the modern economic environment.
As has also been the case for some time, matters relating to global trade remain at the forefront of investors’ minds and continued to be a source of market volatility.
Rather like the late Spring / early Summer weather here in this part of the Northern Hemisphere, conditions during Q2 were decidedly changeable. A period that began in a benign fashion transitioned into a sizeable May sell-off which wiped out almost three months of stockmarket gains and sent government bond yields tumbling. The above-captioned soothing words from the ECB’s outgoing President then turned the investment world’s frown upside down and, along with positive developments on the US / China trade front, propelled global equity benchmarks back to the top of historic ranges and sovereign yields to new lows.
|MSCI World ($)||3.35%||15.63%|
|MSCI World (EUR)||2.09%||16.58%|
|MSCI World (£)||0.000578||16.09%|
|MSCI World (local ccy)||2.97%||15.34%|
|FTSE UK All Share (£)||1.98%||10.39%|
|MSCI Europe ex-UK (EUR)||2.68%||14.91%|
|Japan Topix (¥)||-2.54%||3.82%|
|MSCI Asia ex-Japan ($)||-1.64%||9.39%|
|MSCI Emerging Markets ($)||-0.31%||9.22%|
|MSCI Emerging Markets (EUR)||-1.52%||10.12%|
|MSCI Emerging Markets (£)||2.03%||9.66%|
Although trade-related geopolitics also moved the needle over short periods, data from the major economies and resulting implications for the level and direction of interest rates were the dominant influence on the market agenda, albeit with what appeared to be a somewhat inconsistent logic. A broadly favourable trend in April saw composite PMIs in the US, Europe and China all meet or exceed consensus forecasts (albeit with EU manufacturing in decline), GDP prints that surprised on the upside and US jobs numbers rebound strongly. Despite the consequent reduced likelihood of lower rates that many (including President Trump) were calling for, broad equity indices made steady gains throughout the month.
In May, new tit-for-tat tariff announcements from Washington and Beijing wasn’t the only cause of the abrupt switch in markets’ direction, as, to the surprise of even White House insiders, Mr Trump also threatened to widen the scope of the US’s protectionist measures to include imports from Mexico. Unsurprisingly, emerging markets were among the biggest casualties during the broad sell-off, as investors took on board the prospect of trade wars opening up on a number of new fronts. Macro data during the month was mixed: the US and Europe’s were broadly better than expected, while China disappointed on several key indicators.
Citi China Economic Surprise Index
Boosted by Mr Draghi’s dovish musings and softer than expected data from the US and China (but ironically, not Europe), increased expectations of a shift towards easier monetary policy on a global scale, along with suggestions that the US and China would return to the negotiating table, put investors back into “risk-on” mode in June. Global market benchmarks returned to the top of their ranges, recovering all the ground that was lost in the preceding month’s correction.
While recent history suggests it should perhaps not come as too much of a surprise, it is remarkable to think that barely six months after futures prices were discounting as many as three rate hikes and investors were behaving as if the global economy was hurtling towards recession, markets are now basking in the glow of prospective interest rate cuts and the possibility of a return to Quantitative Easing in at least one of the world’s major economies. As measured by the MSCI AC World Index, global markets are little changed, both in nominal terms and in respect of their price/earnings ratio of 18 times from the levels seen just prior to the sell-off in Q4 of last year (other metrics, such as price/book value price/sales, or price/ free cash flow are also similar). Even if one disregards current consensus earnings estimates as being as overly optimistic (as they usually are), a forward P/E of 16 to 17 times in an environment of easy monetary policy and within the context of prevailing core sovereign bond yields, it is probably fair to say that equities in toto are on the cheap side of fair value.
Add to these supportive fundamentals a continued healthy level of M&A activity, coupled with the fact that Private Equity groups are reported by reliable sources to be sitting on USD2.5 trillion of cash, the case for equities remains favourable. That view would certainly seem to be backed up by the actions of those among our preferred managers with a value bias, who have been reducing the levels of cash within their portfolios in recent months.
Global M&A Activity
Save for a soft start that lasted all of three weeks, it was one-way traffic for core sovereign bonds, as investors adjusted to the changing interest rate outlook. From respective opening marks of 2.41%, -0.07% and 1.00%, the yields on ten-year Treasuries, Bunds and Gilts backed up to 2.60%, 0.08% and 1.24%, before falling steadily for the remainder of the period. In the case of the US and UK markets, closing levels of 1.99%, and 0.79% were the lowest seen for 31 and 32 months, while the Bund’s yield of -0.33% represented an all-time low. Moreover, the accompanying downward shift in the Euro benchmark maturity curve meant that one now has to go out as far as 20 years to find a bond that delivers a positive nominal yield. In Index terms, these movements translated to gains of 3.01%, 1.41% and 2.00% in the respective Bloomberg (>1 year) market indices.
German Bund Yield Curve
Meanwhile, a modest tightening in credit spreads over the quarter added a further tailwind across both investment grade corporates and high yield bonds, with emerging market debt indices also benefiting from the return to “risk-on”.
While there’s no doubt that there is a logic to the direction of bond markets, we can’t help thinking that the extent to which they have rallied over the course of the last three calendar quarters may be a tad overdone. That said, the lag effect means that the impact of any stimulus will not be felt for at least six months and more likely longer, so unless we see a dramatic improvement in macro data, it’s entirely possible (likely?) that lower yields will be here to stay for some time. In an environment of such low (or negative) nominal yields and real yields that are negative across the board, generating worthwhile returns from conventional bond strategies is, to say the least, a challenge. As such, our focus remains on managers who are able to extract value through the selective application of highly flexible strategies across a broad opportunity set, or by specialising in niche areas.
Another relatively quiet quarter on the foreign exchanges saw the Dollar weaken marginally in trade-weighted terms, with the DXY Spot Index recording a decline of 1.19%.
So much for talking up the Pound in our last commentary! Sterling was the weakest of the major currencies by some distance, falling 2.94% in US Dollar terms to revisit its January lows, as the latest episodes of the ongoing Westminster farce were perceived as increasing odds of a no-deal Brexit. At the other end of the performance league table, the South African Rand (+2.94%) and Japanese Yen (+2.79%) were the biggest gainers.
In a recent manager meeting, an EM debt specialist who we’ve known for many years, with whom we have invested in the past and for whom we have a deep admiration suggested that if US trade relations with China continue in the direction in which they have recently been heading, one of the few strategies left to President Trump in his quest to improve the US’s competitive position is to weaken the Dollar. The thinking goes that, with long Dollar positioning so prevalent among investors even a partial unwinding of that crowded trade could send the currency into retreat. He is not alone in thinking this: we have watched, read, or listened to very cogent arguments put forward by a number of very smart thinkers for precisely that scenario.
Broad commodity indices ended the period marginally lower: the Reuters/CRB Index was down 1.48% in US Dollar terms. Agriculturals were both the biggest gainers and losers with Corn (maize) up 17.88%, Wheat +15.35%, and Coffee +14.55%, while Cotton fell 18.63% and Orange Juice was down 15.80%.
Gold, by contrast, was also among the winners, rising sharply over the quarter’s final third and hitting a six-year high on its way to a closing price of USD1,409.45 per troy ounce for a gain of 9.10% in spot price terms.
Gold Spot USD per ounce
Meanwhile, movements in Crude Oil prices followed a very similar pattern to those of equity markets – up in April, down in May and up again in June – but, unlike broad equity benchmarks, the “front month” Brent and West Texas Intermediary contracts closed down 2.97% and 2.78% at USD64.64 and USD58.47 respectively. While an agreement by both OPEC and non-OPEC producers to maintain (and equally importantly, comply with) previously agreed production quotas signalled a renewed commitment to oil price stability, a series of attacks on tankers in the Straits of Hormuz that were blamed on Iranian state-sponsored actors were the only threat to an otherwise orderly market. Although geopolitical events represent an ever-present threat to the status quo, the unprecedented and strong level of co-operation among the world’s major producers suggests that a (Brent) trading range of USD60 – USD70 per barrel is the most likely scenario in the near to medium term.
Download: Q2 Commentary – Shaun McDade