As the sun shone across London, global equities were set for a third straight weekly gain, with Europe setting the pace for a change.
The rise in sovereign bond yields and the ever-present hopes of a trade war thaw (with another goodwill gesture from China) continues to spur a significant rotation among equity market sectors. Over the past month, “cheap” sectors that were hit hard by the summer blues resonating throughout the global economy (reflected in slumping sovereign bond yields) added to their already impressive gains on Friday.
This trend is being led by European equities, highlighting just how beaten down sectors within the Stoxx 600 are compared with those of the S&P 500 index. A look at the leader board for the Stoxx Europe 600 index on Friday showed a 2.7 per cent gain for Banks and Basic Resources, followed by Autos & Parts. These three sectors have each rallied beyond 15 per cent over the past month, more than double the broader market's 7.3 per cent rise for the same period.
Strong gains for sectors such as financials, industrials and energy also stand out as the S&P 500 has climbed back above the 3,000-points threshold in the past month towards record territory. And the rally in value shares, as noted earlier this week, has during prior episodes run hard. On Friday Wall Street saw renewed pressure on momentum stocks, with the result that the technology sector was duly lagging. The sharp convergence of late between US value and momentum factors is shown below.
A key factor, of course, is that of long-term bond yields, which are closing out the week under significant pressure. The European Central Bank’s easing package and push for fiscal spending to supplant monetary support backs the view that bond yields across the region have made their cycle lows. Illustrating the swing in bond markets, Germany’s 30-year debt has risen back above zero to around 0.12 per cent this week, following a slide towards minus 0.3 per cent in mid-August.
The retreat in German yields ripples far and wide, particularly across the Atlantic where the US Treasury market is feeling some heat from a combination of annual core inflation at a cycle high of 2.4 per cent, an economy tracking near-trend growth of around 2 per cent while consumers are holding the line for now, as highlighted by Friday's read on retail sales for August.
How much further bond yields rise from here is clearly an important issue. The mood in fixed income is that a correction makes sense after such a stunning rally during the summer. Beyond that, a substantive change from the low-yield trend is not on the cards.
Chris Iggo at Axa IM explains:
“A real reversal requires the economic data to look better, inflation to pick-up, confidence to be improved by a US-China trade deal, and a resolution to Brexit and some signs that fiscal policy is going to respond to the demands of the ECB. That is a tall order.”
Krishna Memani at Invesco expects a 10-year Treasury yield around 2 per cent by the end of the year and says “the move out of defensives and into cyclicals can continue for a bit but will eventually fade”.
“Rates will remain low and, while policy is supportive, global growth will, at best, stabilise. Be wary of the market rotation talk and don’t let the talk of rotation or regime change sway you into making meaningful changes in your portfolio.”
As the rise in bond yields reverberates, it sets the stage for an interesting Federal Open Market Committee meeting next week.
There is a risk that an expected easing of 25 basis points (shifting fed funds to a range of 1.75 per cent to 2 per cent) is not accompanied by the FOMC signalling further cuts in spite of a futures market looking at a year-end level around 1.60 per cent.
Mark Dowding at BlueBay Asset Management observes:
“We expect a 25bp rate cut, but of more potential interest will be an assessment of whether the FOMC believes that further cuts will be needed in the months ahead.”
With the FTSE All-World equity index nearing its collection of peaks set during July and Wall Street looking at a fresh foray into record territory, investors will soon see whether prior highs remain a barrier or are surpassed. Certainly the money is flowing into risk assets, led by the US (see Quick Hits below), but it remains to be seen whether European equities finally attract sustained inflows.
The message for now is that higher government bond yields and firmer risk assets can prosper, but there are limits.
UniCredit’s Elia Lattuga says:
“In spite of relatively more attractive valuations, equities remain fragile and exposed to persistent uncertainty with regard to the global growth outlook. Central banks might boost risk appetite over the short term, but, in this environment, fixed income appears better positioned to benefit and to weather political risk. EU credit and EM bonds remain our preferred picks as the hunt for yield will likely remain a key market feature in the months to come.”
Quick Hits — What’s on the markets radar
The resumption of quantitative easing by the ECB is certainly controversial both within and outside the central bank. On Friday Dutch central bank boss Klaas Knot publicly criticised the policy as “disproportionate” and said more QE “is disproportionate to the present economic conditions”.
Among readers, their feedback has pointed out how negative rates do more harm than good and, as Mario Draghi stressed on Thursday, that fiscal policy is the way forward.
US equity funds saw their biggest inflows for almost three months during the week ending September 11, according to EPFR. The platform noted: “Funds with a value investment style handily outperformed their growth counterparts across all capitalisations.”
Europe equity funds saw another weekly outflow, which EPFR noted has been the case for 73 of the past 76 weeks. French equity funds set a new outflow record, while Italian equity funds jumped to their highest level since late 2015.
Over at Bank of America Merrill Lynch, it notes:
“Inflows to US high-grade funds and ETFs jumped to $6.94bn this past week ending on September 11. That was the third-largest inflow on record going back to 2008 and the biggest since October 2014.”
That’s plenty of money for companies to tap, as they square away borrowing needs for 2019.
A relief rally for the pound has driven the currency some 3 per cent higher versus the dollar from its nadir earlier this month. Sterling also rallied some 4 per cent from below the €1.08 area, beyond €1.12 versus the euro during the past month. The extended bounce reflects parliament’s obstacles towards a hard Brexit at the end of October, but three-month currency volatility for the pound still remains above that of the Mexican peso.
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