Across many regions, bond yields have fallen during the past two weeks; the US 10-year Treasury yield, for example, has fallen from 2.37% to 2.12%. This was caused, in part, by investors switching out of risk assets into bonds, but it also comes as a reaction to falling inflation expectations. For equity investors, modest inflation and some earnings growth provide a reasonably positive background. Dividend payment levels are also supportive, as equity dividend yields are at multi-decade relative highs compared to interest rates (and interest rates are likely to be heading lower). This should support equity markets, unless we head into a recession. Tactically, we remain comfortable with a neutral exposure to risk assets even though short term volatility has picked up.
Markets were distinctly in risk-off mode in May with deepening investor concern over the world economic and political landscape driving a flight to safe-haven assets. Following a particularly benign backdrop for financial markets through the first four months of the year, the big game-changer has been trade policy. The stand-off between the US and China has continued with the rhetoric showing no signs of improvement. The latest threat from China is that it could restrict exports to the US of rare earth metals, which are used in products such as smartphones and electric vehicles. The negative trade news continued elsewhere, with a surprise tweet from President Trump at the end of the month announcing a new set of tariffs on imports from Mexico, unless they step up efforts to stem the flow of illegal migrants to the US. If only there was a wall! The news accelerated the equity market downturn, precipitated by another tariff-related tweet earlier in the month and caused a sharp fall in the Mexican peso.
Trump’s tweets seem to have called into question investors’ faith in the ‘Trump put’ – the idea that Trump will act to limit a stock market downturn – with the Federal Reserve’s ability to calm markets instead taking precedence. Indeed, bond prices have risen in anticipation of a new bout of monetary easing, with the US bond market now pricing in two interest rate cuts by year-end. Meanwhile, in Europe, German 10-year Bund yields ended the month at their lowest yield on record, -0.20%, as recessionary fears increased.
The political landscape in the UK was similarly fraught. On 24th May, Prime Minister Theresa May announced that she will stand down as Conservative Party leader on the back of the EU parliamentary elections, which saw a collapse in support for the two main political parties in the UK. The beneficiaries of the vote swing were the Brexit Party, which campaigned for a ‘no-deal’ Brexit, the Liberal Democrats and the Green Party. The latter two campaigned for a second referendum. It was a similar story of political fracturing Europe-wide, with the « grand coalition » of conservatives and social democrats losing its absolute majority. Meanwhile, liberals and greens as well as populists and anti-establishment parties continued to build support.
Given the success of the Brexit party in winning-over traditional Tory voters, the UK Conservative Party looks set to try to win them back by veering more in favour of a hard Brexit. The leadership race officially begins on 10th June, but it is already an extremely crowded contest. Whoever wins is going to be faced with the same issues that the outgoing Prime Minister faced – a parliament with no clear majority for what type of Brexit it thinks should be delivered, but opposed to a no-deal Brexit, and European politicians opposed to a renegotiation. There is, therefore, the question as to whether only a general election or second referendum might break the impasse, assuming the EU is once again willing to extend the Brexit deadline to allow such a “democratic event” to take place. Sterling was 3.1% weaker over the month and this helped limit the fall for UK equities in sterling terms.
As discussed above, escalating trade tensions and the darkening global outlook are roiling financial markets and the number of implied interest rate cuts has increased dramatically. The US imports around $30bn of goods from Mexico each month, with around 30% of those being auto-related. Tariffs at 25% on that flow of goods, in addition to those announced for Chinese imports, would start having a significant impact on US industry. However, until the key domestic growth drivers, most notably consumer spending and job growth, show tangible signs of losing speed, the US Federal Reserve is likely to retain a wait-and-see policy stance. Recent economic data has showed weakening fundamentals with consumer and business investment spending failing to pick up although May saw US consumer confidence jump surprisingly to its highest level since last November.
Elsewhere, the latest purchasing manager index in China showed weakness, with the Manufacturing Index coming in at a contractionary 49.4; the forward-looking components of the survey, new orders and new export orders, were notably soft. In contrast, the Non-Manufacturing Index came in at 54.3, underlining the healthier state of the service industry. Eurozone macro data disappointed, notably in Germany where CPI, retail sales, consumer confidence and unemployment came in below market expectations. Eurozone consumer confidence and broad money supply also disappointed.
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