Market balancing act

Investment Policy, August 2019

Market balancing act

The financial markets currently appear to be in a – not altogether secure – state of equilibrium. One positive aspect is the willingness of the world’s key central banks to cut interest rates. The persistent phase of economic weakness is a negative, however. Equity market valuations are once again on the expensive side, and global economic data must improve if these are to be justified. In addition, quarterly results in both the US and Europe will be important. Volatility is back at low levels, and the moment of truth is nearing.  

The main scenario factored in by the financial markets right now is a prolonged “ceasefire” in the trade dispute. But the markets continue to be in thrall to lower interest rates, seemingly disregarding the very real risks of new tensions between the US and China, as well as between the US and Europe (and indeed Iran). The leading indicator for global manufacturing activity declined further in June, and now points to a contraction in worldwide industrial production. The last time this indicator was in negative territory was back in 2012. Weaker order volumes and more restrained investment activity can therefore be expected to weigh further on global economic growth over the next few months. An important question now is whether the interest rate cuts anticipated by the market from the Federal Reserve – and possibly from the ECB too – will suffice to put the global economy back on a healthy growth trajectory. The theoretical answer to this question is yes – but has it really been excessively high interest rates that have undermined the global economy for the last six months or more? Have credit volumes and construction activity been shrinking, for example? No, interest rates have not been too high. The problem has been (and remains) the uncertainty gripping entrepreneurs in various industries with regard to the export picture going forward and the wisdom of making expensive investments. Three factors lie behind this uncertainty: structural breaks (“disruptions”), doubts over the seamless supply of components, and the obvious geopolitical and trade risks. 

Equities
The willingness of central banks to cut interest rates has been received positively, as such a step would reduce the refinancing costs of companies, which would in turn enable them to increase their debt levels, with the funds raised through bond issues then being available for share buybacks or dividends. By contrast, a negative development is the rise in valuations back to the peaks recorded in the spring, be it in terms of price/earnings ratios, 
price/book, or DCF valuations. In addition, it is also only reasonable to wonder if the markets have not been “overshooting” in their anticipation of rate cuts, given that they have already factored in a fall in the Federal Funds rate of no less than 100 basis points. This essentially reflects an expectation of severe recessionary risks by the interest rate and fixed income markets. Quite how this fits with a resurgence in valuations is a legitimate question. The renewed decline in implied volatilities, i.e. the very low market fluctuations expected (and priced in) by the market, appear to be a further argument in favour of a defensive stance in respect of equities. Against this backdrop, an equity strategy focusing on quality looks more reasonable than a strategy involving a high beta (i.e. higher risks), at least until the global economic data start to show a clear improvement.

Higher equity valuations require better economic data or higher corporate earnings.

Gérard Piasko, Chief Investment Officer

Bonds
Over the last few weeks, bond markets have benefited hugely from the prospect of interest rate cuts (above all on the part of the Fed), as well as from statements by the European Central Bank, which has now held out the prospect of even more negative interest rates or indeed a resumption of its bond-buying programme. Corporate bonds of lower quality have performed particularly well thanks to a narrowing of credit spreads. As it is quite possible that we will see exaggerated movements here, a focus on both quality and market liquidity would appear to be a wise approach in the world of fixed income too. Excessive exposure to long-dated bonds could prove very costly in the event of a scaling-back of market expectations of looser monetary policy on the part of central banks. Corporate bonds of high quality look more interesting, particularly in view of the dramatic slump in the yields of government bonds. Viewed globally, the volume of bonds offering a negative yield now stands at more than USD 13 trillion, an all-time high. 

Currencies
A striking feature of the currency markets at the moment is the still low implied volatility viewed in historical terms. This means that markets are expecting extremely 
low fluctuations in exchange rates, above all in the G7 currencies. This is attributable to the expectation of monetary easing of the Fed and the ECB. On the one hand, economic growth is stronger in the US than it is in the Eurozone, but on the other the US has the capacity to cut rates more than the Eurozone, as the Fed raised interest rates from around 0.25% to almost 2.5%. That said, ECB President Mario Draghi has made it clear that the ECB has no interest in a higher euro, a comment that swiftly earned a rebuke from Donald Trump. We believe that volatility in the currency markets will rise – not least because the Brexit problem cannot go unresolved forever. The recent strength of both the Swiss franc and the Japanese yen is evidence that traditional “safe haven” currencies are in demand against a backdrop of risk in a geopolitical picture.

Commodities
The ongoing tensions between Iran and the developed countries of the Western world, which have recently manifested themselves in attacks by Iran on Western oil tankers in the Persian Gulf, is fuelling uncertainties over oil supply. A combination of this factor and the production-cut extensions of OPEC and Russia is managing to keep the oil price relatively buoyant, despite the further rise in US production. The increase in international inventories triggered a price correction back in May. So in addition to geopolitics, the inventory situation will also play an important role over the next few weeks. Gold has increasingly been showing strength since May and asserting its function as a geopolitical “hedge”. From a technical perspective, consolidation is now called for, with any further advances probably requiring a phase of clear weakness on the part of the US dollar, particularly against the euro.
 

Gérard Piasko

Gérard Piasko

Gérard Piasko is CIO and head of the investment committee of private bank Maerki Baumann & Co. AG. Before he was for many years CIO of Julius Baer, Sal. Oppenheim and Deutsche Bank.

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This publication is intended for information and marketing purposes only, and is not geared to the conclusion of a contract. It only contains the market and investment commentaries of Maerki Baumann & Co. AG and an assessment of selected financial instruments. Consequently, this publication does not constitute investment advice or a specific individual investment recommendation, and is not an offer for the purchase or sale of investment instruments. Maerki Baumann & Co. AG does not provide legal or tax advice. In addition, Maerki Baumann & Co. AG accepts no liability whatsoever for the content of this document; in particular, it does not accept any liability for losses of any kind, whether direct, indirect or incidental, which may be incurred as a result of using the information contained in this document and/or arising from the risks inherent in the financial markets.

Editorial deadline: 22. Juli 2019

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