It’s been a very solid start to the year. The “risk” dial has been turned down and investors seem happy to be in the momentum trade. The Q4 earnings season is underway and the optimists will point to the strength of the results from the large American banks as a sign of confidence. While perhaps unpalatable to some, if the banks are doing well then surely the economy is in good shape. In the UK, we expect the Bank of England to cut rates soon, catching up with monetary policy moves from the Federal Reserve and the European Central Bank that were made in 2019 when the UK was still struggling to avoid a hard Brexit. This should help the UK economy and there are already signs that the residential housing market is enjoying a “Boris bounce”. For the foreseeable future, investors just need to sit back and watch to see if the economic data and corporate earnings respond to the improved global sentiment. Market pricing is expecting a lot.
UK and Euro rates
The gap between the Bank of England’s (BoE) key policy rates (Bank Rate) and the European Central Bank’s (ECB) key policy rate (deposit rate) has, since last September, been at its widest since the great financial crisis of more than a decade ago. The current bank rate sits at 0.75% while the Euro deposit rate is at -0.5%, a gap of 1.25% compared to 0.90% at the time of the UK referendum on EU membership. Shortly after that event, the BoE reduced the bank rate but then proceeded to increase it twice – in late 207 and mid-2018 – as sterling bore the brunt of the risks associated with the UK crashing out of the European Union. The need for that risk premium has become much reduced. With a certain irony, the day before the UK officially leaves the EU is likely to see sterling and euro rates take a little step towards renewed convergence. A BoE rate cut appears to be a significant probability at the monetary policy committee on January 30th, bringing the sterling-euro rate gap back down to 1.00%. The move would reflect the catching up that the BoE needs to do relative to the Federal Reserve (Fed) and the ECB in response to the slowdown in global growth over the last eighteen months as well as the reduced risk premium associated with a hard Brexit. It would also align UK and Euro rates more with the relative fundamentals. The current inflation differential between the UK and the Euro Area inflation rate is just 30bps and consensus economic forecasts don’t have the gap moving much away from that this year. Real GDP growth forecasts, according to the Bloomberg consensus, are 1.1% for the UK and 1.0% for the Euro Area. With that backdrop in mind you would expect that both sides will work very hard to achieve the least disruptive agreement for the future trading relationship.
Expectations of the UK rate cut have accelerated since the beginning of the year, the result of dovish comments from a number of the members of the monetary policy committee and the release of some disappointing output and inflation data for the UK. This has propelled an outperformance of UK bonds. Just since the start of the trading year, the yield on the 10-year UK gilt has fallen 17 basis points (bps) compared to just 2bps for German bunds and 6bps for French OATs. At the front-end of the yield curve, UK rates are down 7bps (2-yr gilts) compared to an increase of 3.8bps in France and 2.1bps in Germany. The gap between 10-year UK and Germany is now 85bps compared to 120bps back in September when bond markets peaked. Gilt yields did trade through German yields way back in 2000 when Germany was bearing the brunt of concerns about the introduction of the single currency in Europe but since then UK yields have always been below German. That is likely to remain the case given lower short-term rates in Europe, a higher debt-to-GDP ratio in the UK and the likelihood of more borrowing in the UK given the expected increase in government spending to come in the March budget. However, momentum could reduce the gilt-bund gap even more in the short-term, depending on the tone of the Bank of England’s communication if it does cut rates in a couple of weeks’ time. The UK economy may well have been impacted by the uncertainties over Brexit for the last three years but Germany has been hit harder by the global industrial downturn. It grew by just 0.6% in 2019 compared to an estimated 1.1% for the UK. If the global consensus view of a rebound in the manufacturing cycle is right, the rebound in German growth is likely to be more obvious than any acceleration in the UK. After all, there remains some uncertainty in the outlook. In this scenario, German bund yields should revisit the zero percent level and may even turn slightly positive. In the big picture these are modest moves and any relative outperformance of gilts or bunds is only going to be interesting for government bond fund managers. The more important picture, perhaps, is that bond yields aren’t likely to go lower any time soon and the UK will exercise its option to follow what other central banks have done. That in turn should help brighten the economic outlook for the UK, especially with some fiscal boost from March onwards. On the credit side, UK corporate bonds have also outperformed so far this year and, with a premium of 130bp in the 5yr-10yr part of the credit curve, sterling still looks a better bet for credit investors.
Monetary stimulus is significant
The complexities of the relationship between monetary policy, financial asset prices and the real economy should never be underestimated. Textbooks tell us that lowering interest rates stimulates the demand for credit which expands the money supply and increases either investment or consumer spending. Today, interest rates are less effective a tool in terms of managing the credit cycle, a process that arguably began in the early 1990s and accelerated after the financial crisis. Today, central banks need to rely on a broader set of policy measures including forward guidance (i.e. the promise to keep rates low for a long time or until a certain set of macroeconomic conditions are met) and balance sheet policy. The current bullishness in markets partly rests on the view that a suite of tools employed by central banks has the combined effect of boosting credit and money growth and that in turn should sustain this economic recovery. That is factored into asset prices – the forward guidance of low rates for a long-time is keeping interest rates low across the whole spectrum of maturities, central bank asset purchases are generating liquidity and asset prices are responding. What markets need is for all of this to show up in better data and better corporate earnings.
But earnings need to respond
At the time of writing around 38 out of 500 S&P companies had released Q4 2019 earnings. The surprise index was modestly positive with more reports beating estimates than not. The big financials have been particularly strong, which is not surprising given the buoyancy of markets and the heightened opportunities for trading in 2019 (the upside surprises have been strong so far in the financials). Only a few consumer related companies have reported but so far earnings have mostly beaten estimates. I am not sure at this stage that we can come to many conclusions, at least not until some of the bigger industrials and tech companies have reported. But there is an argument to suggest that earnings do need to surprise on the upside by a material amount given where equity prices are today. The S&P is currently trading on 19 times the level of estimated earnings per share for the next year. That earnings estimate number has been moved up but actual results need to be at least consistent with that to prevent the market from becoming too expensive and, obviously, vulnerable to some sought of quick ratings adjustment. A bullish view would take the argument that given where bond yields are today and given the average difference between the S&P equity earnings yield and the yield on Treasuries, the market is rich but not as overvalued as it has been at times in recent years. Still, the ability of US companies to generate earnings growth in a world where overall GDP growth remains soft is key to sustaining equity market performance in the US. With rising unit labour costs and the fading impact of the 2018 tax cuts, this may prove to be difficult unless growth surprises to the upside in the quarters ahead.
Momentum and technical trump valuations for now
The investment teams I work with use a simple framework to help guide their overall market outlook, assessing the impact of macro trends, valuations, investor sentiment and technical factors to come to a view on expected returns over a certain investment horizon. For fixed income markets these views have just been updated and the conclusions are in line with recent comments that I have made in these notes. The macro outlook is cautiously optimistic with cyclical data expected to be a bit stronger in the first half of this year in response to a reduction in uncertainty around trade and Brexit. This view is starting to be seen in some of the economic data. This week we had data from the US showing continued health in consumer spending (retail sales in December were slightly ahead of expectations) and an improvement in a couple of the regional Federal Reserve surveys of manufacturing activity. In general our assessment of the macro outlook suggests that credit markets should remain well supported as the environment is positive for corporate fundamentals in both developed and emerging economies. Indeed, it is in emerging markets where the delta on the macro outlook is the strongest given some of the weak outcomes to growth in selected emerging economies over the last couple of years (Brazil, for example, is forecast to grow by 2.2% this year after an estimated 1.1% in 2019). What makes our portfolio managers a little hesitant is clearly the level of valuations. Credit spreads are tight, risk-free rates are low. Yet the ultimate comparison – risk-free short term interest rates – unattractive. The gap between the yield on an index of US high yield bonds is still 340bps above Libor, in Europe the similar metric is 290bps, almost 100bps above the previous low of 197bps seen in late 2017. One of the factors keeping markets tight is the strength of demand for fixed income. Part of this is the side-effect of quantitative easing and central bank liquidity provision and the associated search for yield. Another is the ongoing strength of demand from pension funds and insurance companies, particularly for longer-dated high quality credit.
Long credit still, but…
Overall the view is still quite favourable for credit markets but with a more cautious approach to the actual level of risk given the valuation set-up. The one thing that gnaws at me is the overall impact of what central banks are doing. In aggregate, central bank balance sheets are growing as a percentage of GDP. This is also encouraging a growth in outstanding debt. During 2019 the outstanding face value of investment grade credit markets rose by between 4% in the US and 14% in Europe. Government debt outstanding is also rising with 2019 seeing an almost 8% increase in the face value of US Treasury debt. This debt growth is in excess of the nominal growth of global GDP. Debt ratios are thus rising. This may be an intended consequence of QE but it also raises concerns about balance sheets and leverage going forward. Nothing to worry about immediately, but should there be a downturn in growth again, credit concerns will quickly mount.
Cautiously (illogically?) optimistic
Watching Manchester United these days can be painful, the team is clearly lacking creativity in midfield and is prone to disaster in defence. The forward line is strong but does not always fire. Yet, stepping back, I think there is some progress. The team sits in 5th place in the Premier League, is still (just) in the semi-final of the League Cup, has progressed in the FA Cup and is in the last 32 of the Europa League. Any trophy would mark a successful season – a top four premier league place and a trophy would be amazing. A big week lies ahead with Liverpool on Sunday (United are still the only team to take any points off Liverpool this year) and the second leg of the League Cup semi-final next week. I am hoping for one or two new arrivals before the transfer window closes – preferably midfielders – but am genuinely excited about the prospects for many of the young players in the team. Ole is building and hopefully he will be given time to achieve a strong, youthful squad ready to fight for the title in the next couple of years. So like my economic and market view, modest optimism prevails!(with the option-hedge to change my mind quickly should results disappoint and call for the immediate dismissal of the coach).
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