The repercussions of the numerous events that occupied investors’ attention in May were not manifest in the performance of many financial markets.
The MSCI AC World index, for example, ended the month down only slightly (-0.2% in US dollar terms) after rallying until mid-month and then moving more erratically for the rest of the month.
A tale of two halves - Goldilocks...
The first half of May featured a slowing of inflation, still-solid economic data (particularly in the US), and reassuring news on Sino-American trade negotiations.
This combination of good news sent indices of implied volatility for both the S&P 500 and the EuroSTOXX 50 equity benchmarks to their lowest since late January. Crude oil prices rose early in the month to their highest since late 2014, as several factors pointed to reductions in supply.
... morphs into Alice in Wonderland
The performance of many financial markets in the second half of May appeared to reflect an entirely different reality.
First of all, oil fell. An increase in US inventories and OPEC comments about a possible easing of production quotas sent prices to below their late-April levels (USD 67/bbl for WTI).
On the geopolitical and trade front, US President Donald Trump appeared unpredictable: on 24 May, he announced the cancellation of the summit with North Korea before saying the very next day that it was back on.
Prior to this, he had backpedalled on the trade ‘truce’ with China announced on 20 May, saying that he still wanted to limit Chinese imports and investments in the US.
Trade relations with the EU worsened as the end of the exemption on aluminium and steel tariffs approached.
Finally, more than three months after the legislative elections, the Italian political imbroglio undermined equity performance, turnign into the month’s major event.
Volatility rose again at the end of May
Exhibit 1: Volatility on S&P 500 and EuroSTOXX 50 equity indices (weekly data as of 01/06/2018)Source: Thomas Reuters, BNP Paribas Asset Management, 01/06/2018
Cyclical sectors hold up; emerging markets lag
Over the month, the EuroSTOXX fell by 3.7% and the Nikkei 225 lost 1.2%, but the S&P 500 chalked up a 2.2% gain (in local currencies). Emerging market equities fell by 3.8%, due to both the stronger US dollar and to country-specific issues (Turkey and Argentina).Exhibit 2: Equity indices in US dollar terms Source: Bloomberg, BNP Paribas Asset Management, as of 01/06/2018
Within developed financial markets, the eurozone underperformed as "euro risk" resurged, triggered by the political crisis in Italy and as banks, which make up a large part of many indices, fell sharply.
By contrast, most cyclical sectors held up well, which suggests a certain amount of confidence in the economic outlook.
Japanese stocks were hurt by the yen’s appreciation as it assumed its safe-haven status in the second half of the month. The latest company earnings reports were mixed, economic figures disappointed, and support for Prime Minister Abe remains shaky.
US cyclicals (industrial and techn stocks and consumer cyclicals) outperformed, and small caps did well. Telecommunications and utilities fell despite the pull-back in long bond yields in the second half of May.
A roller-coaster ride for eurozone bond yields
At the start of May, the 10-year Bund yield tracked long US bond yields higher from 0.56% to 0.64% on 17 May. It then pulled back as events in Italy pushed German bonds into their safe haven role, falling as low as late 2017 levels. Investors nervousness rose gain after news of a motion of no confidence in the government of Mariano Rajoy in Spain.
'Peripheral' eurozone markets, which had held up well until April, fell sharply on the political news from Rome. The 10-year BTP yield spiked to almost 3.20%, a high since May 2014. The risk premium over German sovereign debt of similar maturities widened to 290bp, a level not seen since the summer of 2013, but still below the July 2012 peak of 525bp, when Mario Draghi said he would do “whatever it takes” to save the euro.
Spanish bond yields rose by much less, but did price in some nervousness on European issues.
These concerns receded at the very end of the month, allowing the 10-year yield to pull back to 2.79% in Italy (still up by 100bp over the month) and to 1.50% in Spain (up 22bp). The Bund yield ended at 0.34%, down by 22bp compared to its level at the end of April.Exhibit 3: Risk premia for Spanish and Italian sovereign debt relative to German Bunds Source: Datastream, BNP Paribas Asset Management, as of 01/06/2018
Financial markets: keep calm and carry on
Recent weeks have been nerve-wracking for investors. The return of geopolitical and, especially, political risk has affected asset prices, but it would be an overstatement to view this as across-the-board bearishness.
Investors appeared to have changed their views in recent weeks on issues such as oil prices, the USD/JPY pairing, and the yield of US long bonds. While technical factors have no doubt played a part, investor attitudes perhaps also reflect a certain confidence that the current environment is sustainable.
For one thing, global economic conditions have remained favourable and central banks are sticking to a rather accommodative line. Despite the uncertainties, we believe there is no real reason for a radical change to this scenario or to market exposures.
So far this year, investors have managed to keep their cool while dealing with, either in turn or simultaneously, inflation risk, the threat of a trade war, geopolitical issues, signs of weakness in eurozone activity, the likely widening of the US fiscal deficit and, now, new political concerns.
In our view, this stiff upper lip is a good sign for equities, especially as there is still a lot of cash in search of opportunities and there are relatively few obvious candidates.