Developments in equity markets during the period
The start of this six-month review period featured a solid upturn in the equity markets after the summer 2015 slump. In October 2015, the MSCI AC World index gained almost 8% in US dollar terms. It then traded mostly directionless for two months before diving in early 2016 and then rebounding strongly. Global equities finished the six-month period in positive territory (the MSCI AC World Index up by 4.4%) with a slight outperformance by emerging markets, the MSCI Emerging Markets index finishing up by 5.7% in USD terms. The gains were chaotic to say the least, with share prices mainly tracking monetary policy expectations and decisions in Europe and the US, as well as oil price trends. Investors pondered these factors as concerns mounted over the health of the global economy, including doubts on the Chinese authorities’ ability to nudge growth to a more consumer-driven model and away from a solely investment-driven one.
Exhibit 1: Changes in the MSCI AC (All country) World Index for the period from 30/10/16 through 28/04/16
Source: Bloomberg, as at 28 April 2016.
The major global markets were hit by fallout from drops in local share prices and currency adjustments, with index volatility spiking several times in February and returning to levels not seen since last summer. Although implied volatility, as expressed by S&P 500 options (the VIX) then receded from 28% in February to 13% at the end of the six-month period, the markets continued to switch back and forth between steep gains and steep losses. This reflected investor nervousness and some scepticism over whether the equity rally was sustainable. The new bout of weakness that sent oil prices down from about USD 45/bbl (in the case of West Texas Intermediate (WTI)) to USD 26/bbl in February 2016, squeezed share prices by backing the assumption of a slowdown in global growth. However, this overlooked the geopolitical issues behind the fall in oil prices, i.e. Saudi Arabia’s determination to oust oil producers having far higher production prices. Ultimately, this factor was priced in – when the oil price threatened to fall below USD 25/bbl, negotiations between Saudi Arabia and some of its partners provided reassurance. This triggered an equity rally that nonetheless petered out as the oil price levelled off under USD 40/bbl in March.
Exhibit 2: Change in the price of crude oil (West Texas Intermediate) during the period from 30/10/15 through 28/04/16
Source: Bloomberg, as at 28 April 2016.
The other major theme on equity investors’ minds was major central bank action. When the banks were resolutely accommodative in reacting to an uncertain global economy and, above all, the rough ride being experienced by financial markets in early 2016, equity markets reacted rather timidly. The exceptional easing measures in Japan (in late January) and the eurozone (in March), and the Fed’s insistence that the normalisation of its key rates would be very gradual all failed to trigger a sustained rally, as investors had doubts on both the relevance of the decisions that had been made and on the remaining margin for manoeuvre. On the microeconomic front, corporate results were rather disappointing, reflecting the environment of anaemic growth and very low inflation, while mergers and acquisitions, which were quite common during the autumn, had less influence on trading thereafter.
The major US indices outperformed their developed market peers by far (+7.3% by the S&P 500). Eurozone markets were hit in early 2016 by concerns over banks and by the stronger euro late in the review period, with the EuroSTOXX 50 losing 3.1%. The Nikkei 225 (-3.6%) was dragged down by a stronger yen. The rally in commodity prices beginning in February provided support for markets in Latin America and emerging Europe, which thus outperformed emerging Asia.
Change in monetary policy during the period
In October, the US Federal Reserve (Fed) shifted its guidance to get investors used to the idea of a December rate hike. Officials reiterated their confidence in the economic scenario despite a dip in industrial activity. Economic data released at the same time provided undeniable support and, after the year’s last meeting, Fed chair Janet Yellen was able to announce the end of the zero-interest-rate policy without triggering turmoil on the financial markets by recalling that, even after this (25bp) rate hike, which sent the fed funds target range to 0.25%-0.50%, monetary policy remained highly accommodating. The Fed then chose the status quo, with Janet Yellen pointing to more uncertain global economic and financial trends, while in the US, the jobs situation continued to improve and the real-estate market remained solid, despite economic indicators that were slightly more disappointing than in early 2015.
Yellen’s decision was probably partly guided by the lower expectations on key rate hikes as priced into fed funds. While financial markets went through a phase of heavy turmoil early in the year, the Fed chair sought to avoid adding to the confusion by making a decision that could have surprised market participants. A few days after the 15-16 March FOMC (monetary policy) meeting, whose findings had seemed highly conservative, several members hinted that it would be appropriate to rapidly restart the process of normalising key rates, pointing in particular to the acceleration in inflation. More than a revolt against Janet Yellen, these comments demonstrated a determination to shift expectations and correct the impression left by the median fed funds rate considered appropriate for the end of 2016. This forecast was lower than after the December FOMC meeting and now points to just two 25bp rate hikes this year, which is modest even for a mere “normalisation” and at a time of growth.
The six-month review period began in fanfare, with Europan Central Bank (ECB) president Mario Draghi hinting in October that aggressive measures would be announced in December and maintaining that expectation throughout November. On 3 December, the ECB came up short of expectations by choosing to lower its deposit facility rate by just 10bp to -0.30% and to extend until “March 2017 and longer if necessary” securities purchases under its quantitative easing (QE) plan.
Since March 2015, securities (including inflation-linked bonds) issued by supranational agencies and national governments were added to covered bonds and asset-backed securities (ABS), which had been bought since autumn 2014. As early as January, Mario Draghi reiterated that the ECB was ready to act “if turbulence on the financial markets or weak energy prices contributed to a reduction in inflation expectations in the eurozone” and, in March brought out the “bazooka” in announcing a cut in all key rates (with the main refinancing rate at 0%, the marginal lending facility at 0.25% and the deposit facility at -0.40%) and a EUR 20 billion increase in monthly asset purchases to EUR 80 billion. Corporate bonds issued by investment–grade, non-banking companies “established” in the eurozone will be eligible for this programme beginning from the end of the second quarter. Lastly, to boost the transmission of monetary policy to the real economy, new targeted long-term refinancing operations (TLTRO II) will be offered beginning in June, maybe even at negative rates (as low as -0.40%) if conditions are met regarding the amount of loans granted to the private sector. This decision was driven by the risk of sustained low inflation and lower inflation expectations, and it could be followed by other announcements, as the ECB still intends to “raise inflation as quickly as possible”.
Events in G3 bond markets during the period
As the six-month review period began, the 10-year US Treasury-note yield was driven up considerably by the emergence of anticipations of a Fed key rate hike in December, rising above 2.30% in early November (from 2.03% at the end of September), in reaction to a solid jobs report on 6 November. Thereafter, with expectations firming up, it traded until January in a rather narrow range of 2.10%-2.30%, which appeared to properly price in the improvement in US economic data. The Fed’s 16 December meeting had no notable impacts on the long section of the curve but drove up two-year yields to above 1% by the end of 2015, a high since spring 2010, due to expectations of a further normalisation of monetary policy in 2016.
Exhibit 3: Changes in the yield of the 10-year US Treasury note during the period from 30/10/15 through 28/04/16
Source: Bloomberg, as at 28 April 2016.
In reaction to equity market turmoil beginning in January, a flight to safety drove gains in government bonds, as did the marked decline in expectations of Fed key rate hikes. The US 10-year T-note yield thus fell to 1.66% on 11 February, a one-year low. The oil price rally beginning on this date triggered a correction of the steep slide in equities. Long US bond yields then tracked Fed comments and expectations of coming monetary policy initiatives. The 10-year US Treasury-note yield moved back towards 2% on the day before the 15-16 March FOMC meeting before turning back down, due to a speech by Janet Yellen that was more accommodating than expected. However, this pullback was shaky and short-lived, due to an acceleration in inflation, rather good economic indicators and words from several FOMC members recalling that the normalisation of key rates was still on the agenda. The 10-year T-note yield ended at 1.77%, down 26bp in six months.
In the eurozone, government bond prices reflected monetary policy decisions and expectations of those decisions on both sides of the Atlantic. The 10-year Bund yield moved from 0.59% at the end of September to a 0.45%-0.70% range until the end of 2015. The lower end of this range was hit after a highly accommodating speech by Mario Draghi on 22 October, and the upper end was hit after the rise in US long yields followed by disappointment caused by the ECB announcements on 3 December, which were well below the expectations that the central bank had itself stimulated. Note that upward pressures on yields are probably due to profit-taking after the 10-year Bund slipped below 0.50%.
Since the start of 2016, declines in German Bund yields have been accentuated by expectations of a new move by the ECB after Mario Draghi’s comments on 21 January promising to “reconsider” monetary policy at the 10 March meeting. Coming on top of the early-year equity market slump, doubts on the economy, and eurozone inflation slipping back into negative territory, these expectations sent the German 10-year yield from 0.63% at end-2015 to 0.11% on 29 February, just above its April 2015 low. For bonds up to nine-year maturities, the German yield curve ended up in negative territory. Trends were a little shaky in March. Amid profit-taking and in the wake of long US bond yields, the 10-year Bund yield moved back to 0.30%, where it more or less held steady until 16 March. A few days were needed to “digest” the ECB’s 10 March announcement of a key rate cut and an increase in monthly securities purchases. The 10-year Bund yield turned down once again, ending at 0.15%, a 44bp decline in six months. Italian and Spanish yields pulled back by 31bp and 36bp, respectively. This slight underperformance is due mainly to risk aversion in early 2016, which led to a widening in peripheral spreads vs. Germany.
Developments in G3 currency markets during the period
Monetary policy adjustments, particularly in the US and the eurozone, triggered heavy volatility on the forex markets, with peaks in volatility to levels not seen since 2011 in the currencies of both major developed and emerging economies. In the case of emerging economies, this nervousness resulted mainly from the prospects of a Fed key rate cut, which was likely to send capital flowing into those emerging economies. The actual rate hike in December had only a slight influence on forex markets. Producer-country currencies tracked shifts in commodities, oil in particular, first downward, then upward.
In light of the ECB’s highly accommodating policy and the start of normalisation in the US, a weakening in the euro vs. the dollar was to be expected. And yet, after trading within a very broad range, the euro gained 2% to end the period at 1.1387 dollars. In October it even moved over 1.14, as many market participants were by then convinced that the Fed would not raise its key rates before the end of 2015. The euro bottomed out for the six-month period at 1.0565, just before the December ECB Council of Governors meeting and after an almost uninterrupted slide. Mario Draghi’s 22 October comments followed by the month-end FOMC meeting, after which the Fed’s determination to move into action before the end of 2015 emerged clearly, sent the exchange rate under 1.06 in late November. Measures announced by the ECB in December fell short of investor expectations and the euro embarked on a chaotic rally to almost 1.14 in late March (after a dip below 1.09 in late February). The March announcements did not disappoint, but some observers deemed this the ECB’s last rate cut, while the Fed is giving the impression of wanting to delay the normalisation of its monetary policy.
Exhibit 4: Change in the exchange rate of the euro versus the US dollar (number of US dollars per euro) during the period from 01/10/15 through 31/03/16
Source: Bloomberg, as at 29 April 2016.
The USD/JPY traded mostly directionless within a broad range (117-124) until January, with shifts not truly indicative of investor convictions, while the Bank of Japan (BoJ) maintained uncertainty on whether or not it would stick to its yen-weakening policy. The surprise rate cut announced in late January (with the adoption of a negative rate) had a very temporary impact on the exchange rate. On the contrary, it settled quickly into a 112-114 range and ended the six-month period at 112.36, vs. 119.74 at end-September 2015. The 112 threshold had not been hit since October 2014. In six months the yen gained 6.6% vs. the dollar even as the BoJ was hinting that new measures were possible to ease monetary policy.
Exhibit 5: Despite the BoJ’s introduction of negative rates on 29 January 2016, the Japanese yen has rallied versus the US dollar (graph showing number of Japanese yen per US dollar for the period from 01/10/15 through 31/03/16)
Source: Bloomberg, as at 29 April 2016.
Economic indicators continue to send out mixed signals on the global economy. Investors are tending to home in on the least encouraging signs and are worried about growth that is showing no signs of accelerating despite highly accommodating monetary policies. One theme likely to trigger new financial turmoil – or at least rein in the appetite for risky assets – is the lack of effectiveness of monetary policies. Concerns are also emerging on the ability of companies to generate sustained profits in this environment of low growth and weak inflation. And, lastly, after the sharp run-up in WTI from USD 26/bbl on 11 February to USD 40/bbl in March, the rally ran out of steam. Stabilisation around USD 40/bbl is not bad news, but the increase in the oil prices was a major factor in the equity rally of recent weeks. Unless new catalysts emerge, the equity market rally could peter out in the short term, as it did in the second half of March. From 1 to 14 March, the MSCI AC World gained 5.5% and then 1.6% during the two following weeks. Investors’ lack of conviction in the economic scenario and doubts on the relevance of current monetary policies (e.g. the effectiveness of additional measures, margins for manoeuvre in the eurozone, and the normalisation of US rates) could further cloud the analysis. The rise in the terrorist threat and the accumulation of political uncertainties are likely to maintain investor nervousness.