The way financial markets have moved over the past three months is a good example of the new and more challenging environment (Exhibit 1). Equity performance was mixed with positive returns in the eurozone, followed by the US, and EM equities trailing with negative returns.
Markets have experienced some difficult cross-currents
Another notable move has been the rally in the crude oil, up by more than 4% in the last three months. Interestingly, the rally was not derailed by a stronger USD. The gains in the USD and rising UST yields versus German yields reflect stronger US economic prospects relative to those in the eurozone. These trends were exacerbated by the escalation of political turmoil in Italy.
Exhibit 1: Mixed cross-asset performance in the past three months as markets digested various macro risks
Source: Bloomberg, BNP Paribas Asset Management, as of 18/06/2018
The other notable market development over the past three months was the sell-off in EM currencies against the USD. Rising UST yields and the stronger USD hurt the EM complex, notably EM currencies, as investors unwound long positions in EM equities and debt. The external vulnerabilities of economies such as Turkey and Argentina exacerbated the move.
Another reason why markets, notably EM, have been more jittery is the escalation of trade tensions between the US and China. In the last few days, the US announced that it is considering increasing tariffs on USD 200 billion worth of Chinese imports. Chinese authorities have responded that they are ready to retaliate with comprehensive measures.
Macro and risk environment – still constructive
Our central macroeconomic scenario is one where global growth remains robust and inflation contained. We refer to this as a ‘Goldilocks’ environment. This is also consistent with the Fed removing monetary stimulus gradually and other central banks starting to normalise monetary policy, notably the ECB.
We expect risky assets, notably equities, to do well as global economic growth supports corporate earnings growth, while monetary policy remains generally accommodative. Our conviction is mainly in eurozone equities where we see room for earnings growth to catch up with the economic cycle and where demand strength should help profit margins to expand further (see exhibit 2).
Exhibit 2: Eurozone earnings growth looks too low compared to activity levels that remain elevated
Source: FactSet, IBES, Markit, BNP Paribas Asset Management, as of 21/06/2018
We also have a long equity risk exposure in Japan and in US banks. In Japan, we expect earnings growth to be stronger than the consensus. US banks should benefit from a maturing growth cycle and from higher interest income as we expects interest rates to rise further over the long run (see exhibit 3).
Exhibit 3: US banks should benefit from rising yields
Source: Bloomberg, BNP Paribas Asset Management, as of 21/06/2018
As we expect inflation to remain contained in the developed world and central banks to normalise policy, we are underweight fixed income. We express this view by being underweight EMU duration.
The macroeconomic backdrop of robust growth and contained inflation should remain supportive of risky assets, but we are aware of market fragilities that have already been flagged by our analysis of financial market dynamics.
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