Following a volatile last few months, we foresee a pause and potentially a reversal in some of the prominent trends. In particular, we expect US Treasury (UST) yields and the US dollar to stabilise in the near term. Here, we discuss these developments in more detail as well as the asset allocation implications.
Our sense is that UST yields have already priced in good news in terms of growth, inflation and monetary policy tightening by the3 Federal Reserve. By contrast, growth in the eurozone economy has slowed, but the ECB has signalled its intention to end its asset purchase programme by the end of 2018, even if it does not expect to raise interest rates until well into 2019.
After the recent rally in US yields and the US dollar, we think enough news has been priced in that we could see at least more stable UST versus German yields and a firmer US dollar versus the euro (see exhibit 1).
Exhibit 1: Higher EUR-USD differentials should help stabilise the USD
Source: Bloomberg, BNP Paribas Asset Management, as of 20/06/2018
A stronger US dollar has been the main reason for the underperformance of emerging market (EM) assets since April. A weaker US dollar should therefore help stabilise EM currencies and EM local debt (see exhibit 2). Two additional factors that should support EM currencies are the restoration of EM rate differentials as EM central banks raise interest rates or sound more hawkish (see exhibit 3), as well as the fact that growth and external fundamentals are stronger than five years ago when growth in China was slowing rapidly, commodity prices were in a bear market and countries such as Brazil and Russia were in recessions.
Exhibit 2: A USD stabilisation should help EM debt local currency
Source: Bloomberg, BNP Paribas as of 15/06/2018
Exhibit 3: EM central banks are turning more hawkish to defend their currencies
Policy rate adjustment in EM since Dec 2017 (%)
Source: Haver, BNP Paribas Asset Management, as of 12/06/2018
Another trend that is experiencing a reversal concerns crude oil. Crude was one of the few risky assets that were making a 20% plus profit this year. But as we explained in our June Asset Allocation monthly, too much good news on demand, supply and geopolitics was priced in, in our view. We think the reversal has further to run as the OPEC producers cartel is making noises that suggest that it is willing to increase supply following downside surprises in production from Venezuela, Angola and, potentially, Iran. Lower or more stable oil prices should help stabilise US breakeven inflation and therefore UST yields (see exhibit 4).
Exhibit 4: US inflation breakevens eased as a result of lower crude prices
Source: Bloomberg, BNP Paribas Asset Management, as of 15/06/2018
Conclusion and asset allocation views
Despite trade tensions and more volatile markets than in 2017, our base case asset allocation scenario remains bullish on equities. We are maintaining our long equity position, with a preference for eurozone equities where we see attractive valuations and earnings growth prospects.
We identified several reversal themes in June:
- Crude oil has likely reached a peak as too much good news on demand, supply and geopolitics was priced in.
- US-German fixed-income spreads look stretched as the ECB intends to end its asset purchases by year-end, while US rates are pricing in a robust US economy and a gradual US tightening cycle by the Fed. We expect US rates to rise gradually longer term but we believe euro core rates have more room to surprise to the upside shorter-term.
- EM local debt should find support after the recent selloff triggered by higher US yields and a stronger dollar. We think that a more stable US dollar and stable UST yields should alleviate the pressure on EM local debt.
The main risks to our base case scenario stem from an inflation surprise or an escalation of trade tensions that could lead to a global economic slowdown.
Our market dynamics analysis (technical dynamics analysis, financing conditions, market dynamics indicators, liquidity monitoring) had already flagged a change in the environment early in 2018, suggesting a more febrile market. In this context, we are maintaining our positive view on risky assets in the next few months, while we continue to monitor market movements closely.
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