As in January, market expectations for a generally dovish monetary policy stance were the main reason for investor appetite for risky assets in February. With central bankers taking their foot off the policy tightening pedal, the equity-favourable environment ran another lap.
- Widespread gains seen in equities, defying any profit-taking pressures
- Perceived headway on Sino-US trade talks gives sentiment a further boost
- Global economic backdrop not better or worse, allowing the party to continue
- Dovish language from the Fed and the ECB helps keep bond yields low
- Nervousness looms, especially if the hopes that have driven equities are dashed
To infinity and beyond?
The global equity rally continued into February (with the MSCI AC World index up 2.5% in US dollar terms), albeit at a far slower pace than in January. The MSCI AC World index gained 10.5% in the first two months of the year, which is remarkable, given how ripe the markets seemed to be for profit-taking after their January rally (+7.8%).
All developed markets took part in the February gains, and other risky asset classes (corporate bonds in particular) also finished the month in positive territory. Gains were not as robust on emerging markets (+0.1% for the MSCI Emerging in US dollar terms), as they were dragged down by Latin American markets and currency movements (in particular in Argentina, Brazil and Mexico). Emerging Europe markets also slowed, but less so. In contrast, Chinese equities rode the lull in the US-Chinese trade conflict, official Chinese stimulus measures, which are beginning to pay off, and the prospect of broader inclusion of A-shares in international indices. This led to outperformance by emerging Asian equities on the whole.
Exhibit 1: Chinese equities rising since the start of 2019
President Trump reported “very good talks” between Chinese and US trade negotiators with “substantial progress”, and announced that he was postponing the 1 March deadline for raising customs tariffs further. Equity markets as a whole rode this perceived headway on the trade dispute. The global equity rally was led by the outperformance by tech stocks (both software and hardware) and industrials, while consumer, financial and telecommunications stocks underperformed. US (S&P 500) and Japanese (Nikkei 225) equities gained 3.0%.
The Tokyo market rode a weaker yen (-2.3% vs. the US dollar), which provided a boost to export-intensive companies, and share buybacks by major companies. In Europe, eurozone equities (EuroStoxx 50) gained 4.4%, almost the same as the Stoxx Europe 50 (+4.6%), while in the UK, the FTSE 100 underperformed. In the eurozone, the banking sector was driven up by the outlook for new ECB targeted long-term refinancing operations. The reporting season has been mixed on the whole, with moderate increases in earnings growth and conservative guidance for the next few quarters.
Exhibit 2: Q4 2018 drop already forgotten (data as of 28/02/2019)
Data as of 28/02/2019
Central banks playing it safe
As was the case in January, monetary policy expectations are the main reason investors are so keen on risky assets. In serving notice that they do not want to rush monetary tightening of normalisation, central banks have offered investors a seemingly pro-equity environment for a little longer than expected. The US Federal Reserve in particular is hinting that it will tolerate (and even encourage) inflation that exceeds its target and announced that it would keep its tightening cycle on hold with regards to key rates, which are now close to what it considers neutral. Everything appears to be falling into place to suggest that the Fed prefers to proceed gingerly by putting its key rate tightening cycle on hold as the international economic outlook is now less clear-cut.
In contrast, the breakeven rate on inflation-linked bonds rose from 1.70% at the end of 2018 to 1.95% at the end of February. Several Fed members warned of the dangers incurred by excessively low inflation expectations, and Jerome Powell pointed out during his Congressional testimony that inflation expectations are the main factor driving inflation. The possibility that the Fed could tolerate inflation above the 2% target for an extended period of time – to “offset” recent years, during which it has been below target – explains the trends in recent weeks on the TIPS (Treasury Inflation-Protected Securities) market. Higher oil prices in February (with WTI up 11.2% on the month) may have played a role in short-term fluctuations. However, as oil prices were higher in early 2018 than currently (at about USD 65/bbl. vs. less than USD 55/bbl on average so far this year), a negative basis effect is why inflation fell year-on-year in January (to 1.6% vs. 1.9% in December).
Exhibit 3: US inflation expected to rise again
The global economic environment has not improved, but nor is it showing any serious signs of a recession occurring any time soon. There is now a broad consensus that economic activity is slowing down. The latest indicators had some good surprises in store, including fourth-quarter US GDP growth that was more solid than expected, and some less good surprises, such as flat GDP in Germany, sluggish growth in the UK and the eurozone, and a contraction in the Italian economy. Investors appear to be so convinced that risks are on the downside that they are generally cheering the lack of bad news, for example on the political front.
The ECB’s wait-and-see stance is justified by the lack of any upward movement in inflation (1.4% year-on-year in January, with core inflation at 1.1%) and by the fact that economic indicators are not pointing to any clear improvement in activity after an increase of just 0.2% in GDP in the fourth quarter (due to stagnation in Germany and a contraction in Italy). The flash composite purchasing manager index (PMI) of the manufacturing and services sectors rose only slightly to 51.4, which points to weak GDP growth. In reaction, the ECB has hinted at a new round of targeted long-term refinancing operations (TLTRO) for banks. How the new TLTROs would work is on the agenda for the 7 March Governing Council meeting. They would also be justified by the slowdown in credit distribution to the private sector at a time when banks are due in 2020 to reimburse large amounts of the sums that they borrowed during previous TLTROs.
So far, so good
It’s hard to say whether investors are still optimistic or more cautious. On the one hand, equities and other risky assets continued to rally in February. On the other hand, expectations of a normalisation in monetary policy are receding, which does not look consistent with clear confidence in growth.
The market has clearly been driven by dovish language from the central banks, led by the Fed. A scenario in which the central bank would tolerate (and even encourage) above-target inflation would naturally serve as a driver of risky asset classes. In an attempt to make its target more credible after several years in which inflation has fallen short of it, the Fed has hinted that it will focus on growth. The ECB, meanwhile, is considering new targeted long-term refinancing operations for banks, as economic activity remains sluggish. Moreover, 10-year Japanese yields have been negative since early February, and the BoJ has acknowledged that its inflation target will probably not be met during the fiscal year ending in March 2021.
With soothing words coming at them from every direction, investors must not overlook the fact that economic indicators continue to disappoint and point to a global economic slowdown but without any very alarming signals having shown up yet.
Constructive statements by US and Chinese authorities appear to suggest a lull in the trade dispute, and investors appear to have been reassured by the latest Brexit developments. And yet, visibility remains low on these two issues, and there could very well be new surprises in store.
The equity rally was a little more tentative in February than in January and now that the major stock indices have returned to their early-October levels, there could be some nervousness in store, especially if the hopes that have driven the equity rally are ultimately dashed.
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