Market Update: May 2019

May 14, 2019 | Articles, Global Markets Update

April found equities in good health, led up by the S&P 500 (+3.93% MoM) and followed by Stoxx (+3.23% MoM) on a combination of trade optimism, ‘dovish’ central banks’ rhetoric and better earnings off Q1FY19 results. Asia ex-Japan (AXJ)/Emerging markets (EM) equities lagged as USD strengthened and Q1 earnings were mixed, although Chinese equities saw a robust ‘beat’ on Q1FY19 results. Fixed income (FI) continued to see inflows to higher quality bonds as parts of the market worried about the risks in credit from a pick-up in defaults. 10y US Treasury (UST) yields recovered from recent lows at around 2.30% to trade in a range of 2.50% to 2.60%, and the UST 2y/10y spread widened out to 23.6bps, dampening talk of an imminent recession after yield curves inverted briefly.

FX saw volatility in several EM currencies around domestic political troubles including Turkey, Argentina – Peso fell to an all-time low – and Brazil. DXY gained through the month on relatively better US macro data relative to other developed markets (DM) and Powell was seen to be more ‘hawkish’ after last week’s Federal Open Market Committee (FOMC) meeting. GBP tested lows at 1.2900 but recovered over the last week to regain the 200DMA support after the Conservative party lost badly in the local elections, spurring hopes they might be more willing to compromise and reach an agreement with the Labour party. The Brent oil price tested 6-month highs above $75/brl after the US ended waivers for countries importing oil from Iran but signs of OPEC+ disunity, notably with Russia, and rising US oil inventories saw the price retreat towards support at $70/brl. Gold moved inversely to USD strength and higher UST yields to fall back below $1,300/Oz and test support at $1,270-80/Oz.

The key decision regarding risk assets is whether Trump and subsequently Lighthizer, are bluffing when threatening to impose 25% tariffs across all imports from China (including $325bn of tariffs they’ve not imposed so far) this Friday. US equities, USD and Gold’s immediate reaction suggests the base case is it is a bluff. Reading various US brokerages on the threat, most seemed to agree with the ‘bluff’ thesis too, with a view neither USA nor China, and that neither Trump nor Xi, want to let a deal fail given the economic and political damage of a failure at this stage. There was one exception to the ‘bluff’ thesis that noted – after contacting people known to them within the US administration’s trade team – that the US had become annoyed by China’s recent reversal on certain agreed points and remained stubborn over key issues such as subsidies to state-owned enterprises, technology transfers and its ‘Made in China’ industrial policies. The piece suggested that, rather than a bluff, the US was deadly serious, and this is a very real breakdown. We would not dismiss this alternative thesis out of hand. We have reiterated several times there was a material risk, about 30% to 40%, a deal would not happen in H1CY19 given the red lines for both countries and the political need for both Trump and Xi to satisfy domestic audiences. On top, in the US, there is clearly a view this is the US’s best opportunity to challenge China’s trade practices and require structural changes before it is too late.

On a medium basis, assuming the trade news works its way out, there are two more fundamental risks, to our cautious view. The first is that Q1 EPS results materially ‘beat’ lowered consensus, hence resulting in decent upgrades to earnings forecasts (ERR). ERRs have been falling for several months, with S&P 500 Q1 consensus cut by over 10% from levels forecasted at the end of September ’18, so it is of note that LGT thinks the ERR for S&P 500 ticked up since results started. S&P 500 has moved sideways since results began, with top-line numbers mostly below expectations, but strong results from the likes of Facebook and Microsoft helped US equities.

The second risk is that falling GDP forecasts stabilise, or even get revised upwards. Thus, it is of interest that Goldman Sachs (GS) have raised their US GDP forecast for ’19 and ’20 to 2.4% and 2.5% (GS rightly noted, if they were to be right, that this might suggest the Fed has become overly cautious). Likewise, sell-sides strategists are noting that China’s reflation is working, and both UBS and HSBC have revised forecasts up to 6.5% for ’19 from 6.2%. Separately, GS sees EU GDP stabilising in Q2 whilst UBS thinks Q1 numbers will surprise to the upside. Overall, GS thinks the global economy will recover from Q2 onwards and pick-up into H2. Should ERRs inflect positively and GS be correct about the imminent recovery in GDP, then equities will be able to ‘bridge across’ to a better H2 and the rally could continue, although it implies UST will sell off. Both Credit Suisse (CS) and UBS have increased their equity allocations last week for the reasons above.

However, the ’bridge’ argument is not our base case. We see a correction as quite possible and have some sympathy with a John Auters piece that argued markets have rebounded too quickly from the sell-off in Q4. He thinks that valuations are not supportive, that we are later in the economic cycle and that he thinks the next move will be to correct sharply again. John suggests markets are more like a boy on the slide and that he will slide down again once he gets to the top. We have completed – fast – a perfect slide to the bottom and then back to the top since September. We are more in the ‘slide’ camp than the bridge over to a better H2, but are well aware there’s a danger of underestimating the resilience of S&P 500 earnings and the strength of the US economy (and at the same time overestimating the same for Europe and Stoxx). The old adage, ‘Sell in May and go away’, might have more relevance this year again!

Given it is a 50/50 bet as to whether Trump is bluffing or not, it would be foolish to be buying into these moderate declines outside A-shares. We had deliberately built up cash levels across portfolios YTD and thus are decently defensively positioned. This month, as noted before, is quite perilous so acting too quickly is likely to be a mistake. For now, we will ride the volatility and not do too much.

Equities

• Shares in the US continued their steady climb into the midst of earnings season, with the S&P 500 (+3.93% MoM) and Nasdaq (+4.74% MoM) inching into all-time high territory, while the Dow Jones Industrial Average (DJIA) (+2.56% MoM) has come close despite having lagged YTD (Figure 1). This underperformance has been largely led by earnings’ disappointments in blue chips like 3M and Intel, but also as shares in index heavyweight Boeing suffered amidst uncertainty around the 737 MAX.

  

Figure 1 Total returns YTD of major US indices                                                                           Source: Bloomberg

• As of 3rd May, 78% of companies in the S&P 500 have reported earnings for 1Q19, 76% (above historical average) of which have reported aggregate earnings beat while 60% (mostly in-line with the historical average) reported a positive revenue surprise. So far this quarter, the index is tracking a -0.8% earnings decline which will mark the first YoY decline in earnings for the index since 2Q16.

• The key data release this month was a 1Q19 GDP surprise, coming in at +3.2% against estimates of a +2.3% increase, though this was mostly driven by ‘transitory’ factors related to trade and inventory which added an estimated 1% to the headline figure. Stripping these anomalies out might suggest a reading that was mostly in-line if not slightly lower-than-expected, although we would highlight that Q1 data has had a major problem with accuracy for years.

• US-China trade news will dictate the shorter-term outlook for the S&P 500. Our base case is that a deal will be struck as it is in the economic interest of both countries, and the political interests of both Trump and Xi, to do so. However, both sides have ‘red lines’ and there is a material chance, perhaps as high as 30-40%, a deal cannot be agreed upon, and that the US will impose 25% tariffs across all imports from China.

• Additionally, Trump must, by 18th May, decide whether to impose auto tariffs on global imports to the US. We think he might hold-off doing so to Japan as both countries are in talks, but it is highly probable Trump will impose tariffs on EU with Germany a notable target, although we think a resolution could be quite fast. In the event of a resurgence in trade tensions, the S&P 500 will prove relatively defensive.

• European equities followed their US counterparts higher in April but led by a steep recovery in Autos (+9.31% MoM), and sizeable gains in the Technology (+7.68% MoM), Banks (+7.54% MoM) and Industrials (+7.28% MoM) sectors. Defensives like Health Care (-1.90% MoM), Real Estate (-1.21%), Telcos (-0.64%) and Utilities (-0.34%) underperformed amidst the broader market rally.

Figure 2: Stoxx 600 Total returns against EU indices in April                                                        Source: Bloomberg

• Across indices in the region (Figure 2), the German DAX (+7.10% MoM) was a clear outperformer on a total return basis, followed by the French CAC 40 (+4.93% MoM) and while Spain’s IBEX (+4.56% MoM). Despite more confirmation around a Brexit delay and as tail risks of a ‘hard Brexit’ subsided, the FTSE 100 (+2.28% MoM) still underperformed quite significantly in April.

• After the ECB turned markedly more ‘dovish’ last month, helping fuel a rally in Stoxx and a weaker Euro, attention going forward will be on what action this might imply with some more bearish strategists anticipating ECB may have to resume QE before the year-end given a weak EU economy.

• Stoxx earnings revisions saw the strongest pick-up in the last week in over ten months and Q1FY19 might be the best quarter for results in two years. It remains to be seen if actual results confirm this recent optimism that appears at odds with very weak economic data – especially in exports and manufacturing.

• The hope is the weakness in the EU economy will be temporary and more a short-term cyclical downturn in manufacturing that is linked to trade disputes and that China’s reflation, with a three to six months lag, will show up in better EU data during Q2. However, if the US-China trade deal fails and the US imposes auto tariffs on EU, an industry which employs over 1mn people in Germany alone, it is possible EU could fall into a recession.

• In Asia (and amongst the bigger global indices), Japan’s Nikkei (+4.97% MoM) has been the quiet outperformer ahead of their ‘Golden Week’ holiday which ran from April 27th to May 6th, while the Shanghai Composite Index (-0.38% MoM) closed the month flat despite having pushed YTD highs over the course of this month (Figure 3).

Figure 3: Underperformance of A-shares in April                                                                          Source: Bloomberg

• ASEAN countries were also noticeably weak, and have been an underperformer so far this year, not least weighed down by continued strength in the US Dollar and relatively higher oil prices (Figure 4).

Figure 4: YTD underperformance of MSCI AC ASEAN Index                                                      Source: Bloomberg

•  With 40% of MSCI China and 100% of A-shares having reported Q1FY19 results, the weighted median company ‘beat’ was 8%+ and the best quarterly results since Q2FY18, although this follows-on from Q4FY18 where profits fell 44% YoY. These robust results will support Chinese equities as the market offering the best EPS growth of any major market this year at +11% and these may be revised up as tax cuts, boosting profitability and consumption, started on 1st May. Outside of China, early AXJ/EM results have been quite mixed and the bias overall is disappointing so far.

• May will be a key month for elections in Asia ex-Japan. We get results in Thailand on the 9th (there is a risk they are annulled), Philippines Senate elections, Indonesia by the 22nd – Jokowi is likely to win by 8-10% and that is positive for local equities – and India on 23rd. Of these, the Thai and Indian elections have binary implications for markets – the risk for India’s risk assets, and INR, is the BJP loses substantial ground (in UP it may lose 48 seats to end up with 30 of the 80 seats in the lower house) that it can only form a weak coalition government dependent on unreliable regional parties and that Modi is replaced as Prime Minister.

Fixed Income

• Sovereign rates were largely driven by economic data in April. A mixed bag of results over the month saw UST yields trade within a 20bps range throughout the period. However, the UST yield curve shifted upwards from the belly of the curve all the way to the long-end, thanks to support from strong manufacturing PMIs at the start of the month. Larger shifts were seen in the long-end, with the 10y and 30y yields rising 9.7bps and 11.4bps MoM respectively (Figure 5). This led to the yield curve steepening, with the 2y/10y spread rising from 14.3bps at the end of March to 23.6bps by the end of April. Similarly, the 5y/30y spread rose from 58.1bps to 65bps while the 3m/10y spread rose from 1.7bps to 8.5bps.

Figure 5: Upward shift in the yield curve in April                                                                           Source: Bloomberg

• European sovereign yields also received a boost at the start of the month after a stronger Chinese manufacturing PMI raised hopes that Europe will benefit from a stronger Chinese economy. However, mixed data thereafter led the Bunds yield to repeatedly test the 0% level through the month. There was only one instance of a significant break above the 0% level after better-than-expected economic data, but the yield failed to sustain the break and fell back towards the 0% level. Bunds yield ended the month 8.3bps higher MoM.

• US high-yield (HY) was the best performing FI sector. US HY debt gained 1.42% MoM in April amid a supply shortage. Issuance in April was at $17bn – the lowest YTD. According to Bloomberg, most deals were oversubscribed, by multiple times with almost all trading above the issue price. April also saw the first PIK offering, hence suggesting that investors might be beginning to be more open to riskier assets and possibly explaining why the CCC space (+2.03% MoM) was the best performing sector within US HY (Figure 6).

Figure 6: CCC outperforms all other HY sectors                                                                           Source: Bloomberg

• Trade tensions could well see 10y UST retest the YTD low and key resistance at 2.30% after breaking below the 2.50% support post-Trump’s tariff threats. Likewise, Bunds 10y yield might go back into negative territory – not least if the US imposes auto tariffs in next week or so.

• There are two major areas of concern in credit should a recession occur and default rates rise, with the first being the huge amount of debt (c$2.2trn) in the BBB space that accounts for 50% of total US IG outstandings. Some are speculating up to $1trn of this is vulnerable to being downgraded to junk that would be disruptive given existing HY FI outstandings of around $1trn. CLOs are the other area of rising concern given that the amount issued is similar to HY FI after huge new issuances in the last two years, but the danger is much of this is poorer quality paper (84% is covenant-light) by highly leveraged companies often (over 6x EBITDA). In contrast, HY FI credit fundamentals are improving as companies deleverage, reduce new issuance and use new debt to refinance more expensive, older debt.

• We continue to highlight, in contrast to the perception EM FI is riskier, that the better credit fundamentals of EM FI – be it sovereign or corporate credit – are being underestimated. EM has lower debt to GDP than DM while EM corporates are deleveraging faster than DM corporates. Debt servicing drivers are also stronger, and demographics are superior to DM where the latter face genuine risks of unsustainable fiscal deficits in the future from unviable pension obligations and entitlements and limited political will to tackle the unpopular choices to rectify the imbalances. We remain positive, structurally, on EM FI with our preferred exposures in shorter duration EM HY FI. We would not chase it should spreads fall further but are comfortable collecting the coupon.

FX

• Volatility in the G7 pairs recovered slightly in April due to AUD and GBP. The Fed continued to remain dovish however the dollar continued to display strength on the back of strong housing and employment data. The DXY traded to a 2-year high of 98.33 on the 26th April, breaking a resistance of 97.70 and is currently maintaining at this level. The biggest winners in April were EM currencies as investors were attracted to yields.

• At the beginning of May, the trade-spat spooked investors. This caused indices to dip lower and JPY to strengthen as investors looked for haven assets. April remained a quiet month except for this, along with AUD and GBP.

• EUR continued its long-term downtrend this month against a stronger USD as traders focused on disappointing industrial data from Germany and strong US consumer data. EUR ended April flat at -0.03%.

• Within a 52-week range, CFTC reports show the EUR remains the largest net short hold with JPY and CHF near their largest net short hold. MXN remains net long as investors seek returns from interest rates. 

Figure 7: CFTC 52W net-short positions

• DXY broke out above resistance at 97.50 to climb above 98 and a test of previous strong resistance at 100.50 was on the cards but recent events have seen it retrace back to 97.50 acting now as key support. The underlying trend for DXY remains up still and so a retest of 100.50 level remains the base case. We are USD ‘bulls’ until it is evident we should not be – not least because most other DM currencies all appear to be less liked be it housing crises weakening the CAD and AUD; weak data impacting EUR and JPY; political headwinds exist for several EM currencies.

• We expect the EU-wide election to be the next major test of the EUR hovering around key support at 1.12 as strong gains by anti-populist parties could see it break below 1.11 and possibly test stronger support in the 1.07-1.08 range. On a more positive note, should the UK Conservative and Labour parties reach a bipartisan deal on BREXIT a likely stronger GBP would boost EUR and reduce economic risks.

• Trade risks boost USD at the expense of EM/AXJ currencies, especially CNY, which has been rooted to around the 6.70 level for months but has now weakened and broke through a support at 6.75. However, the key support is the 200DMA at 6.86, which we expect to fail if a US-China deal falters or fails. A weaker CNY, arguably as important these days as USD for EM currencies, would pressure down AXJ/EM currencies at a time when many central banks, such as the Bank of Korea, are sounding more ‘dovish’ or acting as the Reserve Bank of India has.

Commodities

• Brent continued its momentum from March and gained +11.87% before topping off and ending April +7.72%. Brent returned some of its gains as it failed to breach a key technical resistance of $75, thanks to Trump’s tweet and claim that he demanded OPEC to lower their oil prices. Oil is currently held by the 200DMA acting as a support at 69.24. We currently see a few factors in play against oil falling lower, but continue to believe these biases are overshadowed by the massive rate of which US shale oil is being produced.

• We continue to expect Brent oil will trade in a range of $60-75/brl with upside capped by rapidly expanding US shale oil production and signs that Russia might be unwilling to follow Saudi Arabia’s line on OPEC+ quota discipline as it is wary of losing further market share and a slowing global economy. At the lower end, weaker prices would curtail some US shale output, while OPEC+ would become more sensitive to lower prices relative to higher numbers used to calculate fiscal budgets.

• Gold ended the month flat, developed extensively in its technicals. Following the strength of USD, Gold had a tumultuous period in April. The next support is found at 1,253 after breaking its support at 1,293. We continue to see dollar strength on the back of higher USD real yields and therefore we expect gold to weaken relatively. The next support for gold can be seen at its 200DMA, 1,253.

• On technicals, we see a head and shoulders variant of which the neckline, shown in red below (Figure 8), has recently broken. We believe that this trend will now act as a resistance.

Figure 8: Gold prices see a ‘head and shoulders’                                                                          Source: Bloomberg

• Gold has been in a downtrend since testing recent multi-year highs at $1,340/Oz but appears to have found support at the $1,270/Oz level and may well be buoyed by trade tensions in next few weeks. One prominent sell-side house forecasts it will be back at $1,340/Oz during Q2CY19 and go through $1,400/Oz in the medium term as USD weakens and UST yields fall. It has been quite clear, of late, Gold prices have closely moved, inversely, to moves in USD and UST yields YTD and we expect this to continue.

Market Update: April 2019

Apr 15, 2019 | Articles, Global Markets Update

“Ultimately lower rates are only good to a point because, eventually, the fall in rates is not just about the Fed giving equity investors a “green light” to load up on risk, but also indicates concerns around GDP growth.” `– MORGAN STANLEY

Look through or come off. Financial markets have been surprisingly resilient since the lows at Christmas Eve. Optimism over an early US-China trade deal, the obvious pivot by the Fed to be more ‘dovish’ (FI markets expect a rate cut in ’19 now) relative to its ‘hawkish’ stance last October, and other central banks’ like the ECB and PBoC and China’s more aggressive fiscal reflation, have all helped improve investor sentiment with markets rallying from very oversold conditions at YE18.

Whilst there are undeniably positive drivers, our cautious tactical stance remains as we believe the US-China trade deal will disappoint in leaving considerable post-deal uncertainties with a still material risk that a deal will fail given the wide differences between both parties over post enforcement checks. Underlying corporate earnings are still being downgraded and Q1 results may well disappoint at a time where the S&P 500 has become expensive relative to history whilst other markets are no longer cheap. GDP forecasts continue to be lowered – notably in EU – although China’s GDP outlook has ‘firmed up’.

Political risks are rising in Q2 – notably Brexit agonies, where a ‘no-deal’ is still a distinct possibility, and India, where a likely weak BJP coalition is perhaps the most likely result. Concerns remain around political risks in Turkey, Argentina, South Africa, Brazil, Venezuela, Ukraine and Thailand that could knock-on to EM FX, FI and equities. With strong rallies in equities and JY FI YTD, we believe taking some money off the table makes sense given the potential headwinds and the history of returns in most years since ’09 bar ’17’s exceptional gains. Ultimately, the rally in sovereign bonds YTD, with now around $10tn with negative yields, cannot be reconciled with the rally in riskier assets as the latter implies deflation if not a recession sooner or later.

The main risk to our cautious stance is if investors can use China’s reflation, trade optimism and central banks’ pivot to ‘bridge’ across a weak H1CY19 to an expected recovery in earnings forecast by Q4FY19 and stability in GDP forecasts that would support a further rally in risk assets (and a likely sell-off in USTs). This is not our base case, but we have put in place upside risk management triggers should we be proven wrong.

Recession or not? The inversion of the 3m/10y US yields on 22nd March, the first since ’07, may signal a recession during 2H20 based ib the past albeit this is better in telling us it will happen rather then when (it could be any time from under 12M to well over 3Y). The signal has historically been a reliable predictor of seven of the last nine recessions. There are some very plausible arguments, not least by Mr Dudley (the last New York Fed governor), that this time is different as: quantitative easing by the Fed and other central banks have lowered absolute interest levels to make it technically possible for such an inversion; the Fed is not tightening and financial conditions have eased considerably; there is a breakdown between real interest rates and underlying GDP growth since ’14 as noted by Pictet and; lastly the absence of any obvious ‘bubbles’ in financial assets or the wider economy.

In looking at the components of the US GDP, it is unlikely, given robust consumption underpinned by record low unemployment and accelerating wages (+3.5% YoY in February NFP), we will get a recession in 2020. However, the US economy will slow from Q4CY19 as Federal final spending is set to fall sharply and private sector capital expenditure is expected to ease down, making a ‘shallow’ recession quite feasible. A recession would justify the Fed’s ‘pivot’ and strengthen the FI markets view that the Fed’s next move is to cut rates.

There is a high degree of uncertainty as to what the macro data will bring from deflation and recession to inflation reigniting and GDP numbers surprising to the upside which have binary implications for portfolio construction. Our base case is we avoid a recession this year and next and that exposure to equities remains a better choice than to sovereign bonds. We will need to be nimble and tactically quick to respond to developments which includes a sizable precautionary cash holding to mitigate volatility spikes and to take advantage of them. Strategically we remain convinced we are in a 3.5-year period of low returns and that volatility will rise that argues for portfolio diversification and the use of non-traditional asset classes, as did endowment funds in recent years (Fig 1).

Fig 1: Endowment funds – asset allocation in 2007 vs 2018                                                                                              Source: Bloomberg, Julius Baer

Equities

• Despite a rough start earlier in the month, US equities were broadly higher as all three major indices managed a higher close in March. NASDAQ (+2.61% MoM) outperformed as Tech shares rallied, while the Dow Jones Industrial Average (+0.05% MoM) under performed after its biggest index component, Boeing, fell by as much as -17.2% from all-time highs after questions were raised over safety issues relating to the company’s 737 MAX planes. Notably, small caps also under performed, with the Russell 2,000 (-2.27% MoM) logging a decline as concerns over economic growth lingered (Fig 2).

  

Fig 2: March total returns of the S&P 500, DJIA, Nasdaq and Russell 2000                                                                             Source: Bloomberg

• Technicals show the S&P 500 moved through key resistance levels to within 2% of its all-time high. We believe US equities will struggle to move higher as valuations are now expensive relative to history, and earnings are likely to contract in H1FY19 and we are trimming here.

• Mueller’s report removes the threat of impeachment ahead of the 2020 elections and helps Trump’s re-election chances, especially if the Democrats were to choose a Socialist candidate.

• We expect macro data to slow in 2019 as fiscal spending slows sharply in H2CY19 while private capital expenditure weakens, creating headwinds to consumption. Weaker growth would support a higher weighting in ‘growth’ sectors as IT over ‘value’. Hence, we expect Nasdaq to outperform.

Fig 3: Stoxx 600 MoM sector performance                                                                                                                              Source: Bloomberg

• European equities were also higher as Stoxx 600 gained 1.69% in March, led by gains in Personal & Household Goods and Food & Beverages. Bank stocks were the worst performers, after Draghi indicated rates would stay on hold for the rest of the year, a move which sent Bund yields into negative territory for the second time in history (the first being in 2016).

• Brexit remains the overhang for Stoxx 600 and FTSE 100 and sadly, there is no agreed route and it is still a possibility of a no-deal. The next deadline is 12th April and the hope is an agreement by Parliament based on a ‘softer’ Brexit now that May is reaching out to the Labour party leader.

• Deteriorating macro data YTD in EU could see the bloc’s economy fall into a shallower, technical recession in 2019 and may imply earnings in 2019 could contract relative to the current consensus of +4%.

• There are political risks outside of Brexit as well. The EU election during late May might see anti-Euro populist parties gain considerable ground (even more so if the UK was to be involved in the vote) that would likely be a source of volatility in EURO and FI, which will eventually lead into Stoxx 600.

• Shares in Asia also trended higher across the board, with China A-shares (+5.10% MoM) once again outperforming the region. This time, however, India’s Sensex (+7.82% MoM) surged ahead as INR also gained, taking the index to a +10.17% monthly gain on a USD-adjusted basis. For the quarter, A-shares are still significantly higher at +27.03% compared to the Sensex at +7.79% which still under performs the broader MSCI Asia ex-Japan Index which is up 11.21% in USD terms.

Fig 4: USD-adjusted Total Returns across indices in Asia                                                                                                        Source: Bloomberg

• • Nikkei, on the other hand, fell 0.84% with the Yen mostly unchanged from the start of the month. Japanese equities continue to under perform in Asia, climbing +5.95% this quarter against most other indices which have logged double digit gains. Last weekend, Abe’s coalition also won approval to run a record ¥101.46tn fiscal budget in 2019, with close to ¥2tn set aside for stimulus measure aimed at cushioning the Oct 1 increase in consumption tax

  • AxJ equities are being led higher by Chinese equities and especially A-shares as local retail investors are buying again along with foreign investors, ahead of an increased weighting in MSCI EM next month. We remain overweight Chinese equities and would use any weakness to add to A-shares as we see it hitting 3,600 during 2019 as reflation of the Chinese economy comes about.

Fixed Income

• The UST yield curve shifted lower over the month, especially in the belly of the curve with the 2Y and 10Y yields inclusive. This caused the 3m/10y spread to invert and led to the steepening of the 5y/30y spread. The Fed’s decision to hold rates in its March FOMC meeting while signalling that it won’t raise rates in ’19 caused the 10Y yield to break its 2.6% support to trade below 2.4% for the first time since December ’17. The 2Y yield also fell below the Fed funds floor of 2.25% after the meeting. However, trade optimism and strong manufacturing PMI data from US and China at the end of the month helped push yields higher. March’s developments saw USTs register their best Q1 result in 3Y as the 10Y yield fell 28bps.

• European sovereign bond yields fell too as demand increased amid a slowdown in the European economy. The Bunds yield fell and traded below 0% for the first time since ’16. This saw the total sum of negative yielding debt represented in the Bloomberg Barclays Global Aggregate Bond Index to rise to $10.07tn – the highest level since September ’17.

• Corporate credits saw positive returns across most sectors (Fig 6), but under performed sovereigns as the market turned more risk averse and went up the quality curve. US IG was the best performing sector in the credit space after Asian dollar bonds, returning 2.50% last month. This was mostly supported by falling rates while spreads ended the month mostly unchanged. Strong demand for primary issuances in the IG space also helped lower the borrowing costs for highly rated companies. March saw a 28.57% increase in primary issuances as companies issued $131.28bn worth of debt. IG funds also saw the largest fund inflows in March relative to other sectors. IG funds attracted $13.17bn worth of funds in the month.

Fig 5: Fixed Income sector returns in March ’19 and 19Q1                                                                                                    Source: Bloomberg

• The key question is whether the Fed’s ‘pivot’, not least in what markets perceived as a ‘dovish’ March FOMC meeting, will prove to be the inflection point in this hiking cycle or, as we believe, a pause. Our view is that the markets have mistaken Powell’s comments to be purely about pausing when, in fact, he explicitly noted that the Fed was data-dependent. We see US macro data as being sufficiently strong to allow the Fed to hike one more time – probably in December 2019, whereas we do see EU data weakness being supportive of the ECB’s recent caution and for lower yields.

• Whilst we have long failed to find value in higher quality FI (sovereign and IG), even our preferred weightings in US HY FI and Asian HY FI have seen sufficient spread compression YTD to no longer offer much price upside although we would remain invested to ‘clip’ still decent coupons but warn we could see short-term volatility.

• Tactically, we remain overweight in short-duration paper – be it high quality or HY – as the yield is similar to longer duration paper without the same level of interest rate or default risks.

FX

Fig 6: FX implied volatility near all-time low                                                                                                      Source: Credit Suisse Derivatives Strategy

• Volatility in the G7 pairs, bar GBP, has dipped since the start of 2019 as FX markets remain in uncertainty due to key events such as Sino-US trade development and Brexit (Fig 6). EMFX volatility picked up in March, mainly due to BRL, TRY and ZAR experiencing large movements. (Fig 7).

Fig 7: EM FX volatility vs. G7 FX volalitlity                                                                                                                             Source: Bloomberg

• The Fed’s dot plot implies that interest rates will remain on hold for the remainder of this year and only improve by +25bps in 2020 and inflation unexpected eased in February. This clarity for the USD has finally come through as markets are no longer pulled by “certainty” (positive market data in Jan/Feb) and “uncertainty” (a “patient” Fed in Jan/Feb). Powell noted that interest rates will remain on hold for “some time”.

• The Turkish Lira experienced another bout of volatility since Aug 2018. The jump happened overnight and TRY fell 7.50% to 5.84, past a significant key support at 5.50. The Turkish government has reported its suspicion of large foreign banks shorting the Lira. Overnight rates increased to 1300% to prevent shorting. Emergency interest rate measurements taken by the Turkish government failed to suppress TRY weakness.

• DXY is edging up again towards a key resistance at 97.50 and USD yields bottomed out and it remains, on a relative basis, the best DM economy and that is constructive for the USD. We remain, thus, USD bulls until it is clearer its structural risks (rising fiscal deficit and potential overvaluation) become obstacles.

• The outlook for GBP, BRL, TRY ZAR and the Argentine peso depends on political developments. An agreed cross-party ‘soft’ Brexit deal would boost GBP towards 1.40 but a no-deal departure on 12th April could sink it back to 1.20. EUR, to a greater extent, will be linked to GBP, but the EU-wide elections could also be a downside risk as it was in ’14.

Commodities

Fig 8: Saudi leads OPEC+ cuts to production                                                                                                                       Source: Bloomberg

• Brent crude saw a strong quarter, rising 27.12% YTD and 3.57% in March as OPEC+ cuts to oil production continued. The cartel cut a further 295K/bpd in March, and is believed to continue its commitments to cutting supply and re-balancing the market.

• Volatile production from countries like Egypt added to supply this month, but we believe that the remainder of OPEC+ countries will eventually catch up and limit their supplies, and this effect should outweigh any of the headwinds.

• Gold closed mostly flat this month, unable to move past its US$1,352/Oz high in February. This was understandable given the increased risk-on sentiment reflected by the climb in equity markets. This movement in March formed the right shoulder of a Head and Shoulders pattern which started in January.

• The oil price is being pulled around by OPEC’s (notably Saudi Arabia) supply discipline and regulatory developments on bunker oil relative to rapidly increasing US shale oil production and a slowing global economy impacting demand. In the shorter term, we see the Brent oil price capped around $70/brl but the longer term could see oil prices test $90/brl by 2021 as the effects of the huge 50% fall in capital expenditure since H2CY14 impacts production. Given this, we are trimming our energy exposure.

• Industrial metals are benefiting from optimism around China’s ability to reflate the economy and from a series of supply disruption that have boosted copper and iron ore at a time the mining giants have proven to be disciplined in capacity expansion, and that could lead to prices moving higher from here in 2019.

CONTACT

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