Curmi & Partners

Quarterly Update and Outlook

Q2 2017

Fixed Income

Fixed income markets continued to be well supported by a number of factors. Central bank monetary policies remain accommodative, even though this effort has now peaked. Other positive factors include the gradual recovery in economic growth, few signs of acceleration in inflation, a stable default scenario and generally robust risk appetite. Additionally, during the second quarter of 2017 fixed income markets were boosted further by a decline in benchmark yields (primarily driven by the US market) driven by factors including doubts on Trump’s ability to implement certain policies and French politics.

In Europe, the performance of benchmark yields was relatively mixed, even though the trend was mostly upwards, with a sell-off in sovereign benchmarks at the end of the quarter. Of particular relevance, were certain comments by the European Central Bank’s (“ECB”) president, Mario Draghi towards the end of June, which provided signals of the growing belief in the economic recovery and of the movement towards a less expansionary policy.  

This in line with the view that yields will generally continue to rise in the long-term. The pace of withdrawal of Quantitative Easing (“QE”) is still expected to remain very gradual, and indications on this “tapering” process are likely to be provided towards September.

In the US, the Federal Reserve (“Fed”) raised interest rates by 25bps to 1.00%-1.25% in mid-June, in what was an expected move and the 3rd rate increase in 6 months. However, bond markets have been dominated by the diverging messages from the Fed and the US Treasury (“UST”) bond markets. The Fed has generally maintained its signalling towards higher rates and the reversal of QE whilst bond markets are more focused on inflationary expectations and political developments.

The intention for the Fed to raise rates by the end of the year remains, but subdued inflation expectations, possibly soft economic data, and political turmoil are likely to maintain the long-end of the curve supported in the medium term.

The underlying view is that markets should expect to receive less of a boost from central bank actions compared to recent years.  The ECB is expected to remain more active in maintaining a “cap” on rising yields than the Fed.  Investors should moderate expectations in terms of capital upside, whilst further spread compression seems possible even though credit spreads are already near all-time lows. Rising benchmark yields are likely to have a negative impact on total returns particularly in the sovereign and Investment Grade (“IG”) sectors. However it is noted that given the strong performances during recent months even the HY market could be more vulnerable to some correction, compared to early 2017.

The euro yield environment has so far undergone less of a re-pricing of a future potential turnaround in monetary policy. This, together with the differential in carry, makes Euro IG slightly less attractive compared to USD IG However, opportunities in IG and non-core sovereigns may increase as yields inch higher.

Equities

The equity markets are up substantially on a year to date basis after the rally extended to the second quarter of 2017. The key themes driving the equity market were the improved economic and political scenario and valuations.

Economic and political scenario:

The positive developments in the European political and macro space have put the region’s stock market back on investor’s agenda. Europe’s economy grew 0.6% YoY in 1Q17 and data published in the 2nd quarter suggests that the economy is gathering momentum backed by lower unemployment levels. Political uncertainty in Europe abated following the French and Dutch elections with the political uncertainty index at 234.74 (30/06/2017), down from 288.56 at the start of the year.

On the other hand, US Economic data has been on the whole weaker than expected and despite the economy being close to full employment, labour participation rate is still below pre-crisis levels and wage inflation has been muted. US stocks have benefited from the Trump bump in the latter part of 2016, more specifically the promise of a large government spending programme aimed at an overhaul of the United States infrastructure. There has been no update on this following the election and it’s implementation is still doubtful, raising political uncertainty in the US.

Valuations:

US valuations are looking stretched and are some-what above historical averages. In addition, the S&P 500 index is the only index trading on a PE that is higher than its 95% percentile and is trading on a forward P/E ratio of 16.6x while the Euro Stoxx 600 is trading on a forward P/E ratio of 14.5x. The Shiller P/E (US) stands at 29.6x (29/06/17), a level that has been exceeded only twice: 1929 and 2000 and above its long-term average of circa 15.0x.

Volatility:

Volatility has been somewhat subdued in the past years, particularly when considering the number of high risk events that have taken place. This includes the Brexit vote, elections in the US and France and finally the risk of policy misstep as central banks normalise their monetary policy.

There is the growing feel that risk is being underpriced by a complacent equity market that has become accustomed to central banks involvement when things turn sour. We expect equity market volatility to intensify as central bank normalise monetary policy and reduce their involvement in financial markets.