Monday 22/07/2019

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Investment Desk Analyst

In January, interest rates and the dollar were the key players on financial markets, with equity markets closely monitoring the movements of both. Our expert, Johan Gallopyn, outlines the main trends on the equity, bond and currency markets over the past month.

Equity markets

Equity markets started the year positively and all regions were able to deliver strong performances in January. The same themes as in 2017 still apply, namely the synchronised global economic recovery, growth in corporate profits - stemming in part from the impact of tax reform in the United States - and the favourable interest rate environment. The equity markets lost some of their momentum towards the end of the month, and that had just about everything to do with a surge in bond rates, both in the United States and in Europe. Even though a moderately higher interest rate level is not generally seen as a threat to equity markets, it does cause a rotation within the sectors away from high-yield shares (sectors such as utilities and telecom). Financial shares then benefit again from the steeper yield curve. The weak dollar, in turn, is ensuring strong performance by Emerging Markets and the United States. In the United States, it is striking that more companies than average are able to report a positive surprise regarding turnover when announcing the results for the fourth quarter of 2017. This is in addition to the generally favourable growth environment, also due to the weak dollar. Converted into euro, the performance of the United States and Emerging Markets is strongly eroded, making the European market (MSCI EMU + 3.2%) one of the strongest performing regions in January.

 

Bond markets

There was a fairly remarkable increase in interest rates on the bond markets in January. The 10-year German interest rate was 27 basis points higher and the US 10-year interest rate 30 basis points higher, reaching a level of 0.70% and 2.71%, respectively. The German interest rate thus broke from a horizontal margin between 0.20% and 0.60%, where it had fluctuated for over a year, and the US rate attained levels not seen since April 2014. In addition to the better economic situation worldwide, tax reform in the United States has had a double impact on market sentiment regarding interest rates. In the first place, the tax reform means an additional economic stimulus at a time when the economy is already on a roll and the labour market in the United States is already tight, and this may result in higher inflation. Secondly, the tax reform will lead to a higher government deficit that will have to be financed through the issuance of new bonds, but this at a time when the US central bank has stopped its bond purchases and is reducing its balance sheet. At the same time, we are not yet seeing an acceleration in inflation, certainly in Europe. In Europe, the bonds of the peripheral countries have not followed the upward trend. The Spanish 10-year interest rate even went down another 14 basis points, while the Italian rate remained stable after the jump in December. Corporate bonds had an excellent month (in relative terms) across the board. Both financial and non-financial issuers, and both the better issuers and the lower quality ones, saw their spreads shrink further.

 

Central banks and monetary policy

The press conference held after the most recent meeting of the ECB was largely dominated by the strong euro/weak dollar situation. President Draghi acknowledged that the appreciation of the euro poses a risk to the growth prospects of the eurozone, and confirmed that a weak dollar could lead to looser monetary policy. Nevertheless, the markets were not impressed. As far as the bond purchasing programme is concerned, it is generally expected that the ECB will provide more indications in March of what can be expected after September. Since (core) inflation is still well below the 2% target, the most likely scenario is that there will be a gradual reduction of purchases after September, not an abrupt end. Where the market previously expected a first interest rate increase by the ECB in the second or even third quarter of 2019, that expectation has meanwhile been brought forward to the beginning of 2019. At the last meeting of the Federal Reserve under the chairmanship of Janet Yellen, the interest rate was left unchanged, as expected. The accompanying commentary was seen as rather more hawkish than before, and the market has now almost fully priced in a new rate hike in March.


 

Currencies

The first month of 2018 did not change the trend of lower exchange rates for the US dollar (- 3.3% against the euro). The market is not so much being driven by the current fundamentals of the dollar against other currencies, but instead by changes in expectations. For the current fundamentals the US currency has the advantage (interest rate differential against the euro, monetary policy outlook), but with regard to expectations recent trends are to its detriment. Specifically, the tax reform approved at the end of last year will increase both the budget deficit and the trade deficit. Furthermore, the market sees more possibilities that the monetary policy of central banks other than that of the US will surprise in the direction of more tightening. There were also the statements by US Treasury Secretary Mnuchin that a weak dollar is favourable to US trade, which seem to disregard the official position for a strong dollar. The other dollar currencies, with the exception of the Canadian dollar (- 1.5% against the euro), were able to gain some ground against the euro thanks to more robust commodity prices. Finally, the British Pound rose thanks to hope for smoother Brexit negotiations and a soft exit by the UK.


Commodities

Raw materials prices rose once again. In addition to the continuing positive outlook for global growth, the weaker dollar was again a driver for trends in prices as commodities are often traded in dollars. Last month’s stars (copper and aluminium) slowed down, but other base metals (zinc and nickel both + 6.6% in USD) took the lead. Brent oil price rose to just above USD 70 per barrel (+ 3.3% in USD), a level that had not been seen since the end of 2014. Gold prices equalled the level of early 2016, at around USD 1,350 per ounce. Prices for this precious metal are subject to conflicting forces, with a weaker dollar on the one hand and higher interest rates (prospects) on the other.

 

 

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