Saturday 08/12/2018

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Investment Desk Analyst

October once again lived up to its reputation as a dangerous month for equity markets. Our expert, Johan Gallopyn, examines the causes and indicates the impact on the bond, foreign exchange and commodities markets.

Equity markets

The correction in the equity markets resulted in heavily negative performances in October. The decline since the highest levels reached earlier this year, exceeds 10% for most markets; and at the lowest point even all the gains made by the US S&P500 since the beginning of the year, had gone up in smoke. The decline was triggered by a rise in bond yields in the United States. A higher yield puts a brake on the economy and  makes equities less attractive in relative terms. However, the decline continued due to fears about third quarter results. These were good, first and foremost in the US, but investors are concerned about the sustainability of profits and margins. A number of companies reported higher production costs, which in some cases puts pressure on profit margins. These higher costs have led to a number of profit warnings that were reported on extensively in the press. Slower growth outside the US is also being felt by a various companies, and a number of technical factors playing a role (the blackout period during which companies cannot buy their own shares and the systematic funds that reinforce market trends). The exceptions to this negative market development were the Latin American stock exchanges, which were able to close higher as a result of the presidential elections in Brazil.

 


Bond markets

The yield on 10-year US bonds reached 3.25% midway through the month, the highest level in seven years. A series of strong economic figures and statements by Federal Reserve Chairman Jerome Powell, which were considered hawkish by the market, explain this rise. However, because of the correction in the equity markets the rate fell back to 3.10% by the end of the month. In Europe there was a similar pattern for the German rate, first reaching 0.55% and then falling back to 0.35%. Spreads for the peripheral countries increased, to a limited extent for Spain and Portugal (10 to 15 basis points) and considerably more for Italy (40 basis points). This, of course, has everything to do with the Italian budget for 2019, which continues to cause turmoil. The European Commission (EC) rejected the Italian draft budget, the first time the EC has taken such a step. With the projected increase in the budget deficit to 2.4%, the current government is disregarding the aim of the previous one to reduce debt levels. In addition, the EC is concerned about the Italian government’s overoptimistic growth forecasts. Consequently, the deficit could eventually reach 3% and the reduction in the government debt (130% of GDP) would grind to a halt. The Italian government must submit a revised budget by 13 November at the latest, but comments coming from Rome suggest that no substantial changes will be made. In the meantime, rating agencies Moody’s and S&P have revised their assessment of Italy’s creditworthiness. Moody’s downgraded the rating by one level to Baa3, the lowest rating within ‘investment grade’, with a stable outlook. S&P maintained the BBB rating, the second-lowest within ‘investment grade’, but downgraded the outlook to ‘negative’. The rating agencies’ announcement was largely expected by the markets. Corporate bonds lost some ground, which resulted in higher spreads to government bonds. However, the spreads did not exceed the highest level for this year reached at the beginning of July.

 

 

Central banks and monetary policy

The central banks provided little in the way of news over the past month. President Trump criticized the Federal Reserve because, in his opinion, interest rates have been increased too sharply and the expected upcoming rate hikes will neuter the government’s tax and budgetary measures. The central bank, as an independent institution, will not be influenced by these comments. The European Central Bank is not expected as yet to deviate from its path towards the normalization of monetary policy (ending of bond purchase program as of January 2019 and first rate hike after the summer 2019) in view of rather disappointing growth figures in the eurozone or the situation in Italy. It is generally presumed that the ECB will not take any specific action to support the Italian bond market unless contagion to other peripheral countries becomes a threat.

 


Currencies

As with other ‘safe’ investments, a number of safe haven currencies, such as the dollar (+2.5% against the euro) and the yen (+3.2%), performed well in October. In addition, macroeconomic data in the eurozone tended to be somewhat below expectations while those in the US remained robust overall, a factor that also weighed on the euro. GBP remained virtually unchanged on balance, but experienced considerable volatility over the past month due to the difficult Brexit negotiations. The Scandinavian currencies were weak, with Sweden not yet managing to form a government two months after elections (SEK -0.5% against the euro). The Norwegian currency (-1% against the euro) in turn suffered from the sharp fall in oil prices. The Brazilian real rebounded by 10.4% against the euro after the victory of right-wing populist Jair Bolsonaro in the presidential elections.

 


Commodities

In stark contrast to September, when the price of Brent reached its highest level in almost four years at 85 dollars a barrel, the price fell sharply last month to just above 75 dollars. Oil prices are often volatile because relatively small changes in the expectations for supply or demand can lead to an imbalance in a market that is close to its maximum capacity. In September there were fears that there would be insufficient supply when the export ban on Iranian oil came into force on 4 November. However, in October there were signs that Iran will try to circumvent the US embargo, possibly with the help of Russia and China. Moreover, the scandal surrounding the murder of journalist Jamal Khashoggi erupted, which threatened to disrupt good relations between Saudi Arabia and the US. As a result, Saudi Arabia was forced to announce that it would not use its production as a weapon, read: Saudi Arabia will continue to use its available capacity if necessary. Industrial raw materials declined again following signs of a continued slowdown in growth in China, general risk aversion on the markets and a stronger dollar. This time around, gold was able to benefit from the turbulence on the equity markets. Some market participants expect the US central bank to follow a less aggressive path of interest rate hikes than it is currently proposing. Moreover, the market turbulence in October was also felt in the US market.

 

 

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