Author: NN Investment Partners
Subsiding geopolitical risk and strong earnings have contributed to a more favourable environment for risky assets. Not all regions and sectors are joining the party, however.
Higher oil prices, rising bond yields and a stronger dollar have caused nervousness in emerging markets, which are also held back by an ongoing disappointing news flow from the technology sector.
Improved risk environment not fully reflected in markets
The environment for risky assets has improved somewhat in recent weeks. The risks on the (geo-)political and trade fronts have moved to the background, the earnings season got off to a strong start, and tentative signs of stabilisation are visible in the global economic data surprises. Moreover, indicators of market behaviour provide more comfort as most of them have moved to more neutral levels in the past few weeks.
Nevertheless, global equities are struggling to resume the uptrend that was in place until the market corrected early February. Region and sector leadership has changed as well. Whereas the Eurozone, the UK and Japan have moved up in the past few weeks, emerging markets and, to a lesser extent, the US have more or less traded sideways. Within sectors there are large differences in performance as well. The energy sector, a notable laggard not too long ago, is a clear front runner in April, benefiting from the rise in oil prices. On the other hand, technology has been struggling for some time now, despite relatively strong earnings reports. However, not all these reports were strong. A few reports about waning demand for smartphones, amongst others from major chipmakers, rattled the tech sector and impacted the whole supply chain from producers of semiconductor manufacturing equipment to mobile phone producers. As tech stocks are one of the most crowded trades, continued selling pressure is a non-negligible risk.
The recent underperformance of emerging market (EM) and US equities is to a considerable extent the result of the weakness in the technology sector, given its weight in their market indices of 25-30%.
Bond yields move up as inflation expectations rise
Also financial stocks were lagging, but recently they rebounded. This rebound of the financial sector is clearly the result of one of the most discussed topics of the past weeks: the rise in government bond yields in general and in particular the 10-year US Treasury yield breaching the 3% threshold for the first time in four years last week. The rise in US bond yields is driven by worries about the growing supply of government debt and rising inflation expectations on the back of an increase in the oil price. The latter is supported by the increase in geopolitical risk, due to the flared-up tensions between the US and Russia and the possibility of renewed US sanctions on Iran. Meanwhile OPEC oil output keeps falling as part of the deal with Russia and other non-OPEC producers to cut excess supply.
Dollar strength expected to be temporary
Another notable development is the recent strengthening of the US dollar. An explanation for this dollar rally is the support of higher US interest rates, although we have some doubts about this narrative. A quick look at positioning data in FX markets suggests that the recent dollar appreciation seems to be nothing more than another ‘short squeeze’ as short positions in the US dollar had become quite stretched before the appreciation started. Such corrections are usually short-lived. The US dollar appreciation from early September until mid-December 2017 was, in hindsight, also to a large extent a position adjustment after nine months of dollar weakening. The same seems to be happening now. Hence, we expect the bear trend in the dollar to resume in a couple of weeks or maybe months.
Headwinds for emerging markets
Next to the aforementioned weakness in technology stocks, the rising oil price, combined with increasing US bond yields and a stronger dollar, are creating a more challenging environment for EM assets. Reasons why emerging markets have so far been so resilient are the narrowed macro imbalances, improved domestic demand growth, a benign inflation picture, and the weakening of the US dollar. While we expect the dollar strength to be temporary, inflation may start rising more structurally. EM inflation is more sensitive to higher oil prices because they also impact food prices, and food prices represent a relatively large share of the total consumer prices index in emerging markets.
EM central banks, which on balance have been able to cut interest rates, may start feeling more pressure. Higher inflation risk therefore has the potential to end the period of easy monetary policy in emerging markets.
The good news is that most emerging economies will be able to handle the pressure thanks to lower macro imbalances and a credible macro policy mix. And if market pressure were to intensify anyway, they should be able to prevent a serious confidence crisis thanks to large foreign exchange reserves. But this is a general observation about the EM universe as a whole. There are still vulnerable markets that are struggling in the current global environment. Among the most fundamentally challenged countries, Turkey remains the most vulnerable due to its large external financing requirements and the government’s aggressive growth maximisation strategy. We are also keeping a close eye on the Philippines and Colombia, although the latter benefits from a rising oil price.
We maintain a small overweight in EM equities for the time being given the positive growth momentum, but we keep a close eye on the developments. We have a neutral stance on EM debt, with a clear preference for local-currency over hard-currency bonds.
We prefer to stay cautious in our tactical asset allocation
With regard to our tactical asset allocation, we still feel comfortable with our current stance with underweight positions in spreads and commodities, and neutral stances on equities, real estate and government bonds.
Equity risk premiums are still attractive versus other asset classes, but at the very low levels of yield, these risk premiums are sensitive to changes in interest rates. Fed tightening expectations likely limit further contraction of the risk premium right now, and the strong earnings that are being reported have already been discounted for by investors. Over the last few years, global equity markets moved up faster than global economic growth. So, maybe we are now facing payback time where the economy is catching up while equity markets consolidate. Higher wages will help the consumer and can further support the demand side, but they deliver upward pressure on inflation and downward pressure on profit margins, impacting future earnings.
Finally, we should also realize that we all have a tendency to get used to an environment and that our willingness to hold on to prior beliefs can make us miss the next turn. From this angle, we might now underestimate the extent to which the tailwinds that were blowing in 2017 have faded. For us it makes sense to stay somewhat cautious in this scenario.