Last week we saw equities build on recent gains, credit spreads tighten and volatility subside, with the VIX Index closing below 20 for the first time since early January. Even though risky assets continue to stabilise, economic data has left many investors scratching their heads:
The US
Investors took some relief in the recent stabilisation of commodity prices as well as further evidence that U.S. inflation, particularly core inflation, is firming.
That said, challenges remain. The economic data has been remarkably contradictory of late. Last week, positive news included an uptick in the Chicago Fed National Activity Index (CFNAI), a strong U.S. durable goods report and a further rebound in euro area bank lending. At the same time, however, consumer and small business confidence is falling and the U.S. Services PMI fell into contraction territory. With economic data mixed, it should be no surprise that investor behaviour remains volatile. Last week witnessed safe haven buying with further flows into gold and Treasuries and out flows from U.S. large caps. At the same time, high yield flows continue to steady, with $1.2bn invested last week in the asset class.
Bond Yields and liquidity
While risky assets have stabilised, bond yields remain near record lows: Safe haven bonds remain well-bid, but liquidity continues to be an issue.
The rebound in stocks has yet to lead to any real backup in rates. U.S. 10-year yields are down 50 bps since the start of the year. Outside the U.S. the fall has been equally dramatic. German 10-year yields are down 45 bps while Japanese 10-year yields have plunged into negative territory. But while safe-haven bonds remain well-bid, other parts of the market are still challenged. Year-to-date, high yield issuance is the lowest since 2009.
EU referendum and Sterling
The next four months will prove critical as the U.K. prepares for an EU membership referendum in June: Recent weakness in sterling is another complication for the ECB as they contemplate their next move.
Last week’s referendum announcement, coupled with the news that London Mayor Boris Johnson will support the “leave” campaign pushed the pound down below 1.40, the lowest level versus the dollar since 2009. The recent drop in the pound puts additional pressure on the European Central Bank (ECB); not only has the euro been appreciating but inflation is slipping and economic data is weakening. One recent index of European ‘economic surprises’ (which measures the strength of the data relative to expectations) is now at its lowest level since 2014. All of this suggests that the ECB will be under pressure to deliver a more aggressive stimulus package at its March meeting.
China’s financial reforms
Chinese equities sold off again last week while the currency slipped. Despite the persistent volatility, China appears to be moving towards further reforms in the financial sector.
Stocks fell following an increase in money market rates and further slippage in the exchange rate. Last week the reference rate on the Yuan fell to the lowest level in three years. To help cushion the broader economy, government officials have suggested raising the fiscal deficit to 4% of GDP in an attempt to provide more stimulus. A longer term development was the decision by the People’s Bank of China to liberalise the Chinese interbank bond market. This entails removing the need for eligible offshore investors to use the existing quota system.
Energy/Commodities
Energy and other commodities rebounded last week: The spike in oil appears tentative, but cyclical commodities have been staging a more sustained recovery.
Although Iran threw cold water on the recent Saudi/Russian production agreement, investors were encouraged that there is any talk aimed at stabilising production. Longer term, the drop in crude continues to pressure both oil producers and lenders. Last week, Moody’s downgraded Brazilian debt to junk status and JP Morgan announced it would add $500m to reserves against its energy portfolio. However, outside of energy there are some signs of stabilisation in commodities. The Journal of Commerce Industrial Commodity Metals Index has been steadily gaining ground since last November.
