As the French elections come to a crescendo, global markets appear robust for now
Risk assets have continued to rally in the last week, as markets continue to discount a victory for Emmanuel Macron at this Sunday’s French Presidential run-off. European equities have pushed higher, leading to a compression in corporate credit spreads, and in this environment subordinated financials have outperformed, with investor sentiment buoyed by the prospect of declining political risk, strengthening economic activity and accommodative monetary and fiscal policies across the continent. There has been discussion of a ‘Goldilocks’ economic situation in the US in the past, but this description seems equally justified in Europe at the current point in time and policymakers are probably feeling very relieved as a result. Against this backdrop, French OAT spreads currently stand at their tights of 2017, though remain materially wider than they were prior to when the election campaign started. With Japanese investors still on the side lines, waiting for confirmation of the French vote after they return from Golden Week Holidays next week, we believe there is scope for these trends to run further in the days ahead.
With risk appetite relatively robust, Bund and Treasury yields have pushed modestly high over the course of the last week. The Federal Reserve FOMC meeting appeared to confirm that interest rates remain on an upward trajectory and we remain confident that the next hike will come in June, as long as there is not a substantial market or data shock in the interim, to pull the Fed from this path. It was interesting to hear that the Committee are looking through the soft headline Q1 GDP numbers and we would note that this outturn would have been at 2% but for inventory drawdown and a temporary decline in government spending. For now, we see no reason to change our views on the future path of US rates and market expectations of just 2.5 between now and the end of 2018 look far too complacent in our opinion.
Emerging markets have continued to trade well in this risk on environment, though data from China this week was somewhat softer than expected. This has seen commodities remain relatively soft with oil prices close to the lows of the year at $47.50 and commodity currencies also under pressure. At the moment we do not see a catalyst for these moves to extend further, given the backdrop for global demand remains relatively healthy. However, it remains important to monitor these moves as a move in commodities, such as oil below $40, could change the backdrop for shale investment spending as well as the inflation backdrop.
It strikes us that we may be moving into an environment when the main thing investors fear is fear itself.
Elsewhere, in what is a relatively benign global investment environment, it has been notable to witness the recent relative underperformance of Italian BTPS. Based on anecdotal evidence, it appears that many hedge funds and ‘real money’ investors in the US and UK have built short BTP positions in recent weeks in the anticipation that as soon as the French election passes, Italy will become the next focus. However, we feel that this thinking is too simplistic. Italian elections may not take place until early 2018 and even if the 5 Star movement is the largest party, it will need to work in coalition with others. Moreover, it has been interesting to see leaders in 5 Star moderating their views on the EU in recent weeks and consequently we view it unlikely that such a result will lead Italy looking to leave the Euro. Although it is clear that reform is needed in Italy and the sovereign will be vulnerable in the next recession, improving economic data in the short term is buying Italy some time and therefore those looking for Italian spreads to blow wider, may end up disappointed in the near term and forced to cover these shorts.
Looking ahead, it strikes us that we may be moving into an environment when the main thing investors fear is fear itself. As US equity indices move to new highs and volatility indicators drop to new lows, it is tempting to think that there must be widespread complacency. However, we are at a point in the cycle where global growth is relatively robust, monetary and fiscal policy is accommodative, inflation remains stable at low levels and profits are growing. Moreover widespread calls from analysts citing market valuations as over-stretched may highlight the fact that many are under-invested in stocks and would love to add on a pull-back in prices. In such a scenario, one wonders if markets can continue to climb a wall of worry.
Indeed, the mantra of ‘don’t worry, be happy’ is certainly a refrain that comes to mind when one thinks of Art Laffer, whose economic arguments suggest that tax cuts and infrastructure spending will be self-financing as they raise the level of growth in the economy. Were such thinking to take hold in Washington as our recent policy maker meetings lead us to perceive, then risks still look more skewed to the upside than the downside at the current point in time.