Positive data from the US and Europe lead us to believe that worries with respect to any slowdown in growth are largely misplaced, however, technical moves in markets related to supply, demand and positioning are currently taking centre stage.
During a quieter week overshadowed by World Cup football and the 4 July US holiday, investor confidence has brightened somewhat at the start of the new quarter, with emerging markets rebounding following conciliatory rhetoric in the wake of the expected Andrés Manuel López Obrador (AMLO) victory in the Mexican elections. Equity and credit markets were more mixed, whereas the eurozone periphery was relatively quiet following last weeks’ EU summit. Research meetings with European policymakers this week suggest that the EU is broadly hopeful that the new Italian government will show fiscal restraint when they come to drafting a new budget later in the year, and with populist initiatives more focused on measures to address immigration across the region, Brussels is hopeful for a constructive relationship with Prime Minister Conte and others – in contrast to those calling for an early Italy/EU point of confrontation.
Global economic data remains broadly robust, with the monthly US ISM survey above 60 for only the second time since 2004. In the eurozone, the composite Purchasing managers Index (PMI)rose for the first time since January, assuaging worries that growth is slowing. On an absolute basis, current PMI survey levels close to 55 are consistent with above-trend growth of around 2% on an annual basis and although trade worries may be a feature in months to come, for the time being, underlying economic momentum remains relatively healthy. In this context, lower Bund yields in recent weeks have had more to do with a dovish ECB stance than softer economic data in our view. We continue to believe that the European Central Bank (ECB) will err on the dovish side even as it moves towards reducing its asset purchases. In this context, leaving the door open to an ‘operation twist’, potentially buying more longer-dated securities to replace maturing securities, could be seen as a way of the ECB reminding markets that it does not want to see yields rise too quickly, or for financial conditions to tighten prematurely, thus choking off the economic recovery which is now underway.
This makes us wary of consensual trades and has seen us reduce credit positioning, in case we see a repeat of volatility spikes we have witnessed elsewhere in the past six months.
Meanwhile in the UK, Theresa May continues to work on plans to reconcile her government around a common position with respect to Brexit. However, this continues to be challenging and we remain concerned that, even if it is possible to forge an agreement inside the Tory Party, this plan could still be shot down quickly by a blunt refusal from Brussels. It seems that the UK has still paid little attention to how European Agreements are struck, nor to the weak hand they currently find themselves trying to play, and in the months ahead we continue to look for elevated political volatility. In the wings, our connections within the Labour and trades union movements suggest rising support for a 2nd referendum before March 2019 and if sufficient Conservative MP support is prepared to back this then it is still possible for much to change in the 266 days left before Brexit Day. Yet for now we believe it remains appropriate to adopt a negative view on Gilts versus Bunds, and on the Pound in anticipation that political worries are more likely to rise than fall in the days ahead.
As we look ahead, we sense that investor sentiment is relatively fragile at the start of the second half of the year, with many indices in negative returns year to date and many active managers underperforming. This makes us wary of consensual trades and has seen us reduce credit positioning, in case we see a repeat of volatility spikes we have witnessed elsewhere in the past six months. Technical moves in markets related to supply, demand and portfolio re-positioning have seemed more important in the short term than more fundamental factors and this could continue to be the case over the summer with liquidity relatively thin.
However, further ahead, we continue to believe that underlying macro fundamentals remain broadly constructive. There are risks, such as those emanating from an escalation in current trade conflicts turning into a full blown trade war. However, for now we see policy relatively accommodative and we believe that worries with respect to any slowing in growth are largely misplaced. As highlighted earlier, confidence remains strong and hopefully, as with rising confidence with respect to the prospects to the England football team, these hopes won’t prove to be sorely misplaced!