By Zac Tate, Hottinger Investment Management
July was the month in which markets started to get what they wanted from central banks. On 31st July, the US Federal Reserve (Fed) delivered a 25 basis point cut to interest rates, the first of roughly four such cuts expected by investors before next spring.
Other central banks continued the soothing mood music, with the European Central Bank’s (ECB) Mario Draghi signalling rate cuts and renewed asset purchases and the Bank of Japan’s Haruhiko Kuroda committing strongly to stimulus if the global slowdown continues. By supporting liquidity, the Federal Reserve’s action has emboldened central banks in emerging market economies seeking to provide their own stimulus. The Central Bank of Turkey cut its benchmark one-week repo rate by 4.25 percentage points in July, from 24% to 19.75%, and signalled further cuts in the future. Brazil’s central bank cut rates by 50 basis points for the first time in a year, and in Indonesia and Russia rates fell by 25 basis points last month.
In financial markets, activity was mostly placid. The positive correlation between the total returns of stocks and bonds – rising share prices coinciding with rising bond prices – has started to break down. In July, the price of 10-year US Treasuries fell by 0.34% as the S&P 500 pushed higher by 1.65% over the month. Positive correlations are still strong in the UK, however: 10-year UK gilt prices rose by 2.31%, while the FTSE All-Share rose by 1.02%. UK 10-year government yields have fallen from 1.2% in May to 0.625% at the end of last month as investors – in the search for safer assets – shrug off British political instability and the likely resumption of deficit spending. Meanwhile, German bunds have consistently rallied since October last year, when the first signs of volatility on the back of slowing global activity emerged. Since then, the price for 10-year bunds has risen by 10.5%; in July prices rose by 0.9%. However, European equity markets were negative on the month with the Dax down roughly 3% and the Euro Stoxx 50 1% lower than it was in June.
European equity markets declined sharply, with cyclical sectors leading the fall due to unfavourable global trading conditions and the fading effects of the previous round of monetary stimulus from the ECB. With weak industrial production weighing on activity in Germany and Italy, investors looked to France and Spain to provide a boost to the Eurozone economy. However, French Q2 GDP figures were weaker than expected and confirmed to many that the region as a whole could be moving into a slower lane. Disappointing European earning results, along with Brexit concerns, also contributed to subdued returns from European equity indices.
It is not surprising, therefore, that we saw some evidence of a defensive rotation in the European markets. The only European cyclical sector that saw positive expansion was Consumer Discretionary, which saw price growth of 0.5% in July, according to MSCI indices. Industrials (-1.03%), Financials (-2.31%), IT (-0.95%) and Materials (-3.36%) all saw price declines. Conversely, the defensive sectors either held their own or saw modest gains: Consumer Staples (+2.55%), Utilities (+0.23%), Healthcare (+0.12%) and Telecoms (+0.25). The picture is less clear for the UK, which saw defensive sectors such as Consumer Staples (+2.96) and Healthcare (+9.25) rally, but Utilities (-2.33%) fall back. Ongoing concern over the prospect of a new government that could seek to purchase utility companies at unfavourable valuations continues to bear down on that particular sector.
At the end of July, Fed Chair Jay Powell described his rate cut as a ‘mid-cycle adjustment’ to address softening inflation and sentiment. Asset markets are behaving as if this assessment is correct. Both cyclicals and defensives expanded in the US; the MSCI’s US Technology index (cyclical) and its Consumer Staples index (defensive) rose by over 3%. We think that the US economy is actually in late cycle, a period of the economic cycle where the growth rate of the economy is positive but falling before turning negative. Slower growth means that company earnings are less likely to meet investors’ expectations, raising the likelihood that share prices will fall. We are concerned that the implied earnings expectations priced into valuations are ambitious given the current macroeconomic environment.
Despite the move to ease monetary policy in the United States, the US dollar index strengthened by 1.73% against a basket of other developed currencies. Of particular interest has been the performance of sterling, which weakened by 3.82% against the dollar and 2% against the euro. Concern over the new British Prime Minister’s comfort with the prospect of leaving the European Union with no deal has forced sterling down at a time when wage growth and consumer spending are strong and the Bank of England is more reluctant than others to engage in monetary stimulus.
Further, the gold price (up by 1.9% in July) has been boosted by central bank purchases as these organisations reduce their exposure to US dollar reserves due – in large part – to the unresolved trade stand-off between the US and China and the risk of politicisation of the Federal Reserve.
In a late-cycle environment, real assets can be more attractive than credit products, and it often pays to take some equity risk off the table. While bond yields are low, the rally in this asset class could have some distance to run. We will keep an eye on this as the short-term benefits of capital appreciation could offset the low or negative yield over the holding period.