‘No deal Brexit’ prospects, the formation of an Italian anti-EU coalition, a stronger dollar and a stronger US economy created a mixed bag last month. With a special focus on increasing US bond yields, here is our Market Summary for May 2018.
Equity Markets
May was a mixed month across major equity markets, with strong returns from North America, and Europe and Japan performing poorly.
Better monthly returns came from the UK and Nordic countries, with relatively minor falls in the primary European markets. Although European markets were weaker overall, with the formation of a new Italian populist/anti-EU coalition, rippling political uncertainty and unease through the Eurozone’s weaker nations.
A mixed return in May from emerging markets. European emerging markets provided a drag on emerging markets funds and South America, led lower by a truckers’ strike in Brazil, a decline in the oil price, and falls in oil company shares, fared particularly poorly. Conversely, Russia and China saw strong rises as their currencies gained against the dollar.
Currency Market
Major themes: Stronger dollar, weaker sterling. Fears over the euro outlook and the prospect of a US/China trade war caused a flight to the reserve currency, which gained sharply against sterling and euro. Continued lack of progress in Brexit talks saw a decline in the pound.
Generic Bonds
Like equities, bond market movements reflected Italian political upheaval. Investors switched from riskier Italian, Spanish and Greek bonds to the perceived relative safety of French, German and ECB issues. The spread between stronger and weaker economies’ sovereign bonds widened dramatically. Meanwhile, yields in the UK and US contracted slightly as pressure for further early rate rises appeared to recede, benefiting some long-only bond funds.
EU Bonds
The European Central Bank (ECB) has just announced to end its Quantitative Easing (QE) programme at the end of December 2018, with a phased reduction from the current monthly pace of €30bn to €15bn from the end of September to NIL from the new year.
If, after QE, the European financial landscape is determined to be stable, this could potentially mean interest rate rises from the second half of 2019 and a positive outlook for European bond owners as yields would be set to increase.
US Bond yields head higher.
Since the start of the year, US bond yields have risen higher and faster than expected, and appear to be heading higher for good reasons (better economic growth), rather than bad ones (inflation). There are a plethora of factors at play here, but we’ll concentrate on four:
1) Strong US economy
Missing business confidence led to low business investment over recent years but, with president Trump viewed as more business-friendly, confidence increased following the Trump election with tax reforms driving Business confidence and investment higher.
2) More bonds
Increased bond sales fund increased budget deficit brought about by tax reforms. The US Federal Reserve, having used up much of its reserves to fund last years’ deficit cannot purchase some of the Bonds issued, increasing selling pressure.
3) Stable inflation
Bond markets don’t like inflation, and there is little sign of inflation rising to a level that would concern the authorities, although rising oil prices may spark concerns about increasing inflation further down the line.
4) A potential return to more normal economic conditions
Bond yields traditionally track or slightly exceed nominal GDP growth, but have been very low since the financial crisis due to weak economic growth. Better GDP growth and modest inflation increases produce a steady upward trend in nominal GDP growth, signals a potential return to more normal economic conditions, and lifts US bond yields towards more normal levels.
From the better economic data, we saw a few months ago, US bond yields looked too low pointing to yields being set to rise (and therefore bond prices set to fall). A key factor behind constructing portfolios designed to avoid a traditionally ‘safe-haven’, but fundamentally miss-priced asset class. With stronger economic growth and subdued inflation, those factors remain in play.
If you would like to discuss the impact of the market changes in relation to your portfolio please get in touch with your wealth manager.
