June was characterised by a strong rebound in global equity valuations and a significant rise in bond markets as central bankers, in particular those of the ECB and Federal Reserve , gave assurances that more accommodative monetary policy is on the way.
Good news on the Sino-US trade conflict came late in the month with the announcement on the sidelines of the G20 that negotiations are to restart.
- New packages of monetary easing from the ECB and Fed are imminent
- Equities recovered almost all the ground they lost in May
- Bond yields in G3 countries are back at their all-time lows
Investors are captivated by central bankers’ talk
- Mario Draghi’s wording may have been less hard-hitting than his “whatever it takes” of July 2012, but it was almost as clear and effective.
- His comments on 18 June (“we will use all the flexibility within our mandate to fulfil our mandate”) took markets by surprise. They are seen by market watchers as a commitment by the European Central Bank (ECB) to additional monetary easing measures.The big question now is whether the increased stimulus will come through a cut in interest rates or a new round of bond purchases (quantitative easing).
- President Draghi’s triggered a sharp rally in equity markets, a fall in the exchange rate of the euro verus the US dollar.
- On 19 June the conclusions of the Federal Open Market Committee (FOMC) of the US Federal Reserve gave the rally in equities another. All the main equity indices clawed back the steep losses they suffered in May.
There was some nervousness over renewed tensions in the Gulf after Iran shot down a US drone, US military strikes were called off at the last minute, and new financial sanctions were levied on Iranian assets.As is usual when geopolitical tensions arise in this region these events triggered a rise in oil prices on account of the importance of the Strait of Hormuz for the transport of oil from Saudi Arabia.
On the economic front, indicators have not really worsened in recent weeks, but nor are they sending out any compelling signs of improvement. After the first-quarter rebound in growth (+0.6% GDP in OECD countries, up from 0.3% in the fourth quarter of 2018) and with domestic demand looking solid in most major economies, investors are still concerned about the risks to global growth, concerns that central bankers have done little to dispel
Exhibit 1 : A strong rally in equity markets in June
Equities – renewed appetite for cyclicals
- Equities performed very well on the month, with the MSCI AC World up by 6.4% and the MSCI Emerging gaining 5.7% (both expressed in dollars).
- The MSCI AC World is up 14.9% and the MSCEI Emerging up 9.2%, , year-to-date through June.
- The US was the top-performing developed market in June (+6.9% for the S&P 500, which hit an all-time high on 20 June).
- In US dollar terms Japanese equities (+3.3% by the Nikkei 225) underperformed in contrast, due to the stronger yen.
- The yen, reached its highest level since April 2018 versus the US dollar after the Bank of Japan’s comments were deemed less dovish than the Fed’s.
- Eurozone equities gained 5.9% (as measured by the EuroStoxx 50), despite modest gains by banks, which face the prospect of very low interest rates for a long time.
- Meanwhile, the most cyclical sectors, in particular in upstream production processes, tended to outperform, as they did in US markets.
Interest rates in the eurozone – now at all-time lows
- The bond markets reacted unequivocally to Draghi’s dovish language on 18 June, with the 10-year Bund yield falling below -0.30% (ending the month at -0.33%, a fall of 13bp over the month and 57bp YTD), while the 2-year yield plunged to -0.76%.
Exhibit 2: The German sovereign yield curve plunges into previously uncharted, negative territory
Bond prices rose (and yields fell) across the board.
- The 10-year French OAT slipped below the symbolic mark of 0%;
- Spanish yields are in negative territory up to six-year maturities, with the 10-year yield at 0.40% (-32bp on the month);
- The Italian 10-year yield fell by 57bp on the month to its low since mid-May 2018 at 2.10%.
- The performance of Italian sovereign debt was the most spectacular in absolute terms and also the most surprising, given that it came amidst the ongoing standoff between the Italian government and the European Commission.
- In early June, the EC deemed that the opening of an excessive deficit procedure (EDP) was “justified”. The Italian Prime minister, Giuseppe Conte, wrote to European leaders to reassure them that the structural deficit would be reduced in 2020 while, at the same time, speaking out in favour of tax cuts as part of Italian tax reform.
- The planned issue of miniBOTs (which would be tantamount to IOUs from the Italian state and could, in theory, constitute a parallel currency vs. the euro) also resurfaced.
- The Italian government nonetheless expressed its willingness to cooperate and its determination not to allow the situation to fester, given that Ecofin could rule on 9 July on the opening of an EDP against Italy. The possibility of this decision being pushed back to autumn may partly explain the rally in BTPs’ gains in June.
What to expect in the second half of 2019
Financial markets in June in many ways looked like a replay of January, with bond yields falling and equities rising sharply. What the two months have in common is the highly dovish language of the Fed and the ECB.
The economic environment has stopped worsening but is still showing no clear signs of rebounding, and a soft-growth scenario could very well be the one that plays out. Global trade has so far managed to more or less withstand higher tariffs over the past year, but it is still subject to weakness.
Trade tensions are uppermost in the minds of investors, who tend to react in knee-jerk fashion to statements from Washington and Beijing. Headway made on the trade issue during the G20 summit provided some short-term assurance, but the trade risk is still hovering over global growth, and geopolitical risks have increased recently with tensions in the Gulf region.
Against this backdrop and with inflation expectations very low, the major central banks have stepped up their message of caution. The Fed and the ECB have virtually pledged, subject to the usual caveats of course, to set up new monetary easing measures (cuts in key rates or asset purchases).
This was cheered by investors, as it should prolong the Goldilocks scenario of moderate growth, low inflation and low interest rates. And yet, the central banks’ reprieve looks a little artificial, as if they have simply refused to remove the intravenous drip that has been feeding the economy for the past 10 years.
Yes, investors cheered central bank comments, but they are already looking ahead at the shape the global economy will be in after summer. Markets will remain on edge until there is better news on economic growth.