Stable growth to continue: Economic growth has been stable in most parts and robust in others. The Eurozone has been a bright spot with PMIs indicating an acceleration of growth. India’s data indicates a recovery from the disruptions of GST and demonetization. The US is on a steady course. Only China has shown a slight deceleration, albeit still in expansion, due to macro prudential policies to rein in credit growth in highly levered sectors of the economy.
Inflation weak but could turn. In the US, inflation has slowed in 2017 but perked up in October. A debate regarding inflation and monetary policy is topical within the Fed and will have implications for policy going forward. Inflation has been persistently low despite 10 years of policy accommodation, leading to confusion about the efficacy of policy on prices. In Europe, inflation has also weakened despite the ECB’s continuing QE. Meanwhile in China, inflation which lurched downwards in Q1 of the year is steadily recovering even as the PBOC is trying to cool credit markets. And in India, inflation has recovered to last year’s levels. India’s economy is highly sensitive to oil prices which have recovered in the second half of the year.
In equities, offshore Chinese equities led gains, joined by Japanese equities. Japanese equities have been buoyed by strong sentiment supported by an apparent improvement in economic data as well as resounding political support for the Abe government in the general elections a month ago. In a world of expensive equities, Japanese markets are also more reasonably priced. Indian equities were weak in early November on worries about their trade deficit and rising oil prices but managed to recover their composure for a positive November.
The lack of inflation evidence coupled with the determination of the Fed to raise rates in December, now a 90+% probability event according to the futures markets, have led to a flattening USD yield curve. The market also prices but 2 rate hikes in 2018 against the Fed’s indicated 3. These expectations have implications for fixed income portfolios. Most investors have reacted to expectations of rate hikes by shortening duration to precisely where it has hurt most, the 2 year mark, whereas 10 to 30 year duration has rallied. The EUR curve has imported some of the flattening but with less enthusiasm. 2 year bunds are only -0.70% up from -0.76% a month ago. With HY spreads below 3.4% and BBB spreads below 1.9%, bonds should not be expected to return any more than coupon in 2018, with possibility of loss from both spread widening and duration risk. Given that the ECB has not moved, the marginal impact of an inflexion in policy will be felt most in Europe. As for Asia which is dominated by the Chinese bond market, the PBOC’s efforts to tighten credit has put a lid on returns and will continue to do so. India’s exposure to energy will mean that an energy bull would not take on INR duration.
And finally, last week, the BoJ signalled, albeit vaguely, the concept of a reversal rate, that point at which further policy accommodation hurts the financial industry more than it helps the economy. The market is taking this as an early (very early) sign that the BoJ is contemplating policy normalization. We think it’s still much too early but markets often get ahead of themselves.
Concerted policy normalization, whether appropriate or not, has led to bear flattening across USD, EUR and JPY term structures. There are many implications but we focus for a moment on the banking sector. Banks’ margins are correlated with the 2 year part of the yield curve, not the 30 year. Yet current conditions have caused banks to underperform. In the US, it is fear that a flat yield curve may hurt the banks, in Europe, that rates will not be put up for some time to come, and in Japan that rates will never, ever, ever, be put up. The uncertainty surrounding the tax plan in the US is another damper on the banking sector. If any progress is made on that front, it might release more value from the banks. In Europe, margins have troughed regardless of interest rates due to lower funding costs for newly recapitalized banks. ECB normalization would be a bonus, although we don’t see it coming for some time. The same applies to Japanese banks where the strongest trade at 0.6 – 0.7 price to book, and any normalization by the BoJ could trigger a repricing towards 1X book. We don’t think the BoJ will normalize soon but if they do, it’s a bonus.