Equity markets have continued to rally in recent weeks, led once again by the US market. The optimism of the equity markets comes in sharp contrast to the general decline in bond yields. Damien Petit, Head of Private Banking Investments at Banque de Luxembourg offers some explanations.
During the first six months of the year, the US market posted a rise of some 18% in dollars, its best first-half performance since 1997! The European, Japanese and emerging markets also performed strongly over the period, albeit to a lesser degree.
Equity market investors were reassured by the more dovish tone emanating from the monetary authorities, particularly in the United States, and they seem to have shrugged off the fears of a slowdown which prevailed in the last three months of 2018. Is this just a temporary phase?
Bond yields slump
The optimism of the equity markets comes in sharp contrast to the general decline in bond yields. The equity and bond markets seem to be anticipating very divergent economic prospects. The negative-yielding bond universe has been steadily expanding and now stands at nearly USD 13 trillion. For example, German sovereign debt is posting a negative yield on maturities up to 20 years. On the Swiss debt market, investors have to buy bonds with maturities of at least 45 years to get the slightest positive return. Against this backdrop, the US Treasury bond market, which offers positive 10- and 30-year yields of approx 2% and 2.5% respectively, continues to be relatively attractive to investors, despite the sharp decline in recent months. The slump in bond yields is due to the markets anticipating interventions by the central banks, whose threshold of tolerance for any form of economic and/or financial stress appears to be shrinking.
Three interest rate cuts likely by end-2019
In the United States, the lack of a swift resolution to the US-China trade spat is worrying the Federal Reserve, which is likely to respond by cutting its interest rates. The market is now factoring in three 25-basis point cuts before the end of 2019, an aggressive scenario given the current dynamism of the US economy. A preventive measure of this scale would quickly wipe out the Fed's capacity to react in the event of a much sharper economic downturn in the future.
Interest rate cuts and new asset-purchase programme cannot be ruled out
In the eurozone, despite very little room for manoeuvre – interest rates are at record lows and the ECB's balance sheet has swelled to EUR 4.7 trillion – Mario Draghi recently indicated he would not rule out further interest rate cuts or a return to the asset-purchase programme in the face of very weak inflation projections. Crucially, these measures offer very little certainty of success on growth and inflation but have potentially negative consequences, especially on the banking sector. The markets are now waiting to see whether Christine Lagarde, due to be confirmed as the new President of the ECB in October 2019, will follow in her predecessor’s footsteps.
Cautious view on equities
In a context of growing divergence between rising equity prices and worsening economic fundamentals, we are maintaining a cautious view on equities. This is reflected by slightly underweighting the asset class in our discretionary portfolios in favour of cash. We do not consider valuations are sufficiently attractive to give equities a higher weighting. Within the equity portfolio, we continue to focus on high-quality companies – avoiding the financial sector in particular – which are capable of generating sustainable dividends. That is a valuable attribute in a structurally low interest rate environment.