Adrien Pichoud Economist
Maurice Harari Senior Multi Asset Portfolio Manager
Wanda Mottu Portfolio Manager
Christophe Buttigieg Portfolio Manager
01

Eurozone - The positive growth outlook is now largely discounted

As the old German saying goes, trees don’t grow to the sky. This certainly applies to economic surprise indices that compare actual economic data releases to market expectations. They are by definition mean-reverting, as any sustained positive (or negative) streak of macro data leads to an upward (or downward) adjustment in market expectations.

In that respect, the uninterrupted 16 months of positive economic surprises for the Eurozone was already remarkable and reflected entrenched pessimism and scepticism on the ability of the old Europe to finally reach escape velocity after a double-dip recession.

However, as GDP growth settled above 2% and market consensus finally moved toward a positive stance on the European growth outlook, the potential for positive surprises diminished. Then the inevitable happened: confidence and activity indices edged down from their record high levels in February and dragged the Economic Surprise index into negative territory. Such a decline simply reflects the fact that the (still positive!) growth outlook for the Eurozone is now largely expected. In the meantime, it is the US economy’s turn to deliver positive surprises as the impact of tax reform is gradually discounted in economic forecasts.

Eurozone economic surprise index finally turns negative

Sources: Bloomberg, SYZ Asset Management. Data as at: 9 March 2018

Graph 01

Spain and now Portugal have erased the last recession (unlike Italy)

Sources: Bloomberg, SYZ Asset Management. Data as at: 9 March 2018

Graph 02
02

Eurozone - …but is nonetheless still real and sustained

The Eurozone economy may not positively surprise the markets anymore but actual economic data continue to describe solid and sometimes strong growth across all economies and sectors. PMI indices in the manufacturing and service sectors and various confidence indices still point to annualised GDP growth of around 2.5% - more than twice the long-term potential growth rate.

The GDP data for Q4 2017 strengthened this picture: Eurozone output was up 0.6%, led by strong expansion in Spain and Portugal (+0.7%), but also in Germany and France (+0.6%). Italy (+0.3%) continues to lag somewhat behind and is still looking to reach its GDP level of Spring 2011, as domestic demand remains tame.

The catch up of the Spanish and Portuguese economies after their deep 2011-12 recession is, on the contrary, spectacular. Portugal just recovered its pre-recession GDP level, offseting an 8% decline. And Spain keeps growing at an enviable 3% yearly rate that even mighty Germany is not able to sustain.

03

United States - Inflation remains under control for the moment

After the US economy accelerated last year and President Trump got his tax cut packaged approved just before Christmas, concerns around the growth dynamic and its sustainability have vanished. All eyes are now on inflation-related data and their impact on future Federal Reserve monetary policy.

Indeed, the path of the rate normalisation is key for financial markets that have been accustomed to low rates for so long. The favourable global economic backdrop warrants a normalisation of US credit conditions and such normalisation can be implemented gradually as long as the pace of price increases remains mild. Any unexpected acceleration in inflation, on the contrary, could lead the Fed to tighten its monetary policy more rapidly.

In this context, no wonder that a small spark (higher-than-expected hourly wage growth) can trigger a spike in volatility such as the one observed in February. Even if this data point is expected to be revised lower a month later as happened in this case. For now, price and wage gauges of inflation remain at subdued levels and do not require the Fed to become more aggressive. Financial markets certainly hope that it will continue.

Inflation gaugues gently trend higher but remain tame for now

Sources: Bloomberg, SYZ Asset Management. Data as at: 9 March 2018

Graph 03

Tight credit spreads were another manifestation of low volatility

Sources: Bloomberg, SYZ Asset Management. Data as at: 9 March 2018

Graph 04
04

Fixed Income - Credit spreads and volatility are two sides of the same coin

Equity markets were not the only area where volatility reached abnormaly low levels in 2017. If the well-known VIX index of S&P500 volatility hovered at or close to all-time lows for most of the second half of last year, the MOVE index of US rates volatility also reached an all-time low late in 2017. It then rose from mid-January to hit a nine month high in February, reflecting rising uncertainty and concerns around the inflation and monetary policy outlook.

Credit spreads, a gauge of the premium that private borrowers have to pay over the "risk-free" government rate, are ultimately driven by the same underlying factors as volatility. It is therefore no surprise to see a close relationship in their evolution. Credit spreads widened too in February, more significantly for riskier High Yield issuers (in the ITRAXX XOVER index) than for Investment Grade issuers (in the ITRAXX MAIN index).

If volatility, on rates and equities, and credit spreads have come down since February, uncertainty and fears around the inflation outlook make these bouts of volatility likely to shake markets again in the future. The impact of higher volatility on credit spreads and therefore corporate bonds shouldn’t be forgotten.

05

Emerging markets - Monetary policy easing trend at play

Monetary policy trends in developed economies are quite harmonised, all trending toward (gradual) removal of the unprecedented stimulus of the past decade. Within emerging economies, the picture looks quite different. Several large EM central banks are on a clear monetary easing path: central banks in Brazil and Russia cut their key short term rate again in February, and the South African central bank may follow later in the year.

The combination of a positive global growth dynamic, the stabilisation (or even decline) of the US dollar and of firmer oil prices has helped to reverse higher-inflation dynamics fuelled by currency decline in EM. Central bankers now have room to loosen their policy and support economic activity.

This trend is not shared by all large emerging economies. In Turkey, the central bank is "on hold" due to double-digit inflation. However, no doubt if inflation slows down and the lira stabilises, it will be keen to lower its key rate. In Mexico, political risk has continued to weigh on the peso and has kept the imported inflation dynamic alive, on top of one-off effects linked to tax increases. Hence, the central bank has had to hike rates again in February. But here too, a reversal in the inflation dynamic could open the door to a monetary policy loosening in the second half of the year, after the presidential election.

Monetary policies in emerging economies are trending toward easing

Sources: Bloomberg, SYZ Asset Management. Data as at: 9 March 2018

Graph 05

S&P 500 and Bloomberg Barclays US Corporate HY (OAS)

Sources: Bloomberg, SYZ Asset Management. Data as at: 14 March 2018

Graph 06
06

Equities – S&P 500 sold off while US High Yield was more resilient

Equity markets were under pressure from the end of January, with the S&P 500 down -8.6% as of the 8th of February before recovering some of the losses and ending the month in the red at -3.7%.

The sell-off came on the back of prospects of tighter monetary conditions in the US, a stronger employment report for January - including better average hourly earnings - coupled at the same time with inflation gradually moving towards the target of developed market central banks. This, paired with concerns about asset valuations, led to a sharp correction in equity markets in the first few weeks of the month.

Moreover, volatility finally returned to markets, while global rates creeping up and credit spreads widening -however, these were more resilient than equities.

More surprisingly, in this market environment, high yield has still managed to outperform investment grade credit.

07

Equities – US regional banks outperforming the broad US equity market

Since the US Federal Reserve initiated its rate tightening cycle at the end of 2015, regional banks have been outperforming the broad index by circa +14%.

The prospect for higher interest rates in the US benefitted directly regional banks that are closely correlated to the evolution of the 10Y US Treasury yield.

Moreover, the so-called "Trump effect" is perceived to be positive for US banks in general as net interest income is generally improving coupled at the same time with potentially lower corporate taxes. It is also allowing the return of excess capital to US banks, leading to more share buybacks.

Banks’ profitability is improving and pushing share prices up because of higher short-term interest rates, forward inflation expectations picking up and stronger economic momentum in the US.

In this context, the performance of the S&P 500 index in 2018 is so far up +1.8% vs. +6.2% for the DJ US Select Regional Banks index, helped by a steeper yield curve - the 10Y US Treasury yield was up +46 bps reaching 2.87% at the end of February.

S&P 500 and DJ US Select Regional Banks index evolution (rebased at 100) vs. US Generic 10 Year Yield

Sources: Bloomberg, SYZ Asset Management. Data as at: 14 March 2018

Graph 07

Emerging markets five-year Credit Default Swap

Sources: Bloomberg, SYZ Asset Management. Data as at: 28 February 2018

Graph 08
08

Emerging markets - Russia wins back investment grade rating at S&P

S&P announced on the 23rd of February its decision to raise Russia’s sovereign credit rating back to investment grade. Russia was downgraded by S&P in 2015 when the country entered into recession following the oil price collapse and the implementation of international sanctions. S&P made its latest decision based on Russia’s commitment to conservative economic policies that are helping the country to adjust to an environment of lower energy prices and international sanctions.

Fitch already categorised Russia as investment grade while Moody’s scores it as high yield but with a positive outlook. Hence, Moody’s could follow the same path as S&P and raise the rating to investment grade in the coming 12 to 18 months.

Last year, the Russian five-year CDS contract was trading in between emerging investment grade issuers (Colombia and Mexico) and high yield names (Brazil and Turkey). Russia is now trading in line with investment grade peers like Colombia, which has the same S&P rating, and Mexico, rated two notches higher.

09

Switzerland - Moderate but robust growth

Despite relatively weak growth in 2017, the Swiss economy ended the year on a more upbeat note with economic growth accelerating in the second half. The pursuit of growth in the current economic environment, with the Eurozone maintaining its expansion as the central banks (ECB and SNB) keep a relatively accommodative stance, should pave the way for an economic bump in 2018.

GDP expanded 0.6% in the last quarter of 2017 and 1.9% on a year-on-year basis. Growth was broad-based across various sectors, but the robustness of manufacturing activity provided a substantial momentum. Better growth in Europe and a weaker currency also supported the Swiss export-led economy.

While subdued inflation persists, the SNB is expected to maintain a supportive economic environment by keeping unchanged its expansive monetary policy in the medium term. In this environment and with leading economic indicators pointing to upcoming trends, the Swiss economy is expected to maintain its cap and grow at 2.3% in 2018.

Swiss economy resumes solid growth

Sources: Bloomberg, SYZ Asset Management. Data as at: 28 February 2018

Graph 09

Japan stocks fall on yen’s surge

Sources: Bloomberg, SYZ Asset Management. Data as at: 28 February 2018

Graph 10
10

Japan - BoJ suprises the market with tightening comments

Despite the well-known negative correlation between the yen and the Japanese stock market weakening last year, the relationship came back into the spotlight in February. While global stocks rebounded after the selloff, the Topix index and the Nikkei 225 failed to follow and dropped further, mainly because of yen’s jump.

The cause of the sharp currency appreciation was a comment from Mr. Kuroda saying that the Bank of Japan would consider winding down quantitative easing in the 2019 fiscal year.

Japan being a country very sensitive to exports, moves in the JPY tend to ricochet in the equity market. The comments of Kuroda demonstrate that the currency remains fragile to external shocks and should be a signal to BoJ that the market is not ready yet for tightening. Moreover, inflation figures in Japan remain far away from the inflation target. Both elements are lowering the likelihood of a potential tightening.