What’s driving markets?
12 SEPT, 2024
By Marco Giordano from Wellington Management
Bond markets have been discounting over the past few weeks an increase in global economic weakness; if this is correct, equity markets could see an adjustment. In addition, the ECB and the Fed will hold their September meetings in the coming days. The ECB comes into the meeting on the back of inflation data that reminds us of the potential for upside surprises. What factors will determine the course of the markets? Marco Giordano, chief fixed income investment officer at Wellington Management, answers.
Author: Marco Giordano, director de inversiones de renta fija de Wellington Management
- Bonds or equities, which is “right”? Following the rally in July and August, the level of bond yields relative to cyclical risk assets looks rich. Bonds are pricing in a significant slowdown of the economy while risk assets are still holding up. Should there be signs of a lift in cyclical data, we could see a retracement of bond yields. Equally, should bond markets have correctly priced in weakness in the global economy, equity markets would need to adjust. Over the last two years, global equity valuations have been climbing steadily, while bond yields have been declining from their peak in Q4 last year
.
If we focus on the last months, US labour market data has been the key driving force behind the bond rally. There is a lot of focus on market pricing, with futures still suggesting four cuts are due by the end of the year, meaning markets are expecting the Fed to deliver a 50bps cut in one of the three remaining meetings. That said, markets are still only pricing in a neutral rate higher than Fed’s (3% vs. Fed estimate of 2.75%), leaving space for the rally to continue.
- More cuts ahead. In Europe, despite recent inflation data coming in higher than ECB expectations, we don’t think this data will stop policymakers from delivering a further cut at the September meeting. There was a similar set-up in June, and if anything, the difference now is that the growth leads imply downside risk to the ECB’s forecast for Q3 growth. The ECB is also putting more weight on the forward-looking wage leads, some of which have been softer than the current inflation data. We continue to think the ECB is biased to cut rates but will cut gradually, given the potential for upside surprises in inflation in the next year.
The Bank of England has shown a clear dovish bias, despite some of the latest data suggesting a very different path than that discussed by policymakers. Inflation is proving sticky with an improving economic growth outlook through renewed housing activity, strong consumer spending and resilient household balance sheets. The risk of a policy error remains elevated.
- PBoC intervention. There has been mounting pressure for policymakers to try to shift the negative market narrative around the Chinese economy’s disappointing growth prospects. Last month we highlighted ongoing weakness in the real estate market and local government debt, which prompted a surprise reduction of various policy rates by the People’s Bank of China (PBoC). In August, we saw a dramatic shift in policymakers’ response to the relentless rally in bond yields, caused by slow economic growth, weak consumer confidence and underwhelming inflation (0.5% is the latest reading). Chinese fixed income increasingly stands out relative to the rest of the world.
Against this backdrop, we’ve seen the first outright intervention by the PBoC, confirming in a press release that it had sold long-dated bonds and purchased short-dated bonds in the open market, in an operation worth 100bn yuan (~$14bn). By doing this, the central bank is pursuing several objectives:
- Temper the significant rally in bonds, preempting the situation experienced by US regional banks last year where a sudden snap back in yields after a sustained rally caused systemic solvency concerns
- Maintain an upward-sloping curve while injecting liquidity in financial markets
- Encourage investors to avoid crowding into government bonds and divert flows elsewhere
- Ultimately stave off the risk of deflation setting in to the economy
- High yield default rates appear to have peaked, declining in both the US and Europe over the last few months. While we expect default rates to remain around long-term averages (~4-5%) over the next 12 months, we do not see a full-scale default cycle on the horizon given solid issuer fundamentals as well as a lack of near-term maturities. Market optimism appears to be reflected in spreads, which continue to trade relatively tight versus history.
