Political turmoil in the UK
Second quarter was filled with risk and modest
returns
It all
seems a bit odd. Equities have moved back towards the top of their recent
trading sessions, and yet the US ten-year government bond yield continues to
languish at one of the lowest yields in 10 years.
The bond market is
still deeply sceptical about the outlook for growth, while equities hold at
their highs in the hope of growth. Meanwhile, Brexit has caused mayhem in
European political circles. We are waiting for new leadership in the
UK and possibly Europe to guide us on how discussions over the UK’s exit may
develop.
The
second quarter has shown us that risk is very much at large. It was a quarter
which again proved that a bias to fixed income investment worked best. Trying
to time the markets was at best hazardous if not outright destructive of
portfolio returns. The markets have not just had to deal with Brexit, but a
Federal Reserve that has shifted from hawks to doves and are possibly on their
way back again. The US 10 year government bond yield that started the month at
1.77% traded as high as 1.92% and ended the quarter at 1.47%. The global
developed market equity index in dollar terms traded in an 8% band, but
delivered just a 0.3% capital return for the second quarter. Global sovereign
debt gave 4.3% return. Bonds still reign supreme on a risk-adjusted basis.
The
market is still picking over what Brexit means for the medium-term outlook for
the UK and EU. To be honest, it is very difficult for the financial
market to come to any firm conclusions about the impact of the UK leaving the
EU. At this stage, we don’t even know how the UK and the EU will position
themselves in the negotiations. The result of the UK Conservative
party leadership election will be announced on the 9th September, unless the
candidates decide to stand aside and allow one candidate to run unopposed.
Until we know who has one and hence what strategy they are likely to adopt in
their negotiations with the EU, it is difficult to gauge just how difficult
those negotiations will be. Equally from the EU side, the politics of the
situation looks murky. The press is suggesting that the current President of
the European Commission Jean-Claude Juncker no longer has the full support of
the German government. His rather belligerent attitude post to the Brexit vote
appears to have not resonated with the majority of EU heads of government.
The
markets are starting to see a more dynamic situation in the UK where the
conversation is moving away from just how bad it is going to be, to what we are
going to do about it. Mark
Carney the Governor of the Bank of England in the past week talked about “some
monetary policy easing”. While George Osborne the UK Chancellor of the
Exchequer talked about the possible need to accelerate cuts in corporation tax,
probably down to a lower level of 15% as opposed to the 17.5% the government
mentioned before.
UK
sterling, while stabilising at levels of around $1.33, still looks vulnerable. Although the fall
has made UK exporters immediately more competitive in global markets, it will
take some time, as it always does, for a much improved competitive position to
translate into a marked improvement in export volumes. Also in the background,
the UK has an enormous current account deficit to fund that requires capital
inflows to stabilise the currency. With such uncertainty over the UK’s access
to the EU, companies that were considering expanding their businesses in the UK
to gain access to the EU may at the very least hesitate.
Equity
markets have made progress, but they still struggle to get support from the
fundamentals such as corporate earnings. The latest set of corporate
earnings revisions for June shows another round of downgrades to numbers for
the developed markets. Despite the bad news flow, the equity markets
have pushed to their highs in recent trading sessions. However, investor
interest has centred on defensive stocks; cyclical stocks have underperformed
defensive stocks in Europe since the Brexit vote.
With such
challenges in Europe, investors are revisiting other parts of the world in
search of safer and more predictable investment opportunities. Attention
has turned to the ASEAN region where GDP growth of 5% is being maintained. Indonesia,
for example, should see higher GDP growth in the second half of the year. A
pick up in government spending should reinforce strong investment spending
taking GDP growth to 5.0%.
The
quality of the situation has been getting better with Indonesia’s short-term
external debt falling to $38.1 billion, the lowest since 2012. Indonesian
equities have made new highs in recent trading sessions and remain well
supported by Asian institutional fund buying. Indonesia bonds still trade at
reasonable spreads over treasuries and should find more support, despite the
likelihood of more debt issuance in the coming months. The equity and bond
markets of Thailand and Philippines have been much in demand and are probably
fair value at present.
As the
Holy month of Ramadan draws to a close the regional and fixed income markets
are looking forward to a strong pipeline of deals. Kuwait is also
aiming to tap international capital markets to raise close to $10 billion in
Eurobonds to help bridge their budget deficit. We expect GCC and international
investors to welcome a new issuer of benchmark size to the GCC bond markets,
and we expect any bond sale to do well. We still await the Kingdom of Saudi
Arabia Eurobond multi-tranche transaction, which we expect to see post-Eid.
Given market appetite we expect the tenures to be skewed towards five and ten
years with some proportion possibly aimed at a 30-year maturity. In a sign of
the international interest in the Kingdom, Saudi Electricity secured $1.5
billion in unsecured financing from China’s ICBC.
Global
bond markets will be looking to some key data this week to see if yields are
going to hold at current low levels. The employment report on Friday will be
chewed over by the markets to see if there are any signs that the labour market
will be sufficiently vibrant to push the Fed to increase interest rates. The
market is pricing a very low probability of Fed funds rate rise this year
(12%). The market expects a 170,000 change in non-farm payrolls up from last
month’s lowly 25,000.
Gary
Dugan
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