From struggling European banks to sharply rising Treasury yields, there has been no summer lull for global investors. Below we take a closer look at the global economy and financial markets through five key charts.
India joins Asian banks on the road to rate hikes
The Reserve Bank of India (RBI) decided to follow the path of other Asian central banks, such as Bank Indonesia or the Philippines' central bank, by hiking its repo rate by 25 basis points (bps) to 6.25 per cent at the June Monetary Policy Committee (MPC) meeting.
The move was not fully expected; 25 out of 35 analysts predicted rates would remain unchanged in a Bloomberg survey. The RBI acted ahead of the widely anticipated Fed rate hike to try to stem market pressures. The six MPC members were unanimous in their decision to hike rates, however they highlighted the risk to the inflation outlook.
CPI (consumer prices index) inflation continued to increase in May at 4.9 per cent, versus 4.6 per cent in April, and is expected to trend higher in a context of a closing output gap, rising oil prices, a weaker Indian rupee and higher agricultural Minimum Support Prices (MSP).
The RBI could follow in the footsteps of Bank Indonesia, which hiked rates three consecutive times, and will raise interest rates by 25bps in its August meeting.
The pressure mounts for European banks
Lately, European banks have been under pressure. Financials are the worst-performing sector on a YTD basis and lag the broader index by 10 per cent.
Expectations for improvements in European economic growth, which resulted in a steeper yield curve, dominated in 2017 and fuelled the European banks’ rally. But it seems to have peaked and for the time being, the asset class is no longer attractive.
The flat yield curve, which makes it difficult for banks to grow their net interest margin, has made the earnings outlook for banks one of the worst in the region. Moreover, non-performing loans are still acting as a drag on banks’ profitability, especially in Italy. In terms of money flow, institutional investors are no longer overweight banks.
Finally, in June, the European Central Bank prolonged its accommodative stance for at least 12 months, dragging the overall banking sector further down.
Investors eye US two-year treasuries as Fed begins normalisation
Since the global financial crisis started nearly ten years ago, major developed central banks have been implementing ultra-accommodative monetary policies. They have brought interest rates to record low levels – sometimes in negative territory – while using unconventional measures such as quantitative easing to stimulate the economy.
During this long period of financial repression, 'risk-free' asset returns have been compressed – the US two-year Treasury was for example yielding under 0.5 per cent. However, over the same period, the US equity (S&P 500) dividend yield was hovering around 2 per cent and on top of that return, it was possible to get price appreciation from companies increasing their future earnings.
In the US, since the Fed started normalising its monetary policy, short-term rates have repriced, with US two-year Treasuries yielding 2.5 per cent, and are again becoming appealing for US investors compared to the lower and riskier 2 per cent S&P 500 dividend yield.
Big things come in small packages
Over the past few weeks, US small-cap stocks impressively outperformed large-cap stocks, generating more than 4 per cent overperformance in the last quarter. Small caps, usually known to be more risky and volatile than large caps, have recently become less risky due to the current political landscape.
First, US president Donald Trump has embarked on a broad effort to reduce taxes and regulation for US businesses as part of his plan to ‘Make America Great Again’ and this move has largely benefitted smaller companies.
Second, the White House's strong rhetoric against China and the escalating trade war are having a strong impact on international companies and less of an impact on US-oriented businesses. On average, US small caps rely on 20 per cent of overseas sales and are therefore more immune to trade tensions and US dollar volatility.
Volatility in emerging market currencies shows no sign of slowing
While volatility in equity markets has so far been relatively contained, the foreign exchange market is telling another story, particularly in emerging markets. Turkey, Brazil, Russia, Mexico, have all seen their currency volatility jump to very high levels over the last three months.
In June, the JPM Emerging Volatility index, a gauge of aggregate implied volatility for emerging currencies, reached its highest level since February 2017. On a year-on-year basis, the Turkish lira's volatility jumped by close to 60 per cent while the volatility of the Mexican peso and the Brazilian real increased by 25 per cent in June. Aside from internal political issues, emerging markets have been under pressure from US monetary policy normalisation, protectionist measures and fears of a turning point in global synchronised growth.
This situation may not come to an end anytime soon as trade frictions between the world’s biggest economies are still escalating.
Adrien Pichoud is chief economist at SYZ Asset Management. The views expressed above are his own and should not be taken as financial advice.