Financial markets entered the second half of the year with fading investors’ sentiment in view of the fiscal crisis in Europe and signs of slower growth in the US and China. Exceptionally accommodative monetary policy is lessening the impact, but equities and commodities sensitive to the economic cycle have still come under pressure. The dollar has given back some ground, but government bonds in the major developed markets have continued to prosper.
Fixed Income
Yields on prime long-term government bonds are being pushed down by spare capacities, low inflation, delayed rate hikes by central banks and the fact that numerous institutional investors have to put their funds somewhere. Although fears of a relapse into recession or protracted deflationary risks remain remote, these issues could dominate the situation in bond markets on both sides of the Atlantic for some time. As such, in the absence of a change in sentiment or momentum, yields may continue to remain low in the short term, resulting in flatter curves. Over the medium term however, yields should start to reverse, particularly in the US, as the double-dip premium is gradually priced out.
Against this background it is not surprising that expectations of central bank tightening have been pared back sharply. Moreover, in countries where fiscal tightening is taking place, it should continue to benefit government bonds by weighing on growth and thereby reducing the need for an early tightening of monetary policy. Accordingly, it seems more likely that interest rates will remain on hold for longer in the eurozone than in the US. At the moment, markets are fully discounting a rate hike in the US and the UK towards the last quarter of 2011 while a first rate hike by the ECB is seen more distant.
Credit
In line with the broad global macroeconomic trend, corporate fundamentals continued to improve over the first half of the year as evident by declining debt levels, increasing cash on balance sheets, add a lower default rate. Nonetheless, credit spreads in the major Western developed economies have widened since late April as the focus turned to the European sovereign debt situation and the financial reform in the US. The drivers for tighter credit spreads by year-end remain in place, though they have weakened since the start of the year.
The US economy may be slowing, but it is not heading for a double dip. Corporate balance sheets are typically in better shape than those of households and governments, and central banks are likely to continue to do whatever it takes to prevent the emergence of another liquidity crisis. Accordingly the second half of the year should result it some moderate contraction across credit. However, the prospects for further increases in the total returns on investment grade are less positive, given the persistence of low interest rates. Better returns are therefore expected in high yield due to the wider spreads and lower sensitivity to interest rates.
Markets remain sceptical over whether public finances in the euro-zone peripheral countries will be consolidated according to plan, pushing yield spreads of some peripheral government bonds over Bunds to their crisis peaks. But the economy in the peripheral countries is faring better than assumed in the stability programmes and for the most part the deficit targets for 2010 are within reach. Therefore, yield spreads could be somewhat lower at year-end. Nevertheless they will remain high in the medium term amid concerns the peripherals will struggle to stay on track for consolidation.
Equities
A relatively benign second quarter reporting season in recent weeks, has helped offset the increasingly negative sentiment generated by economic indicators. As the impact of earnings begins to fade, however, there is a risk that the only relevant aspect for the equity markets in the weeks ahead will be the economic indicators, which will most likely continue to worsen. Nevertheless, the valuation of most stock indices remains modest and should thus support prices going forward. This is particularly relevant in continental Europe where the market offers decent earnings growth prospects.
In contrast, in the US, the market is likely to track a broadly sideways path. The stage of the economic cycle is not supportive and valuations are not especially compelling by historical standards. Nonetheless, the market may be assigning far too high a probability of double-dip scenarios, which could provide an opportunity to accumulate stocks on corrections.
Slower global growth and monetary tightening in many emerging markets could cap the upside in this asset class for a while but the long term outlook remains positive though, especially in Asia. Chinese equities have underperformed the broader region so far this year but attractive valuations and prospects for lower policy tightening should provide the backdrop for a better performance in the second half.
In contrast, in India, where GDP growth is still accelerating, monetary policy is still loose and capital inflows remain high, the market should consolidate as valuations remain stretched. From a sector point of view, the downshifting in the global manufacturing sector raises downside risks for the industrial and cyclical sectors more generally. In contrast, signs that global regulators are softening onerous liquidity requirements on banks should bode well for the sector.
Commodities
Since October 2009, oil prices have been trading mostly in a range between US$70 and US$85 a barrel. The market message is clearly that crude oil supplies will be adequate to meet demand in the second half of the year, and a stronger dollar will continue to limit price peaks. However, with OPEC compliance holding relatively firm, the drilling ban in the US Gulf of Mexico still pending, the hurricane season under way and the fact that the market is already pricing in some significant slowdown in economic momentum, downside price risks also appear limited. Consequently, oil prices should experience little deviation from the established price range in the weeks and months ahead.
The gold price too has been showing some signs of modest fatigue over the past weeks. Financial investors, who are of great importance to the gold market, have left the “safe haven” of gold, as the trimming of growth expectations has fed through into lower inflation concerns. However, given the seriousness of the fiscal challenges that many of the world’s major economies are facing and the potential for inflation concerns to rise against a backdrop of monetary policy accommodation, the likelihood is that enough investors will continue buying gold to support further gains over the medium term.
Base metals have performed poorly since late April, with prices further exacerbated by weak fundamentals. Inventories remain high, demand is still below pre-crisis levels in most developed countries, and production recovered markedly in the first half of 2010. In China, the pace of growth in demand is expected to decelerate in the second half of the year, particularly for metals used heavily in construction. In contrast, production has been recovering strongly since the start of 2010 as cutbacks have been unwound. Although there are serious long-term supply constraints, a great deal of idle capacity remains and underlying surpluses are likely to persist in most metals markets this year. This may continue to weigh on prices in the second half of 2010. Structurally, copper has the strongest fundamentals; it is the only metal where China is still a large net importer, and it faces more pressing supply constraints than most.
Foreign Exchange
The dollar has given back ground since early June amid signs of slower US economic growth and diminished fears about a near-term financial meltdown in Europe. As the Fed keeps the door open for further stimulating measures, negative data might put further pressure on the dollar in the short term. Later in the year, data is expected to improve slightly again so that the Fed will not take any further action.
Moreover it has to be borne in mind that the ECB will not be raising interest rates for some time to come either. Even if markets are not currently focussing on the debt crisis in the euro-zone the difficulties have not yet been solved and marked fiscal tightening dampens the euro-area growth outlook. The confidence in the euro, reflected in the exchange rates, should therefore prove to be unsustainable and a downward correction in the EUR-USD is expected in the medium term.
Compared to the euro, sterling should fare less badly against the US dollar as the commitment of the UK’s new coalition government to fiscal tightening should maintain market confidence in UK assets. As the economic outlook in Great Britain is slightly better than in the eurozone, sterling has the potential for a moderate appreciation against the euro over the coming months.
Finally, the Australian dollar has weakened against the US dollar since May despite the expected short-term interest rate differential between Australia and the US staying supportive. This is probably due to risk aversion and weakness in commodity prices, two themes which are expected to persist over the next few months. Moreover, the recent elections results which brought about a hung parliament would meant that the future importance of a handful of independent MPs for Australian politics will leave financial markets uncomfortable and weight on the Aussie dollar.
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