General market overview
After a burst of volatility in the first quarter of 2018, financial markets settled down in April, despite a flurry of breaking news stories from and about the White House, including news on trade policies. If fully implemented, new U.S. tariffs and related measures might well have a negative impact on share prices, but investors seemed to take the news in stride, believing that a full-blown trade war would be avoided. At the same time, markets also had to contend with the corporate reporting season. Although many companies managed to surpass earnings expectations, their stocks were still punished. That was true across a wide variety of sectors. Among the victims was one of the leading U.S. construction-equipment manufacturers, whose quarterly figures were at first applauded by the market but whose stocks slipped sharply when its top management told analysts during a teleconference that the first quarter could have marked the peak of the current year. Some investors swiftly extended this notion to the overall market, fearing that this might be as good as things are likely to get and that the cyclical peak has already been reached. Looking at the usual pattern of missing and beating consensus forecasts, the U.S. reporting season was very positive – roughly 80% of all companies beat the forecasts (the best result since 2010), and have done so by an average of 8.9% (twice the historic average), whereas the reporting season in Europe was rather neutral. Partly, this reflected currency effects, i.e. the strong euro in the first quarter, which dragged down earnings of many European exporters. In Japan as well, a strong currency (in this case the strong yen) was blamed for the very conservative corporate outlooks in the first quarter. However, annual consensus forecasts were not really corrected downwards in the wake of the reporting season, which is somewhat unusual. But there were no upwards corrections either.
This divergence in reported earnings might have been expected to give the U.S. stock market a renewed boost compared to those of other developed markets. Instead, European and Japanese stocks performed so well in April that they almost managed to catch up with the U.S. stock market. This means that all major stock markets have more or less returned to their levels seen at the beginning of 2018.
Investors in currencies, fixed income and commodities definitely experienced a more exciting April. Although sharp rises were rather sporadic, even smaller increases enabled some asset classes to break long-term records. The 10-year U.S. Treasury yield thus managed to surpass the 3% mark for the first time since the turn from 2013 to 2014. As the 2-year yield has simultaneously risen to 2.5% for the first time since 2008, the yield curve (10-year minus 2-year) flattened to 43 basis points , its lowest level since 2007. You have to go even further back in history to find a match of another indicator: The yield spread of 10-year U.S. Treasuries and Bunds, which rose to almost 2.4%, a level last seen in 1989. Even the dollar could no longer withstand these movements. Although it had traded in a very tight range vs. the euro since February, the dollar broke out to the upside of this band in the last week of April.
Finally, it is worth mentioning the path of oil prices. OPEC has managed to restrict supply so that today, oil prices are almost three times as high as at their low in early 2016.
Outlook and changes
How do these April developments impact our outlook? In particular, how will the confluence of political developments, corporate profitability, and economic activity affect the markets? Let’s start with the economy. We assume that growth was only temporarily constrained in the first quarter and will soon gain steam, starting with a strong second quarter. First-quarter performance should be considered an even less reliable guide for 2018 economic growth than usual, because of, guess what, the weather. In 2018, we saw unusual weather patterns in both the United States and Europe, including heavy snow hitting London. Whether the weather was good or bad is in the eye of the beholder – this justification should no longer concern all that many investors anyway. Two reasons which without any doubt weakened performance in Europe were fewer working days than in the previous year and an extraordinarily severe wave of influenza.
We continue to hold a positive view on equities. The reporting season has been overall encouraging so that we feel quite comfortable with our forecasts: Earnings growth of roughly 10% in Europe and between 15% and 20% in the United States and in emerging markets. In our view, equities in the United States and in Europe are more likely to move up rather than down by 5% in the near term. We have downgraded Japan to neutral for the time being, since corporates tended to communicate very cautiously during the reporting season and the political situation of Prime Minister Abe remains opaque. Europe and the emerging markets appear to be more attractively valued than the United States. However, trade disputes remain the elephant in the room, and decisions will be taken in May that could decide whether the elephant makes itself more comfortable or starts withdrawing again.
We have made no changes at a sector level but do acknowledge that the picture has brightened for several defensive segments, such as utilities, where we nevertheless keep an underweight. Although energy continues to appear particularly suited as a hedge against geopolitical tensions, the current cash-flow generation is not really convincing. Our downgrade of the materials sector last month has been proven right – particularly metals and mining are burdened by weaker demand from China. This sector risks being additionally impaired if a strengthening dollar starts to put further downward pressure on prices. Consumer demand has remained rather strong in the first four months, however with sharply diverging trends. Although non-cyclical consumer stocks underlined their defensive qualities on weaker market days again, they are still struggling. For this reason, we favor cyclical consumer stocks.
One of our most important changes is upgrading the dollar vs. the euro to positive. Apart from fundamental reasons for strategically favoring the dollar – especially the record level of the yield spread between U.S. and German government bonds mentioned above – the picture has also turned more interesting from a tactical viewpoint.
As already mentioned, many rates only made minor moves in April, but nevertheless managed to break some long-term records. While we cannot ignore these moves, we do not feel compelled to change our strategic forecasts. We still believe in a moderate rate cycle that will peak at levels way below those seen in previous cycle peaks. We therefore stay neutral on U.S. Treasury yields. We upgrade 10-year UK and 30-year German government bonds to neutral, after their yields rallied during April. We turn more positive on emerging-market bonds, as in our view the repricing has gone far enough to compensate for trade-related risks.
