Markets punch drunk

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Henrietta Pacquement, (pictured) lead portfolio manager & head of Quantitative Analytics ECM Asset Management.

It’s not easy weaning oneself off liquidity after years of central bank largess. Last week saw global equity markets cave on the back of poor inflation numbers across the globe and reduced global growth expectations. Add to that concerns about Greece, Russia, the Middle East, oil, Ebola and equities were faced with a powerful cocktail that pushed a number of markets into correction territory if not bear market territory in the case of Greece in the space of a few days. This generated a bid for fixed income with quite an extraordinary day last Wednesday where 10 year US rates had a ‘flash rally’ and traded within a 35bps range in the space of a few hours.

In light of these moves and disappointments about earnings potential, it is worth reviewing corporate trends in recent years to see if these moves are justified in equities and what kind of blowback they may have into credit.

Top line growth has come under pressure over the last few years in the US and in Europe with European revenues dipping negative and US revenues showing only slight progression recently. Companies are still reluctant, be it in the US or in Europe, to put capital back to work in the form of capex. The re-leveraging that is occurring in the US is predominantly driven by shareholder friendly activity in the form of M&A, dividends or share buybacks. Europe is still working on balance sheet deleveraging and is very conservative in terms of use of capital. European companies are being hampered by poor revenue trends in their efforts. In both the US and Europe this situation doesn’t indicate strong growth prospects. It is also not conducive to high levels of inflation as revenues are not being used to hike salaries to maintain competitiveness. This has been one of the issues highlighted by the Fed or the BoE and one of the reasons central banks have been reluctant to bring forward rate hikes.

Earnings prospects go some way to explain equity market jitters. So where are we in the credit cycle in Europe? Still in repair mode, with high yield potentially further down the credit cycle than investment grade as growth prospects remain subdued. For high yield, low growth has more potential to put pressure on top lines and make the deleveraging exercise more difficult. As a result, the environment is arguably more supportive for credit spreads in Europe than for equities and suggests credit spreads are likely to remain range bound for now.

However, despite fundamentals, we are still clearly in the hands of the central bankers. The markets are hypersensitive to their next decisions. Last week’s moves highlight again how dependant markets are on their words and actions. Last Thursday, strong US data helped turn sentiment turning the trend on US equities. However, the turn was also supported by more dovish comments from Fed members given recent inflation trends. Last Friday, the European markets were given a boost by ECB comments suggesting asset purchases would start within days.

It is worth noting that financial fragmentation remains between Eurozone countries. Aggregate lending rates to non-financial companies are still markedly higher in countries like Italy and Spain compared to Germany or even France. While progress is being made, the ECB is keen to continue to close the gap. Inflation levels are also too low in Europe. The ECB has a clear mandate to keep inflation levels within target. As a result, the markets may be underestimating the ECB’s willingness and ability to act.

While the Fed is further ahead in its cycle and looking to the next step of rate hikes, the ECB is in a different situation. The ECB is still firmly in easing mode and will be taking up the torch of quantitative easing. So the markets are still likely to get their fix in months to come.

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