Trade news flows continue to shape risk-sentiment, with attention now turning to November PMIs
US Equities continued to rise, with the S&P 500 Index (SPX) at 3120. However, the reflation trade, that has supported risk assets since early October, weakened in the past week, with Emerging Market equities down by 1.5% and Speculative Grade corporate spreads increasing. Government Bond yields declined in core markets, while euro area periphery bond spreads widened across the board (see Markets).
Risk appetite was curbed by weaker-than-expected Chinese data and trade news. Indeed, October high-frequency Chinese economic indicators disappointed (see Economics). As Chinese real GDP growth oscillates around 6%, the Government may respond with modest infrastructure, fiscal and monetary easing. Indeed, the PBOC surprised markets on Monday, when it cut a key rate slightly (by 5 bps to 2.5%) for the first time since 2015. At the same time, in the past week, President Trump threatened to raise tariffs significantly on China if a trade agreement was not reached.
Having said that, the US and China plan to conclude their “in depth” talks in the coming weeks, in order to finalize the “Phase one” agreement reached on October 11th. Such an event would suggest a low probability of re-escalation in trade tensions, at least until the November 2020 US Presidential Elections. Recall that the weighted average tariff rate on bilateral trade has increased from 3% to 16% (imports from China) and from 7% to 22% (imports from the US).
The global monetary easing cycle (initiated in July) resulted in a considerable number of G20 central banks cutting policy interest rates (see graph below). As monetary policy affects the economy with a time lag, the easing of financial conditions during 2019 is expected to support economic activity during 2020, despite the fact that the Federal Reserve and the ECB are likely to remain on hold.
Following gains of 20% year-to-date, the MSCI AC World Index trades on a forward P/E ratio of 15.7x, modestly above (+14% or +1.1 STDEV) its 2004-2019 average. Regional differences are significant, with the US equity market appearing the most expensive (+18% or 1.4 STDEV above average, while Japan, EMEA and the UK are the preferred value trades based on P/E metrics (see graphs page 3).
Rising bond yields since early October, with the BBG/Barclays Global Government Bond yield up by 15 bps to 0.9%, did little to curtail the equity rally, as the yield increase mainly reflected better prospects for the global economy (from a low base), alongside declining expectations for additional central bank easing.
Higher yields should not impede the equity market rising as long as trade tensions continue to de-escalate and global growth bottoms out as expected. The correlation between changes in 10-Year US Treasury yields and the SPX 12-month forward P/E is positive, explaining 35% of the P/E variance according to our calculations (see graph page 3). A negative scenario for equities includes: i) a renewed escalation in trade tensions; and ii) political woes, including Trump’s impeachment probe, Hong Kong, Brexit and Italian politics, resulting in safe-haven demand bids for Government bonds.