Risk-off mode prevails in global markets as the spike in US Treasury yields, Italian budget woes and Chinese growth concerns hurt sentiment
US Government bond yields rose substantially, challenging equity bulls, following comments by Fed Chair Powell that US monetary policy is “a long way” from neutral (suggesting further rate hikes) and solid US economic data (the unemployment rate fell to 3.7%, its lowest since 1969 – see Economics). The US 10Yr Treasury yield increased by 17 bps wow to 3.23%, at 2011 high levels, with the 10/2 curve steepening by 11 bps to 35 bps and the S&P500 down by 1% to 2886.
Italian budget woes hurt investor sentiment as the EC noted that Italy’s revised budgetary targets appear prima facie to point to a significant deviation from the fiscal path. 10-Year BTP/Bund spreads widened to a 5-year high of 304 bps, while Italian equities (market and banks) recorded losses of -2.4% (-9.2% ytd) and -3.7% (-22.2% ytd) on Monday, respectively.
Looking forward, the 2019 Italian Budget must be submitted to Brussels by October 15th. The EC can ask Italy to submit a new plan within two weeks if it detects non-compliance with EU rules. Thereafter, the Italian Government will have three weeks to present a new Budget (mid to end-November). In the meantime, credit rating agencies will issue their update assessments, likely by end-month, with a high likelihood of rating downgrades. Overall, Italian assets will continue to be pressured by elevated policy uncertainty.
Global equity markets declined across the board (MSCI ACWI: -1.8% wow | +0.3% ytd in $ terms), with developed markets (-1.5% wow) overperforming emerging markets (-4.5% wow) by a wide margin. Emerging market equities ended the week at a 17-month low, with renewed pressures emerging on Monday, due to heightening concerns regarding the Chinese growth outlook (amplified by the PBOC’s reserve requirement cut – see Economics) and the likely escalation of the US-China trade war.
Japanese equities recorded losses, in line with the broader equity market reaction to higher bond yields and policy jitters. Note that domestic large-caps (Nikkei225) had gained traction in the past month (+4% since Aug 31 | +4.5% ytd), supported, inter alia, by i) easing trade tensions; ii) a weaker JPY (-2.4% against the USD to ¥113.7/$); and iii) a positive economic outlook.
In terms of price composition, the Energy sector (MSCI) is up 19% ytd, while the Defensive sectors (Healthcare, Utilities, Telecoms) have outperformed their cyclical peers – a warning sign for the durability of the headline index appreciation. Notwithstanding their ytd losses, Financials have performed well since end-August (up by 7%), as the regime shift in BoJ policy in the summer has revived the 10-2Yr term spread in JGBs from a low of 15 bps in June to 27 bps in early October, supporting bank profitability expectations.
Overall, corporate profitability remains subdued, with consensus estimates for Japanese equity market (MSCI) EPS growth at +4.0% yoy in 2018 and +4.2% yoy in 2019, and EPS revisions stuck in negative territory. We doubt that the September rally has legs, especially under the scenario of a deterioration in risk sentiment that may lead to a JPY appreciation (as a safe-haven harbor), hurting Japanese equities (see graph below).