The first quarter of 2019 turned out to be the exact opposite of Q4 2018 and all of last year. If during last year, no asset class provided positive return, then in first quarter of this year almost every major asset class provided positive performance. Euro-based investors got an additional boost from the 1.8% USD appreciation against the euro.

Many asset classes experienced the best start of the year in several years, but crude oil prices especially stood out. WTI crude prices finished in the first quarter with an over 30% increase, the best start of the year since 2009. OPEC production cuts and sanctions against Venezuela and Iran were among the main drivers of the price surge. However, overall investors’ optimism also contributed significantly, which pushed commodity prices in general higher by almost 11% (as measured by Thomson Reuters/CoreCommodity CRB index in EUR).

Global bonds also performed extraordinarily well in the first quarter of this year. Emerging market bonds stood out with a close to 10% gain by the end of March. Global high-yield bonds followed closely with an almost 8% gain in Q1 2019. The switch of the global central banks from tightening to easing mode, which drove interest rates down, resulted in an over 3.5% total return from global government bonds in just three months.

Equity Market Performance

  1m YTD 2019 Distance from all-time high
Developed Markets ex US (EUR) 1,5% 11,0% 8,8%
All Country World Index (EUR) 2,4% 13,6% 0,0%
Europe (EUR) 1,6% 12,0% 9,1%
Emerging Markets (EUR) 2,1% 11,5% 0,0%
S&P 500 (USD) 1,8% 13,1% 2,7%

* - based on monthly data
Source: MSCI, finance.yahoo.com​

Equity market returns were also spectacular in the first quarter of this year. The All Country World index (ACWI) continued its winning streak, gaining 2.4% in March and bringing the year-to-date gain to 13.6%. Helped by the USD appreciation, the euro-based ACWI has fully erased the Q4 2018 losses and managed to reach a new all-time high. Developed market equities are in the lead this year, driven by US stocks with their over 15% year-to-date gain. An exceptional surge of Chinese equities since the beginning of the year, which appreciated over 20%, is helping emerging market stocks stay close behind.

Global central banks made a shift to a more accommodative monetary policy stance

One of the most important factors for the market decline in Q4 2018 was investors’ fear that the central banks may tighten monetary policy too much, right at a time when the global economy was slowing. As global interest rates moved higher in the expectation of a tighter monetary policy, investors started to exit from the equity markets, resulting in sell-off.


In March, however, acknowledging the slowing economic growth and inflation rate staying significantly below the target, global central banks have completely reversed their course. At first, it was the ECB that cancelled plans for any rate hikes this year. Additionally, the ECB announced that they were discussing the possibility of introducing a tiered rate system. The logic of a tiered rate system is that the banks would be able to receive a higher weighted average interest rate for their reserves held in the central bank. Such a system has two potential benefits. First, it will help reduce the effects of the negative rates on banks’ profitability and let the ECB maintain negative rates for longer. Second, such a tiered system would allow the ECB to decrease the rates even more, if needed. As a consequence, although a tiered rate system is at the initial stage of discussion, the market has priced in a small probability of the ECB lowering rates further.

In the second half of March the Fed followed the ECB, switching to a more accommodative monetary policy stance. Reversing earlier plans, Fed President Powell has suggested that no more rate hikes are expected. Additionally, the Fed is now prepared to allow inflation to overshoot the target in the short term to ensure that the rise in inflation is sustainable. As a result, the market is now pricing in an over 40% probability of the Fed lowering rates till the end of the year. Finally, the Fed has pledged to stop reducing the size of its balance sheet starting from October, meaning more liquidity in the economy.

Declining inflation has impacts beyond those on major developed market central banks. In emerging economies, inflation is also decreasing. Consequently, central banks have room for looser monetary policies. This has led to the adjustment of investor expectations, and investors are now looking for lower policy rates in emerging markets.

Does the US yield curve inversion signal recession?

The US yield curve once again gained the spotlight in March as parts of it became inverted, meaning that short-term interest rates became higher than longer-term rates. As there is no official measure for the yield curve, you can take the spread of any pair of Treasuries. The most closely watched yield pairs are 10-year versus 3-month and 10-year versus 2-year. And it’s the 10-year versus the 3-month that became inverted in March.

Inversion of the yield curve is usually an important event, as it is considered an indicator of recession ahead. The yield curve inversion preceded every US recession since 1982 by around a year, on average. There was, however, a case in 1998 when the yield curve briefly inverted, but no recession followed. Research by the Fed has shown that the yield curve must stay inverted for 3 months to provide a reliable signal.

There are some important signs that the current inversion of the curve may not signal a future recession. First, the inversion affected only a part of the yield curve and lasted only a few days. Secondly, the yield curve usually inverts as short-term rates rise due to the Fed hiking rates, which slows down the economy. This time, however, the Fed is not expected to hike rates any more and the current real rates (interest rate adjusted for inflation) are still very low.

Summing up, although there are very solid arguments that this time the yield curve inversion may not mean an upcoming recession, it still makes sense to be cautious.

Global equity market price action is strong

The start of the year was exceptionally strong for global equity markets. There were only six other cases since 1970 when the MSCI World index gained a similar or higher percentage in the first quarter of the year. In five out of those six cases the performance in the rest of the year was also positive. However, the average gain for the rest of the year was fairly modest at just 5.2%.


Additionally, by the end of March, the 50-day moving average of the MSCI All Country World index crossed above the 200-day moving average. That is usually considered a positive technical sign, suggesting market gains ahead. There were 17 such cases since 1990 with an average gain of 10% when the position was held until the 50-day moving average crossed below the 200-day moving average. However, this is not a very reliable signal as out of those 17 cases, the market has declined eight times.

Global economic growth continues to slow

Concurrent indicators of global economic growth continue showing signs of slowdown. The latest Chinese PMI (Purchasing Manager Index) numbers provide some hope of a rebound in growth as the numbers were better than expected. However, global leading indicators continue to show slowing growth ahead.

Summary economic indicator

  Value 1 month change 1 year change
Global Manufacturing PMI 50,6 0 -2,7
Global Services PMI 53,7 0,4 0,5
Global Composite PMI 52,8 0,2 -0,4
OECD Composite Leading Indicator 99,2 0 -1,1

Source: Bloomberg, OECD.org

The successful completion of a trade deal between US and China could provide a much-needed boost. However, the market already seems to be pricing in a positive result. Therefore, any negative surprise there may pose a significant risk.

Outlook

Global equity markets have quickly reversed course from last year, boosted by looser monetary policy and hopes for a trade deal between US and China. However, the real test for investor optimism will be the new earnings season.

Analysts have significantly adjusted down earnings growth estimates. European corporate earnings are expected to decrease 3.4% in Q1 compared to last year. In the US, earnings are expected to decline 2.3% compared to last year. With such reduced estimates there is a potential for positive surprises as actual earnings beat lower expectations.

However, the most important part of the current earnings season is forward guidance. Both in the US and Europe earnings are expected to significantly rebound by the end of the year. Therefore, if companies come out with weak guidance, analysts will be forced to reduce year-end estimates, which could be a negative event for global equities.

Overall, there are several risks for the short-term outlook of the global financial markets, so investors should be prepared for higher volatility. On the other hand, moderate inflation, the accommodative global monetary policy and close to fair valuation should imply good potential for global stocks in the longer term.

Anton Skvortsov
Investment Advice Development Manager in Baltics

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