Markets this week

Market Update: The return of volatility

The return of volatility due to rising US political risks could open up opportunities. Fundamentals such as earnings and data are strong, especially in the Euro area and Asia.

Asia ex-Japan equities have been stable amid the volatility, underscoring our strong preference for the market. The S&P500 faces a technical support 2% below current levels.

We expect Treasury yields to return to the 2.30-2.65% range once political risks abate. This means we would await better entry points for rate-sensitive USD bonds.

What’s new in the markets this week?

Rise in US political risk shatters calm. Equity volatility surged from near-record lows as US stocks suffered their biggest one-day decline since September. There is concern that political uncertainty after the firing of the FBI Director may delay, if not derail, Trump’s pro-growth reform agenda, including tax cuts, deregulation and infrastructure spending.

While a pullback is not surprising after the record-breaking rally in the past six months, we would use any wider drawdown to add exposure to our preferred equity markets – Euro area and Asia ex-Japan – where fundamentals and valuations remain attractive, in our view.

Fed rate hike expectations lowered. US 10-year Treasury yields fell close to the bottom of their six-month range and the USD index fell to a six-month low as money markets pared back expectations of Fed rate hikes for the rest of the year.

We still expect the Fed to raise rates twice more this year, especially with growth recovering in Q2 and a tightening labour market likely boosting wages and inflation. This week’s industrial output data showed a continued and strong recovery.

Strong Euro area, Asia ex-Japan data. Euro area growth expectations (ZEW survey) rose to its strongest since 2015, mirroring region-wide improvement. In Asia, though China’s fixed investment and industrial output growth slowed, retail sales stayed robust.

The government unveiled an approximately USD 500bn investment programme under its One-Belt-One-Road initiative, which is positive for Asia’s medium-term growth.

Implications

Opportunity to rebalance. While there is a risk of near-term downside, investors overweight on US equities have a chance to lock in six months of gains and rebalance towards Euro area and Asia ex-Japan equities.

Renewed political uncertainty in Brazil underlines our preference for Asia within EM equities.

Technical levels key. The S&P500 fell below its 50DMA and is 2% above its technical support level. A further breach could extend losses. Indices in Europe and Asia remained above their 50DMAs, indicating resilience amid increased US volatility.

What we are watching? US political developments; US home sales and durable goods orders; Euro area PMI; Japan inflation.

What does this mean for investors?

US stocks led global equities lower amid a rise in political risk. In Emerging Markets, Asia ex-Japan equities were stable while Brazilian equities plunged amid renewed political uncertainty.

Safe-havens such as government bonds, gold and JPY gained.

Equities: Improving earnings outlook

Earnings revised higher. US and Euro area 2017 earnings growth estimates have been revised up by 0.4% to 11% and 20%, respectively, since 1 April on upbeat Q1 earnings and strong corporate guidance.

We do not believe Q1 earnings growth was solely due to higher commodity prices and favorable base effects. Rising business spending and improving business sentiment point to continued strong demand, providing room for earnings to deliver positive surprises.

China’s One-Belt-One-Road plan positive for infrastructure. President Xi Jinping unveiled a multinational investment programme that could total up to USD 500bn over the next five years. The plan is likely to drive valuation multiples higher for the engineering and construction sector in the short term as the proposed investment could boost revenue for the sector.

Strong Korean earnings. Q1 earnings exceeded expectations by almost 8%. This further supports our bullish view on Korean equities amid expectations of fiscal stimulus and measures to improve corporate governance by the new government.

Bonds: Treasury yields downside limited

US political risk drags yields lower. US 10-year Treasury yields fell towards 2.2%, while German and Japanese yields remained resilient. We expect US 10-year yields to recover towards 2.30- 2.65% as very long investor positioning normalizes and markets refocus on the prospect for higher Fed rates.

Waiting for better entry levels for EM bonds. Emerging Market (EM) bonds have performed well in recent weeks. However, given our expectations of a likely rebound in US Treasury yields and their elevated interest rate sensitivity, we would wait for better entry points for USD-denominated bonds. Similarly, we believe a likely short-term rebound in the USD may present better entry opportunities in local currency bonds.