It’s hard to get an objective frame of reference for global growth unless you look at prices. We’ll often hear a steady drip, drip, drip of economic data points—some measuring the past and some looking forward—but most people would be hard-pressed to say how that all tallies and paints a picture of deterioration. That’s why it was so great to see that Bloomberg produced two excellent charts this morning. One contrasts the US/emerging market equity price levels and emerging market Dollar-denominated bond yields. The other compares US/EU equity prices levels and relative bond yields between Germany and Italy.
Starting with emerging markets, there is an interesting narrative at play which shows how increasing USD funding costs (yields rising) and lower relative equity prices reflect increasing market perceptions of risk. Even though the Federal Reserve is expected to decrease interest rates again before the end of the year—which should ease conditions for global USD funding—rising yields implies the market has increasing doubts about repayment in the event of an economic downturn. It also suggests that emerging market equity risk premiums—the excess return required by markets to invest in said geography—are rising. In total, markets are getting nervous about keeping their funds in emerging markets.
Turning to the EU comparison, the opposite dynamic is taking place. The European Central Bank’s negative interest rate policy (NIRP) combined with capital tiering—a proportion of bank excess cash is exempt from negative interest rates—has helped level the playing field for periphery banks. This is illustrated via the falling spread of Italian cost of borrowing over the benchmark German Bund. Despite this falling funding cost, EU equity prices have not risen and look comparatively cheap versus the US broad market index. Perhaps the conclusion to be drawn is that we are in for a potential EU equity rally… But maybe not. The dynamic we haven’t mentioned which has been a key driver of lower Italian bond yields is ‘reach for yield’, which means investors are turning towards increasingly risky investments which drives their price higher (decreasing their yield).
Bottom line: In fact, we might draw the opposite conclusion. We are witnessing bond prices moving higher, equities reluctant to follow, and deteriorating economic statistics. Together these are a sign that bond prices are overstretched, not that equities are undervalued. If you need a second point of reference, the pullback from emerging markets is a compelling sign that investors are becoming more cautious, and those who are holding Italian debt might just decide the price is wrong.
Continued Brexit pessimism contributed to the Pound moving lower against the Dollar in yesterday’s session. The pair remains above support at the 50-day moving average, but Sterling’s trade-weighted index has been trending lower reinforcing the bearish outlook for the near-term. Data remains light today but Bank of England members Haldane and Tenreyro will be speaking later.
The UK’s political turmoil meant that the pair also moved lower in yesterday’s session but ultimately held above the 1.12 level. However, we’ve seen a break below to a low of 1.1170 in this morning’s session, which could mean that the pair next targets the 100-day moving average around 1.1140.
Yesterday, we saw some more two-way price action for the pair, albeit in a tight trading range. Positive German industrial data, released this morning, may provide the impetus for another push towards the 1.10 level, but the pair has tried and failed to recapture this handle no less than three times now.