NN IP: Environment for equities remains friendly

(Foto: Koen Straetmans, Senior Strategist Multi-Asset)

Spread products at large continue to build on the strong performance they have generated since the beginning of last year. Within spread products, euro-denominated credits (both investment grade and high yield) have outperformed their US dollar counterparts so far this year. This outperformance of EUR credits materialized mainly from Q2 onwards. Factors that have been influential in this respect were the improvement in relative macroeconomic surprises in the Eurozone versus the US, a strong European corporate earnings pattern and the removal of a political tail risk with the passing of the French presidential elections. The slower (expected) path of monetary policy normalization in the Eurozone compared to the US has probably also played a role.

The path of monetary policy normalization and market expectations hereof is likely to be a key factor for fixed income products going forward. June may provide some further insights in this respect. The ECB will likely change (neutralize) its risk assessment on the economic outlook and potentially reveal some forward policy guidance. As for the Fed, another rate hike is fully priced but any further hints at upcoming balance sheet size reduction will be looked for.

The latest inflation data do not indicate a swift reversal in the current gradual nature of this monetary policy normalization process. The ECB since long has emphasized its dissatisfaction with the pace of underlying inflation. With core inflation in the Eurozone at +0.9% y-o-y in May (versus +1.2% in April) the central bank has likely gained little comfort in this respect. Similarly in the US, core inflation at +1.9% y-o-y in April (versus +2% in March) and a decline in the core PCE deflator to +1.5% y-o-y in April from +1.6% in March indicate little upward inflationary pressure so far.

In the formation of inflation expectations, oil prices have continued to play an important role. As such oil prices have remained influential in the formation of market-based inflation expectations. Over the last five years, the correlation between Brent oil prices and 5yr 5yr forward inflation swaps (a measure of the market’s inflation expectations) has been strong and positive at +0.92 (see Figure 1). The last two years this correlation has become somewhat less strong (at +0.40) but in the past 12 months it has been rising again to +0.77.

The ECB remains of the view that underlying inflation (expectations) is unconvincingly low and therefore is expected to maintain its accommodative policy in order to re-anchor inflation expectations. The latter had been rising since the summer of last year on improving macroeconomic data as well as rising oil prices. A levelling off of global macroeconomic surprises since March and a decline in oil prices similarly have weighed on the downside in inflation expectations since.

No negative effect from commodity weakness and fading macro surprises

The renewed decline in oil prices and a levelling off in global macroeconomic surprises since March have been noteworthy developments. They have not prevented a continuation of spread tightening, however. This is remarkable indeed, as spread correlation of main spread categories to G10 macro surprises for example has been negative across the board over longer time horizons. Rising macroeconomic surprises hence have tended to move in tandem with tightening credit spreads (and vice versa). Interestingly, this year this spread correlation with macro surprises has switched sign and is now positive at close to +0.50 for both Global HY as well as EMD HC Sovereign. HY and EMD appear to have shrugged off the declining macro surprises so far and spreads have continued to tighten regardless. Similarly, weakness in commodity prices has not prevented spreads of HY and EMD to tighten further this year.

Whereas spread correlation of Global HY and EMD HC Sovereign to commodity prices has been negative over longer time horizons at -0.27 and -0.74 respectively (lower commodity prices, wider spreads), the sign of correlation has switched to positive so far this year at +0.38 and +0.67 respectively. This same pattern is visible in spread correlation versus oil prices. Weakness in commodity prices has not derailed spread performance this year (in particular in EMD), indicating other factors, not the least accommodative central banks, have remained supportive.