Market Insights – February 4th, 2020

Essentials

The pound reacted well to the Bank of England’s decision to keep interest rates the same. This is almost certainly because leading indicators have improved since the general election, which lifted some of the prevailing uncertainty. But the UK is now officially in the transition period, and talks with the EU will be tough.

Almost half of all S&P 500 companies have now published their Q4 earnings figures. The results are good – three quarters of firms managed to beat the consensus. What’s more, they did so by a much larger margin than in previous quarters, in terms of both earnings per share and income.

The coronavirus epidemic continues to spread, with more than 17,000 cases confirmed so far. There have been around 360 deaths, so the mortality rate is still much lower than for the Sars outbreak in 2009. Fears of a global epidemic have rattled the financial markets. But drastic isolation measures have been put in place by China, which means there’s still hope that the epidemic will be relatively short-lived.

Are investors too sanguine about inflation?

At the start of the year, it was feared that tensions between Iran and the USA would disrupt the oil market. Those fears are now long gone, but instead investors are concerned that the coronavirus outbreak in China will cause demand for oil to slip. As a result, energy prices have fallen by more than 10% since the start of the year. This trend caused inflation expectations and long-term interest rates to drop sharply. But the situation is likely to change, and oil prices should pick up again once the worst of the coronavirus outbreak is behind us. These recent developments only go to show how much of an enigma the absence of inflation this late in the macro cycle is for central bankers.

Monetary policy makers must be concerned about inflation being too low when the period of expansion finally ends, as that could easily turn into severe deflation once the recession sets in. And history shows that deflation is a much more formidable enemy for central banks. Stimulus policies have less effect when economic agents postpone purchase and investment decisions in the hope that prices will fall even further. The US Federal Reserve surely had these thoughts in mind when it reversed policy course in 2019. It announced a new round of rate cuts, began expanding its balance sheet again and raised its implicit long-term inflation target from 2% to 2.5%. Other central banks – led by the European Central Bank and the Bank of Japan – followed suit.

The excessive drop in sovereign bond yields since last summer can undoubtedly be attributed to this change in tactics. For investors, long-term interest rates clearly aren’t enough to offset current inflation. Even a minor uptick in inflation expectations will inevitably push bond prices downwards. Given this scenario, we are avoiding very long-term bonds. In the broader bond market, emerging-market debt offers the best prospects, especially issues denominated in certain local currencies, which should pick up again once the coronavirus threat has subsided.

Things are looking up in Europe