Finding opportunity in an equity vacuum

Global equities were flat going into the week following an earlier rally attempt. The new Italian government, North Korean anger over South Korea and US military drills, weak global macro and higher rates were a strong enough cocktail for equity markets to hold back. At current levels equity markets are right at the middle between the January highs and February lows with a compressed 5% trading range established since late February. Our prediction is that the range trading will continue the coming months. There is no convincing upside catalyst that can take global equities above their January highs. On the other hand, the global macro economy is not bad enough to push equities into a tailspin. Against expectations macro is weak, but the absolute activity level is still sufficiently strong to support equity levels. On balance, there more forces weakening the structure of financial markets than strengthening them. The most key risk going forward is emerging market credit given the trajectory of a stronger USD and rising US interest rates.

Don’t touch Italy

The new Italian government proposed by the League and 5-Star Movement is a big headline risk over the weekend. Investors should have little exposure to Italian equities going into the weekend. Italian equities, government bonds and credit bonds are selling off and our view is that this could continue. While the new government says that their programme is no threat to the euro the reality is that both parties have deep roots in the anti-establishment and anti-euro movements. So far the communicated policies have surrounded debt forgiveness of bonds the European Central Bank has already bought which is de facto a wealth transfer to Italy. In general the ideas floating around from debt forgiveness, guaranteed minimum income to tax cuts will all lead to a worse credit outlook and uncertainty over the fiscal trajectory. Overall the new Italian government will not strengthen the euro area but weaken it and prudent investors should demand an increased risk premium for holding Italian assets. We are underweight Italian equities based on recent political developments. If the political and economic outlook improves then Italian equities could become interesting again as the equity market is very cheap valued at a 50% discount to global equities.

EM credit is the canary in the coal mine

According to a global market risk indicator from Bank of America the market risk remains below the historical average which should be positive for risk assets. However, the leading indicators on global trade (South Korea recently printed negative export growth y/y) are rapidly deteriorating although still positive on an absolute level  and thus despite benign market risk equity markets have failed to stage a comeback. Beneath the calm surface a small EM crisis is brewing with Turkey and Argentina assets selling off although Argentinian equities have stabilised somewhat. The cause of EM pain is weaker countries compared to 2008 across debt-to-GDP, lower current accounts and lower growth potential. Add on top of that, rising US interest rates (with US 10-year yields now at 3.1%) and a stronger USD increasing the refinancing pain as many EM countries have financed themselves in USD during the low interest rate environment. The key indicator to follow is EM credit (see chart) currently down 6% from the peak which is largest setback since late 2016. EM equities are still interesting from a valuation perspective , with the upcoming China A-shares inclusion into the MSCI Emerging Market Index starting on June 1, followed by a second round on September 1. As a result we still have EM equities on overweight in our recent House View from this Monday. In other words, we are still overweight EM equities but we are watching EM credit for any signs that pain is coming through the pipes.