The beginning of the year was characterised by a rise in sovereign long-term bond yields.
The 10y US Treasury yield jumped to 2.8% and the 10y German Bund yield rose above 0.7%. This was the result of:
- A significant upward revision of market fed funds expectations. Markets are now pricing three rate hikes in 2018 reflecting the current dot plot.
- Confirmation of the reduction in the accommodative stance of monetary policies.The ECB will buy €30bn of bonds a month (for at least the first nine months of 2018), which is half of the €60bn it bought previously and the sovereign debt purchase program (PSPP) has clearly been cut more than the other programme. It is worth also keeping in mind that the Fed will not reinvest the $270bn of US treasuries maturing this year.
- The jump in US Treasury department funding needs. The Treasury is set to borrow nearly $1 trillion this year, and nearly double the amount borrowed by the federal government in 2017.
In early February, wages rise at 2.6% has been a catalyst of the equity market sell-off.
The Vix exceeded 37 its highest level since 2015. What is the rationale behind these rapid movements?
- We enjoyed a complacent environment for a very long period. Before the fall, The US equity market was posting its best start to a year since 2003.
- The rise in wages and borrowing costs could drag down future earnings. Earnings expectations are pretty highs. In fact, the first quarter of 2018 marked a record increase in S&P 500 EPS estimates for Q1 2018 motivated by the new tax law, rising oil prices (energy sector), higher interest rates (financials sector). The Q4 earnings reporting season appears to be robust. These good results were already priced in by the market.
- Rising bond yields. Returns from stocks look relatively less attractive.
- Technical factors (algorithmic equity trading) that triggered relevant stop losses.
At the opposite, corporate bond markets and European sovereign spreads remained resilient:
- Global economic activity continue to strengthen. The pickup in growth has been broad based. In the US, growth forecasts have been revised upwards. In Euro area, the recovery is intensifying and extending to all the countries.
- The rebalancing of profits and wages is not necessarily a bad news for the US economy. It's extremely important to understand that the growth in profits seen during this cycle has been driven more by margin growth than growth in sales. US margins are currently at all-time highs. In other words, pressure on wages has enabled corporations to increase their profits. On a macroeconomic level, the trend has resulted in very strong growth in GDP from corporate profits at the expense of labour. Raising wages could – all other things being equal – increase revenue momentum. Increasingly robust demand is indispensable to promoting the investment recovery.
- US companies are deleveraging. This is completely unusual at this stage of the cycle. In recent years, US companies have increased their debt to record levels, but the majority has gone toward share buybacks and acquisitions. Investment spending remained very limited. This is specifically due to the flat demand environment.
- The ECB is strongly supported the euro Corporate bond market via its Corporate bond purchase programme (CSPP). In the corporate bond market, the ECB faces less supply constraints than in the sovereign bond market (no scarcity issue). As we expected, the cut in the CSPP has been much less pronounced than the cut in the PSPP.
What’s next on credit markets?
Inflation expectations will be key. At this stage, our economists don’t see a risk of inflation spikes in the US, and confirm the base scenario of rising but subdued inflation (2.3% expected in 2018). However, an upward surprise in inflation could push the Fed to be more aggressive in raising rate and lead to tighter financing conditions.
On the credit side, valuations are still in line with solid fundamentals but are got richer versus implied volatility. We remain cautious about the low-rated segments of HY especially in the US. High leverage makes American companies vulnerable.