Financial markets have been treading water over the past couple of months with no clear direction in key markets. Stocks are broadly flat and US 10-year yields and the EUR/USD are trading in a tight range.
Stock markets have been caught between a soft patch in growth, stretched valuation and geopolitical risks on the one hand and a medium-term positive economic outlook and still dovish Fed on the other. So far this year global stocks have not been able to outperform bond markets, where falling yields in especially Germany have led to decent returns. A 10-year German bond has delivered around 5% return so far this year.
The risk of the punch bowl being taken away any time soon is low, as inflation pressures are low and the Fed keeps telling us that there is significant slack in the labour market. A global re-acceleration in growth starting in Q2 will likely continue to underpin stock markets. In H2 we expect 3-3.5% growth in the US, around 2% growth in the euro area and 8%% growth in China, leaving global growth running at slightly above 4%. The question is if investors are willing to look through a slightly stretched valuation and still slow earnings growth on the expectations that earnings will pick up soon. In the short term we still believe markets will be hesitant but the scope for a pick-up in earnings growth and the fact that bonds and credit have gotten expensive as well should lead to outperformance of stocks over bonds in the medium to long term.
Following the strong rally in German bonds in the first part of the year, we see limited room for a much further decline in yields. Inflation has likely bottomed and activity continues to strengthen. However, as long as further ECB easing with the possibility of QE is still on the table, we are likely to be stuck with low yields. The same is the case in the US where 10-year yields will likely remain in a tight range in the short term. However, going into H2 we believe upward pressure on bond yields will come from 1) a gradual rise in inflation in both the euro area and the US and 2) US job growth picking up steam with job gains of 250k per month over the summer and autumn.
Euro inflation low in the short term but watch food prices
This week euro area inflation showed a rise to 0.7% in April from 0.5% in March driven by a rise in core inflation increasing to 1.0% from 0.7% in March, see Higher euro inflation in April but below ECB’s forecast, 30 April 2014. We believe euro inflation bottomed in March and although inflation is expected to remain broadly unchanged at low levels in the next couple of months, there are rising upward risks in the second half from the rise in global food prices. The CRB food stuff index (in EUR) has risen 22% since December with still no sign of changing course. The increase stems from a combination of extreme weather, geopolitics and supply disruptions, see Global food prices surge, 11 March 2014.
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