Fin de siècle is French for “end of century” but is also a term used to refer to the years from the end of the 19th century until the outbreak of World War I. It’s also seen as a time of decadence and the end of the belle époque. There was a sense that the end of an era was nigh.
Just like today. The heatwave summer of 2018 came to an abrupt end with the sudden onset of winter, especially in France and Spain, where hundreds of cars got stuck in the snow. At political level, the Merkel era is drawing to a close: she will not seek re-election as leader of her party in December and she announced that she will not run in the next parliamentary elections. The scramble to succeed her has begun and it will be telling in terms of the future internal direction of the party.
But enough with the introduction already; what we really want to talk about is the capital markets. After an extremely bumpy October, leading to marked declines¹ on the global equity markets (see Figure 1), the seemingly never-ending upturn is showing some signs of faltering. Not that a recession is on the horizon, but there is a sense that it will come at some point. Between now and then we could face one or two challenges on the markets. Figure 2 shows the effect the falls in stock prices had on credit spreads. Often in the past, the credit markets have set the agenda for equities but this October the opposite was the case. Weak equities led to a sharp widening in high yield spreads. There has been much speculation about the cause of the equity downturn but, to my mind, no truly convincing arguments. Of course, one argument is political uncertainty in all its facets but there was nothing really new about any of it. The reporting season for the third quarter was satisfactory, too, with corporate profits, in most cases, surpassing what were high expectations as it was. A big question mark still remains, therefore, which perhaps will not be answered for some time yet.
Figure 1: Market capitalisation on the equity markets
Figure 2: S&P500 equity index and high-yield OAS
Figure 3: Investment grade spreads in EUR and USD
Figure 4: High-yield spreads in EUR and USD
Looking at the above, it is interesting to note the wide variation between the movement in spreads on corporate bonds denominated in euro and the spreads in U.S. dollars, especially in the high-yield segment (see Figure 4). No doubt this is due largely to the higher corporate profits – caused partly by Trump’s tax reforms – and thus the distinctly better performance of the U.S. equity markets than their European counterparts. However, this does not explain why investment grade spreads look very similar (see Figure 3). Presumably, the index components are very similar in euros and dollars because many IG issuers issue bonds in both currencies. In the high-yield segment, the U.S. market has a much greater energy sector weighting. Either way, there is still room for improvement in all of the four segments we have looked at here and this, as well as the ongoing liquidity shortage on the bond markets, is likely to spoil the fun in the coming months.
Figure 5: U.S. GDP
Figure 6: Eurozone GDP
While we may understand the global context, we should also look at the regional variations that are reflected in economic growth. To illustrate these variations more vividly, we have used identical scales in Figure 5 and Figure 6. Even though the first estimate of economic growth in the U.S. of 3.5% (QoQ ann.) was lower than in the previous quarter, not only is the eurozone lagging behind, it is actually weakening, with growth of only 0.8% (QoQ ann.). The aforementioned tax reforms under Trump have brought about a distinct surge in growth. Not only that, but the excessive bureaucracy in Europe and increasingly strict environmental legislation is, of course, dampening economic momentum in the eurozone countries. Moral judgement aside, this is an undeniable fact.
The trend in economic data overall is completely different for the U.S., as we can see from the surprise indicator for both economic areas (Figures 7 and 8). While expectations in relation to the U.S. were well beaten at the beginning of the year, the opposite tended to be the case in the eurozone. On this side of the Atlantic, the figures were much weaker than expected, and now the data is again falling short of estimates. In addition, political uncertainty was a negative factor, most recently in Italy. It’s no wonder that European equities were so much weaker than their U.S. counterparts. There are also big differences in the changes in market expectations for money market interest rates. Figure 9 charts not only the trend in 3-month rates in the U.S., but also the changes in expectations for this trend. Since the beginning of the year, market expectations for future rates have risen between 0.5% and 1%. In the eurozone, on the other hand, expectations tend to be unchanged (see Figure 10). In other words, central bank policy comes as no surprise and is on a very steady course while political events are failing to inject impetus.
On the contrary, the diesel emissions scandal, as well as the strict introduction of the new WLTC/WLTP standard for measuring fuel consumption on 1 September, are putting the brakes on the automotive industry. The sector is immensely important for the German economy, which has the largest share of eurozone GDP. Figure 11 charts new passenger car registrations in Germany. The year-on-year drop of more than 30% speaks volumes and does not bode well for economic development in Germany and, with that, in the eurozone as a whole between now and the end of the year.
Figure 7: U.S. economic surprise indicator
Figure 8: Eurozone economic surprise indicator
Figure 9: 3-month EuroDollar interest rate and the implied rates at the beginning of the year and at the end of October
Figure 10: 3-month Euribor interest rate and the implied rates at the beginning of the year and at the end of October
Figure 11: New car registrations in Germany
Figure 12: Currency hedging costs on a 12-month basis in EUR/USD
In summary, it can be said at this point that in Europe in particular economic growth has lost a significant amount of momentum. It is too early to tell whether this is a temporary phenomenon or, in central bank parlance, a transitory event. As things currently stand, the downturn is significant enough to cause concern that the ECB is much too far behind the curve and that the next European recession could be practically around the corner, while the key rate still stands at -0.4%. Where’s the room in that for positive stimulus?
In the U.S., however, things look comparatively rosy. Momentum is still intact and Donald Trump will – if he holds the majority in Congress in the midterm elections, which are imminent at the time of writing – continue his very pro-business policies. If he, as currently expected, loses his majority in the House, the Democrats are sure to block as many of his initiatives as possible. So, for now, all we can do is wait. The following questions remain, however: How much more stimulus can Trump’s government inject? Will it be enough to push out the next recession further and perhaps even beyond the horizon?
If things turn out as indicated, it will mean that the challenging times on the capital markets will continue indefinitely. For euro investors the cost of currency hedging, which is of course set largely by the interest rate differential, may continue to rise sharply and thus make hedged investments in USD assets prohibitively expensive (see Figure 12). Investors who are unwilling or unable to take the currency risks are all but confined to the eurozone, where investors are rewarded with negative real yields and poorer prospects on the equity markets.
Success in this environment still calls for expertise and a steady hand. Whether fin de siècle or end of an era, times have rarely been easy on the capital markets. That said, in this environment it is getting tougher and tougher.
¹ In total, valuations on all equity markets lost more than USD 8,000,000,000,000 in October. This is almost double Germany’s GDP in 2017.