In Focus monthly - June 2018

Q2 review

Disciplinarian markets

Higher interest rates are far from universally popular. All expenditure has to be viewed through the prism of the interest rate at which it was financed. As interest rates rise, everything from the decision to splash out on some ‘Paw Patrol’ plastic to placate the little savages to state infrastructure projects needs to be re-evaluated.

Higher interest rates also change the complexion of past projects. Populist political leaders therefore tend to be on fertile ground railing against them – Turkish President Tayyip Erdogan recently described higher interest rates as the “mother and father of all evil”, adding to his previous (extraordinary) suggestion that higher interest rates actually cause higher inflation. Whatever your views on higher interest rates, this was a quarter when they did us all a few favours.

When the tide goes out...

It is precisely because the act of raising interest rates is more often than not going to be unpopular, that central banking has been wrenched from the clammy paws of the politicians in most of the world’s major economies. Independent, unpopular, central banking is rightly cherished by investors, as the recent flare up in Turkey proved.

President Erdogan’s promise to step up his role in the economy after elections at the end of June was not well received by markets. The lira plunged, borrowing costs soared (Figure 1), and the country gazed briefly into the economic abyss. In response, the central bank, against earlier ‘advice’ from the President, has raised interest rates by a cumulative 5%. Disaster seems to have been averted for now, with some trust restored in the inflation-fighting credibility of the Turkish central bank.

The lira plunged, borrowing costs soared

Others around the world have also been using the ultra-low interest rates of the post-crisis era to live beyond their means, or swim without their trunks, as the saying goes. Such swimmers are always easier to spot when the tide goes out, or when interest rates rise, as they are in the US at the moment.

However, using a scorecard that focuses on factors ranging from external funding needs and debt exposures to its ability to attract foreign investment flows, we find that the sinners seem relatively isolated amongst the emerging market economies this time around. Argentina, Turkey and South Africa stand out. Reassuringly, emerging Asia, where we remain most positive within emerging market equities, appears to be most resilient to rising US interest rates on this measure.

Populism blunted?

Italy was another example of the restraining influence of the bond market in this quarter. Some wild statements on spending plans, debt forgiveness and even euro membership from the incoming Italian government saw borrowing costs in the economy understandably spike higher (Figure 2). Try going to your mortgage advisor and suggest that you are going to work less, spend more, and may want to pay your mortgage back in a ‘new’ currency, and see what interest rate you are offered on the loan.

Italian government bowing costs spiked

However, a few days of rising panic in markets served to blunt some of the new coalition’s proposals. A new, less incendiary finance minister was proposed and reassurances were given on EU membership among other things. Markets calmed again. This disciplinary streak in markets may also come in handy in the UK before too long.

Wider hubris?

These examples of living beyond means, or trying to, will not be limited to specific countries. As always, there will be lenders and borrowers all over the world who have misjudged or misled, or both. As the cost of borrowing in the US continues to rise across all maturities, more of these misallocations will no doubt be revealed. However, our bet remains that these incidences of traditional late cycle hubris will not have taken on the systemic importance that some of the cycle-killers of the past managed.

Animal spirits and wider risk appetite have been constrained for much of this economic cycle, in large part a function of the long shadow cast by the Great Financial Crisis and indeed the still-smouldering Euro Crisis. That shadow has started to fade in the last couple of years (Figure 3). Consumers and businesses ready to borrow are finally meeting banks ready and more able to lend. Higher interest rates will be important in enforcing some discipline on these actors.

Consumers and businesses meet banks ready to lend

Rising interest rates complicate the job of investing in capital markets of course, particularly for those looking for less risk. Large chunks of the high-quality government and corporate bond market will continue to offer more diversification than real return appeal for a while yet (Figure 4).

High quality real return will be low for a while

We continue to argue that carefully weighed credit risk remains an important part of portfolios in this context. The world economy in aggregate still looks capable of providing plenty of juice to service some of these riskier credits. Nonetheless, we should be prepared for more unsightly revelations in the second half of the year.

European equities – Italy’s rage


The ever-smouldering euro crisis briefly burst back into flames this month. After months of wrangling, a populist coalition, throwing together the political extremities, managed to form a government.  A proposed fiscal programme that will surely blow a sizeable hole the nation’s budget if fully implemented set investor nerves jangling. Italian borrowing costs soared, risk assets were sold off and column inches were filled. Amidst these worries, we examine whether our tactical overweight to European equities remains warranted.

Clearing a path

A further deterioration here can affect the equity market through two channels. The first, and most immediate, is price multiple de-rating as investors bake in a slightly higher risk that Italy returns to the lira and all that would follow.

The second channel is through economic contagion. Waning private sector confidence from yet more political uncertainty can further slow an already moderating growth profile as businesses and consumers hold up on spending. In the worst-case scenario, an Italian version of the 2015 Syriza-EU showdown would hit Italy’s already troubled banking sector, with reverberations on the wider Eurozone banking sector and economy.

The key question is whether the probability of economic contagion is high enough to justify removing our overweight to Europe. If we cut through the headline noise, is there a high enough likelihood that the new Italian government brings forth another full-blown euro crisis? For now, our answer is no.

The latest high-frequency business surveys tell us that confidence in the real economy hasn’t materially deteriorated in May. This may change as we move further along, but from past experience, we know that spikes in political uncertainty aren’t necessarily followed by cutbacks in spending1.

There are also reassuringly considerable constraints, both external and internal, that limit the government’s ability to fully implement its proposals, let alone initiate a damaging showdown with the EU2. Granted, political actors can act in irrational ways, and accidents do happen, but it’s unwise to base our entire tactical positioning on the small probability of a tail risk event.

Reasons for Europe

Once we’re clear on the politics, we then re-examine whether the fundamental case for European equities remains intact. We still believe it does. While the market increasingly debates the late-cycle nature of the US/global economy, Europe's own cycle is less mature from an economic and earnings perspective (Figure 1). As long as global nominal growth continues to hold up, then Europe's younger profit cycle remains attractive to us.

Europe has a younger profit cycle

We’ve mentioned how valuations matter less when it comes to making tactical plays. With growth momentum slowing and headline risks ranging from trade wars to Italian politics weighing on investor sentiment, we don't think the backdrop is conducive for higher European equity valuations over the short term anyway. Still, the region’s prospects aren’t harmed by its relative undervaluation, with the region still looking cheap versus its global peers in a historical context (Figure 2). At the very least, low valuations may help serve as a cushion from further de-rating.

European equities relatively undervalued

We still think that European equities have an attractive relative upside over a medium-term horizon. Nevertheless, we think this is a region with a relatively high reward/high risk profile. Therefore, a tactical play on European equities should be sized and diversified appropriately, as we are doing within our own tactical asset allocation.

European peripheral debt – euro crisis redux?

Italian spreads widened to their highest levels since 2013 in May, as markets fretted over Italy’s fiscal path under its new populist government. The government’s newly proposed policies call for all sorts of goodies such as a universal basic income, tax reductions, and a decrease in the mandatory retirement age. If fully implemented, they will likely raise Italy’s already worrisome debt/GDP ratio, threatening the country’s debt sustainability. Unsurprisingly, markets are increasingly worried about a return to the dark days of the Euro Crisis.

It’s tempting to oversimplify things and overemphasise the parallels between 2012 and the current situation. However, there are two important differences here. Firstly, the spillover to other peripheral bond yields has so far been muted – this is primarily an Italy-focussed, rather than periphery-wide issue.

Spillover to peripheral yields have been relatively muted

Second, the level of spread widening in Italian debt remains well below the 2012 Euro Crisis. To us, these nuances reflect a few key differentiating factors relative to 2012 – factors that lead us to believe that a 2012-style meltdown remains unlikely for now.

The first differentiating factor is the overall macro backdrop for the Eurozone. Despite the recent moderation in activity indicators, Eurozone growth remains firmly positive. The peripheral nations themselves (including Italy) have also made great strides in reducing their macroeconomic imbalances. Today, most of them have significantly reduced their budget deficits, while enjoying current account surpluses. This stands in stark contrast to 2011-2012, when sizable ‘twin deficits’ left them vulnerable to the whims of foreign investors. In this context, the muted spillovers we are seeing so far seem understandable.

Peripheral economies have reduced their budget deficits

The second differentiating factor today is the European Central Bank (ECB). Back in 2012, the Euro Crisis was formed of three interlocking crises: a banking crisis, a sovereign debt crisis, and a growth crisis. Surging peripheral yields threatened the solvency of European banks which had outsized exposure to peripheral debt. This impaired the credit lending channel, thus further weighing on economies already burdened by austerity and the after-effects of the Great Recession.

The resulting slowdown in growth further threatened the fiscal sustainability of the peripheral economies, which then placed further upward pressure on yields, and so forth… This negative feedback loop was only broken when the ECB committed itself as a fiscal backstop, with the unveiling of a facility known as outright monetary transactions (OMT). OMT allows the ECB to purchase Eurozone sovereign debt in the secondary markets, which implicitly places a theoretical cap on sovereign yields. While the use of the OMT comes with strict conditionality, it should nevertheless put a ceiling on contagion risk.

Finally, European banks are in much better shape today relative to 2012. Granted, pockets of idiosyncratic risk remain (Italy in particular), and profitability remains stubbornly below pre-crisis levels. However, European banks have materially improved their ability to resist negative shocks. Liquidity provision from the ECB in the form of Long Term Targeted Refinancing Operations (TLTROs) has bolstered balance sheet liquidity, bad assets have been ring-fenced, capital ratios have improved, and profitability is starting to recover.

Together, these factors should limit the risk that the current political crisis in Italy morphs into a full-blown Eurozone-wide financial crisis. Although political uncertainty in Italy will likely linger, the bar for wider contagion risk is far higher today, in our view.

A look at precious metals


Gold has failed to live up to its traditional safe haven allure this year. Sporadically turbulent equity markets, escalating trade tensions and plenty of geopolitical uncertainty have been met with little more than a shrug from the gold price. Instead the direction of the US dollar seems to have been the key driver of gold prices.

Currently, the US dollar has the tendency to weaken in an environment of strong equity markets. Vice versa, it does well on weakness in stocks, heightened trade tensions and waves of risk aversion. The US dollar and gold prices have a strong negative relationship. As a result, gold has surprisingly behaved as a risk-on asset in recent months. Whether this will remain the case in coming months and quarters remains open to debate.

Gold bugs will point to solid fundamental drivers for gold this year with solid indicative demand for jewellery, gold’s largest demand driver and a still resilient outlook for the Chinese economy. Nonetheless our suspicion remains that as the real yield available on the benchmark safe haven, US Treasuries, continues to rise, the safe haven appeal of yield-less gold will continue to wane.

Gold is lacking its safe haven allure


This year, the gold-silver ratio peaked over the 80x level, a level deeply inconsistent with a positive outlook for the global economy. Silver money manager positioning data was net short a long time in 2018. Such a short position in silver is unsustainable, prompting a recovery.

This view is reinforced by the 2018 GFMS silver survey recently published. The report shows that the silver market recorded a deficit last year for a fifth consecutive year, even as retail investment fell considerably. A continued recovery in industrial demand as well as stagnating recycling volume and higher jewellery consumption is expected to support fundamentals this year. China’s expanding middle class and a pickup in investment demand could add to momentum.


Palladium has offered investors a wild ride this year. After moving above 1,100 USD per troy ounce in January, subsequent weakness in equity markets and trade tensions between the US and China triggered a sell-off in palladium prices. Palladium’s price decrease was so pronounced that in just over one day, palladium traded at a rare discount to platinum. Fundamentals, as outlined in the latest Johnson Matthew (JM) report, however continue to favour palladium over platinum.

According to JM, after five years of sustained deficits, the global platinum market reported a modest surplus in 2017 and there is likely to be a moderate surplus again this year. On the other hand, palladium had a deficit in 2017, the sixth consecutive year, and the largest since 2014. Whilst there is the risk of increasing supply due to metal recoveries from scrapped catalyst converters and ETFs selling off holdings, stricter worldwide emission controls support palladium demand this year.

Investment Conclusion

Looking forward, a continuation of Fed rate hikes and a modest rise in US Treasury yields will most likely result in modest price weakness in precious metals. Precious metals’ appeal as non-yielding assets will probably lose some shine; other commodity sectors like oil look more appealing.3

Market talk

Charlie Thomas (Head of Strategy, Environment and Sustainability, and Manager of the Jupiter Ecology Fund) talks to Ian Aylward (Head of Manager Selection at Barclays) about managing a portfolio focused on sustainable investments, and the changes he has witnessed in this marketplace. Read this month’s guest interview.

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