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Update on fixed income markets


Markets have been buffeted by a number of unexpected events in recent months and here, we explore how these events have shaped financial markets over this time.

 

The outcome of the ‘Brexit’ vote – that the UK has decided to leave the European Union – was a shock. The main initial impact has been to the British pound. Prior to the vote the value of the British pound against the US dollar was fair, so it was not surprising to see a big fall in the pound. Further downside is expected. It is anticipated there will be a sharp slowdown in growth in the UK in the second half of 2016 as businesses hold back investment. There is a better than even chance of a recession in the next year, but it will be prudent to assess data to confirm that.

In terms of secondary impacts on global growth, so far the country most affected is Japan with a much weaker Nikkei and stronger yen. More monetary policy easing is needed, and is coming, in Japan.

A casualty of the Brexit vote may also be the Italian banks. They have poor profitability, asset quality and transparency around non-performing loans and a legal system that makes disposing of assets very difficult. The system needs recapitalising but because the court system is so cumbersome, new capital is likely to come from the Italian government. Markets so far have been sanguine about the wider effects of problems in Italian banks but this is a risk that is under-appreciated.

Macroeconomic review

For the UK economy, the outcome of the Brexit vote is bad news. According to estimates from the UK Treasury and the Organisation for Economic Co-operation and Development, the impact on trade, the financial sector and labour mobility could leave the UK economy around five per cent smaller than otherwise in 15 years’ time. In the short term there is a risk of recession, as UK businesses will be uncertain about their continued access to the European Union. The negative impact on the UK economy will be partly offset by a weaker British pound, making UK businesses more competitive.

US economic data has been mainly positive recently. While durable goods orders have been weak, the June manufacturing purchasing managers’ index, as well as home prices, have risen. Home sales have also been strong and jobless claims have fallen sharply. The US’s top 33 banks passed a US Federal Reserve stress test, indicating they have enough capital to withstand a severe economic shock.

The European Central Bank is still rolling out its quantitative easing program. The bank expects inflation to be below the target range, and current monetary policy stance remains in place. Eurozone economic confidence improved for the second month in a row in June and remains at levels consistent with continued economic growth. Unemployment remains high at 10.21 per cent and bank lending continues to increase modestly. Eurozone March quarter gross domestic product growth was revised up to 0.6 per cent quarter-on-quarter, further confirming growth is continuing at a reasonable pace.

The Eurozone composite business conditions purchasing managers’ index fell slightly in June, with a decline in services offsetting a gain in manufacturing. It remains at a level consistent with moderate growth. Eurozone economic sentiment fell only slightly in June and remains consistent with moderate growth and a pick-up in bank lending growth is a positive sign.

Chinese data released in June for May was mixed, with slowing growth in investment but stable growth in retail sales and industrial production. Combined with stronger exports and stable business conditions, growth looks to be tracking at 6.5 per cent to seven per cent a year, but policy looks like it will have to remain stimulatory. Chinese exports fell four per cent year-on-year in May, which was in line with expectations, but the fall in imports moderated to just -0.4 per cent year-on-year, which is indicative of higher commodity prices and possibly improved domestic demand.

Meanwhile, Chinese consumer price inflation fell to two per cent year-on-year but producer price deflation continues to abate, which is a good sign. Chinese business conditions purchasing managers’ indices for June were little changed and consistent with growth forecasts.

Domestic conditions

In Australia consumer confidence weakened a little in June but remained positive. The Reserve Bank of Australia (RBA) rate cut in May had a very large positive impact on confidence readings in May and this was expected to fade in June.

However, the survey was taken in the week consumers heard news about the RBA keeping the cash rate unchanged and news on the better than expected gross domestic product growth figures. But consumer confidence continues to be weaker than business confidence – a trend that has been constant for a few years.

Finally, Australian employment increased by 17,900 workers in May – a little above the market consensus of 15,000. The unemployment rate was unchanged at 5.7 per cent, with the participation rate also unchanged at 64.8 per cent. Jobs growth has slowed from the high levels seen in 2015, but the unemployment rate is still lower than where it was a year ago. Given the structural change occurring in the economy, these trends should continue.

About the author
Simon Warner, Head of Fixed Income at AMP Capital is responsible for the management of AMP Capital’s active fixed income strategies including macro markets, credit markets, commercial lending and protected growth, managing nearly 30 investment professionals across Australia, New Zealand, Hong Kong and the US.
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