Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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More green shoots from global manufacturing PMI figures and South Korea
Peter Garnry
Chief Investment Strategist
Summary: It seems equities have been more right than bonds this time in its outlook for the economy. Equities have continued to discount a soft patch and return to trend growth scenario, and it looks increasingly like that is the scenario that is materialising. South Korea's current account in September jumped back to average levels suggesting economic activity is rebounding from low levels. In today's equity update we also highlight Italian equities as a potential interesting bet in 2020 as we believe the Italian government will be allowed to expand its fiscal deficit. We also take a look at ISS, the biggest decliner today in the STOXX 600 Index, which is revising down its outlook.
The rebound narrative is strengthening every week now and the JPM Global Manufacturing Index printed its third straight gain in October supporting the view that global manufacturing sector is on its way out its recession. But more importantly the slowdown in the manufacturing sector never created large spill over effects into the services sector so it might be that the global economy is turning back to trend growth. While the probability for this scenario is rising it’s still not a clear path and things could still reverse quickly with the supposedly US-China “phase one” trade deal as the biggest tail-risk to investors in the event the trade deal is not done.
Adding to the positive change in global manufacturing PMI figures South Korea reported overnight a strong gain in its current account balance to $7.5bn in September suggesting economic activity is again picking up in South Korea. As one the most sensitive economies to growth in Asia and economic statistics that investors can believe it’s an important signal to the market that the bleeding might have stopped for now. South Korean financial assets have recently performed well in tandem with the rest of the emerging markets and the stronger Chinese Yuan has supported the momentum in emerging market equities. If OECD’s global leading indicators (CLI) this month confirm a turning point in September or at least that it’s imminent, so maybe in October, then the global economy is shifting from contraction to the recovery phase and in this phase emerging market equities have historically been the best performing asset class.
European leaders have pointed fingers at Italy for their intention to increase the fiscal deficit, but the facts are that Italy’s fiscal deficit as a percentage of GDP is expected to be -2.3% in 2019 which is well within the -3% threshold agreed to in the EU’s Growth and Stability Pact. At the same time France, which is currently the growth engine in Europe, is expected to have a deficit of -3.2% of GDP in 2019 as the French government has increased spending to support growth. Our view is that Italy will be allowed to increase the deficit and there is room with the primary surplus (government revenues -minus expenditures excluding interest payments) of around 3.2%. This will create growth tailwind for Italy and if growth globally rebounds Europe will benefit as well with Italian equities potentially as the big winner. Italian equities are valued at a 35% discount to global equities and have an attractive 4% dividend yield on top of positive earnings expectations and the potential for valuation expansion. Italian equities could be the contrarian bet in 2020.
The biggest decliner in the STOXX 600 Index today is the Danish facility service company ISS down 17% as the company is lowering its outlook and longer-term guidance for growth and operating margins. However, the business is generating a stable free cash flow of DKK 2.6bn on an annualized basis which given the current enterprise value of DKK 46bn translate into an attractive free cash flow yield of 5.6%. Given the yield hunting investors this stable business should be able to attract marginal buyers with this free cash flow yield. The biggest risk for ISS is if there is a sustained slowdown in the economy as increased bankruptcies will impact top line growth significantly.
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