nl 2q16 uk · moneymarketandixedincome amidst# an# acrosstheboard# economic# slowdown,# global#...
TRANSCRIPT
In search of lost yields
SPRING 2016
Central banks’ ultra-‐accommodative policies are struggling to boost economic growth, but they do not fail to make life very dif<icult for investors. To witness, risk-‐free investments have lost their yield virtually everywhere in the world, and have in some countries even turned into a penalty for investors ! Global growth is either in decline or weak. In<lation is rising slightly in the United States but globally, we are far from overheating. Low interest rates are thus here to prevail and the hunt for yield will keep bringing investors to equity markets, an operation ... not devoid of risk.
The pendulum points to fear
As is known, markets oscillate between excesses in both fear and greed. Greece is currently out of investors’ anxiety radar, but this has not ring-‐fenced them to start the year in "panic" mode, as they got worried, in turn, by a hard landing of the Chinese economy, a recession in the US, a growth standstill in the euro area, all topped off by the fear of a "Brexit". Following a pretty hectic Eirst quarter, what’s in for investors? Markets are always right for sure, but sometimes the perception of investors does go beyond reality.
Let's start with the United States. Economic growth shows a modest 2%. Several factors account for this. On the one hand, the sharp fall in oil prices gave a brake on investment in equipment, a key driver of growth. On the other hand, household consumption has not increased as much as expected following this counter-‐oil shock. Last but not least, the stronger dollar has hit net exports. Bottom line, Eirst quarter growth will probably be disappointing.
Should we however fear a recession of the US economy? The danger seems small, and for several reasons. First, with regard to oil prices, history suggests that it is annual increases of over 20% in real terms which are typically followed by recession, as shown by the graph below. Certainly not decreases of 50%! That said, the sweet spot for black gold is probably a little over $ 50 a barrel, a level above which the production in North America generates positive cash Elows.
Secondly, consumers remain in the driving seat of US growth, and ... our favourite indicator of the annual variation of their conEidence remains well above its "recessionary" threshold, helped as it were by encouraging Eigures on the job market.
US economic growth being on a soft patch has a pleasing outcome for investors: the Fed's policy will certainly be less restrictive than the 3 rate hikes announced last December. Among the indicators that attest it, we can use the so-‐called "Taylor rule" which provides an estimate of where the key rate of the Central Bank should be, based, Eirstly, on differences between the rate of measured
1. The fall of crude per barrel should boost growth in the USA economy
inElation and its target of 2%, and, secondly, the gap between economic growth and its full employment threshold. The graph shows that this theoretical rate should currently be negative, a sign that the monetary policy of the Central Bank has no need to be restrictive in light of the low probability of an overheating growth.
What about other threats on the growth of the world economy? Clearly, it is China that dominates fears. The origin of the current slowdown in the Middle Kingdom is a major structural transition from an economy traditionally worn by investment and exports to one supported mainly by household consumption. The landing of the Chinese economy
should be smooth, helped it need be by expansionary monetary and Eiscal policies. Visible on the previous graph, the deleveraging process is also a piece of good news, although total private credit remains high at 170% of GDP.
Perhaps more than the downturn itself, it is the lack of reliable economic data that worries investors. Hence, their focus on any Eirm – albeit indirect -‐ evidence that the economy is in slowdown mode: the currency devaluations operated abruptly by the Central Bank. They caused quite a bit of market turmoil during the Eirst quarter. I bet that if the central bank holds the lesson that devaluations do produce anxiety, it should act with more tact to prevent capital Elight and new market backlashes.
In the euro area, growth remained anchored around 2%, and the outlook remains uncertain. The good news came in March from the European Central Bank, when it announced a new arsenal of unconventional monetary measures to boost growth. The key to their success lies in a more generous policy of commercial banks in providing new credits to individuals and businesses. In this sense, the low bond yields should reduce the incentive for banks to use the quasi-‐free liquidity provided by the Central Bank to buy sovereign bonds. The "monetary reElation" program of the European Central Bank will eventually prove successful, as the ECB still has a plenty of scope for the expansion of its balance sheet. This point is made clear in the chart below which compares the evolution of the respective Central Banks balance sheets in the US, Japan, Switzerland and… the Eurozone.
2. The "Taylor rule" excludes any monetary tightening from the Fed
3. China ; Consumer's deleveraging continues
4. The ECB still has room to manoeuver
The "Brexit" will continue to rank high on investors’ “worry agenda”: the probability that such nightmare scenario comes true is low but we cannot rule out that the populist arguments of the UKIP party will ultimately prevail over reason. Sterling would be the Eirst victim of the Brexit, as the currency is still overvalued by a good 15% in relative to its purchasing power parity level. On the macroeconomic front, we can estimate that the damage from Brexit be up to 10 times higher for the United Kingdom than for the European Union.
In short, global economic growth will therefore remain low in developed countries, and will slow in emerging countries, especially China. Faced with this subdued growth, what are the prospects for the policies of central banks and for the Einancial markets?
Central banks have wiped out risk free rates
All over the world, central banks have blown up their balance sheets, Eirst by lowering key interest rates to a minimum and then by massively injecting liquidity through bond purchases. As a result, risk-‐free yields have almost disappeared, both for short-‐term liquidity and for many government bonds. In Germany, the Netherlands and Switzerland, bond yields have turned negative shortly after the Swiss National Bank has opted for the negative rate policy, in December 2014.
It is not in the habits of central banks to fully open the liquidity tap. They have being doing so since the 2008 crisis in an attempt to stimulate growth, and possibly even break the neck of the deElation threat. The key to success remains a more generous policy of credit conducted by commercial banks.
At time to take stock, it is clear that central banks have only very partially achieved their growth target. Credit fails to restart lastingly in the euro area and in Switzerland, the franc remains the most expensive currency in the world. The former partly accounts for the latter: the lack of growth in the euro zone is such that investors fear that the debt overhang in the peripheral countries of the euro zone like Greece might return under the spotlights. Thus the franc retains its role as a safe haven currency.
We are probably expecting too much from central banks today. As the saying goes: they can bring the horse to water, but when it comes to forcing it to drink ... That is: central bankers can open the liquidity tap. But if commercial banks are not
thirsty, credit will not restart, growth will remain sluggish ... and bonds will continue to offer unattractive returns.
Risky assets attractive by default?
With bond yields close to zero, when not negative, both private and institutional investors are pushed to fetch income of the real estate side, or high yield bonds, alternative investments, absolute return strategies and, of course, Equity markets.
Equity markets valuations are not signiEicantly different from their historical averages. The attractiveness of risky assets is measured mainly with the lack of yields offered by cash and bond markets. For example, the MSCI EMU -‐ which groups 10 major developed countries of the European Union -‐ displays a dividend yield which is 4 times higher than that of European bonds!
Buying Equities because bonds do not offer attractive returns makes sense but … is not without risk! The attractiveness of risky assets by lack of alternatives must be played out with caution in any investment policy, especially as economic growth halftone provides a satisfactory macroeconomic framework, but without panache.
Michel GirardinEconomic Advisor
5. Eurozone ; Dividend yields plead for Equities
Money-‐market and Fixed-‐income
Amidst an across-‐the-‐board economic slowdown, global economic activity sent out slightly more encouraging signs during the second half of the Eirst quarter. The US dollar’s weakening and the commodity price rally helped relieve pressure on emerging economies, and accommodating measures by the main central banks helped reElate Einancial asset valuations. The Fed played for time by reducing its cycle to two key rate hikes in 2016, while the ECB accelerated the pace of its quantitative easing while boosting credit and supporting the banking sector. Sovereign yields rose slightly in the US (1.7% on 10-‐year paper) while turning back down in the euro zone (to 0.15% on 10-‐year German paper). In our balanced allocation we continue to focus on high yield bonds (14%) and convertibles (6%), on which we have r e d u c e d t h e a v e r a g e s e n s i t i v i t y. O u r underweighting of investment grade and overweighting of money-‐market and cash (24%) continues to penalise returns.
Equities
Prospects of a steep and sustained correction in equity markets gave way to renewed optimism as fears of a US recession and a hard landing in China faded. However, the upturn in US, emerging and commodity indices has come at the expense of euro zone and Japanese markets, which remain quite depressed. We moved to a slight underweighting of equities in our balanced allocation (43% vs. 45% neutral) while reducing our weighting of Europe (16%) and raising our emerging market exposure (5%). We also rebalanced the portfolio towards value and away from growth.
Currencies
After a long period of gains, the US dollar began a phase of consolidation in the wake of a rally in commodity and emerging markets. Despite its overvaluation it is hard to bet on a falling dollar as long as monetary policies remain uncoupled between the US and the other main countries. We unwound our tactical exposure to the US dollar.
Outlook
For the market rally to have legs, new tangible signs are needed of a stabilisation in the global economy and a coming acceleration in growth. Emerging economies have once again become attractively priced but are not yet out of the woods both on cyclical and structural plan. Among developed economies, Japan and Europe are having a hard time getting back on the path of virtuous growth, with the euro zone also facing governance problems that could darken its outlook. In the US, the situation appears to be stabilising in the direction of moderate growth driven mainly by consumption. In a non-‐inElationary, low-‐interest rate universe, investor risk appetite is natural and justiEies high valuations. But for how long? Caution is still in order, in our view, and we feel that apart from the catching up by certain markets, the current rally now has little room to go.
Armand du Pontavice, CIO
Investment Policy