In recent weeks, the bond and equity markets have been in turmoil. The epicentre of the problem is clearly on the side of the bond market, where the spectre of a crash is haunting investors – especially since the Fed is beginning to worry openly about excessively low interest rates and the overvalued stock market. On the equity market, the rise in interest rates was investors’ chance to take their profits.
Market risks are being joined by economic risks: the end-of-cycle in the US and the hard landing in China. Finally, on the political plane, the risks of a Grexit and, more recently, a Brexit have come to the forefront. Should we fear a bond crash, Grexit or Brexit? In a nutshell, our answer is no. Having said that, investors should be prepared for increasing volatility.
Toward a bond crash?
False alarm or serious warning?
Without a doubt it is statements by US fund managers on the abnormally low interest rates and the bond bubble that are behind the recent correction, seen in most of the advanced countries. But what is getting the most attention is that it happened on the German bond market, because the Bund 10-year rate had fallen to 0.05%, and some were even expecting it to fall into negative territory, as we had already seen in Switzerland. In just a few days, it came back to nearly 0.8% (in trading on 7 May) before stabilising around 0.5%, while short-term rates stayed in negative territory.
Interest rates are still too low with regard to all the existing valuation metrics. However, unlike the equity markets, the bond markets cannot suffer a crash when the central banks are at work. The example of Japan shows the extent to which securities-buying programmes are an overly decisive factor for rates. In the eurozone, the ECB’s purchases will keep interest rates very low. The ECB bought only €110 billion in securities (out of a programme of €1100 billion). In other words, 90% of its securities purchasing programme still lies ahead.
All other things being equal, the imbalance between issuance schedules and demand for ECB securities clearly argues in favour of another downturn in German bond yields in the months to come.
The ECB has committed to continuing its QE until September 2016, even if the economy improves sharply. Indeed, it will take time to contain deflationary pressures. The recent rise in long-term rates illustrates the need for anchoring expectations with a long-lasting securities-purchasing programme. Because a failed QE (i.e. a sharp rise in interest rates or the euro) would quash the recovery and fears over the solvency of some States would surely resurface.
The curve steepens again in a gradual reflation phase
That said, regardless of any technical factors that many have caused the recent correction, it is important to note that the correction on the Bund is coming soon after an upward correction of inflation expectations. The five-year inflation swap in five years – a metric touted by Mario Draghi to measure market anticipations – has risen sharply over recent weeks. It is striking to note that for the past 18 months, this metric has been closely correlated to oil prices. So everything seems to be happening as though medium-term inflation expectations depended on today’s oil prices...
It is clear that if the price of oil stabilises at current levels ($60), projected (year-end) inflation will be revised upward in the eurozone. But that is clearly unrelated to the medium-term inflation outlook. No more than the decline in oil prices is a vector of deflation, the rise is not a vector of self-sustaining inflation. The ECB will probably have to give more instruction on the fact that it is the trend in core inflation that counts above all. Yet on that side, we expect no notable acceleration by 2016. It will take more than the cyclical recovery that is expected to drive eurozone unemployment down in any lasting way. The second-round effects on wages cannot materialise in a high-unemployment environment. Not to mention that the recent rise in rates, the euro, and oil threatens to weigh down the economy in the nearer term...
What it means for the markets: long-term interest rates in Germany are not poised to come back up for good. Yet this does not mean they are going to fall back down to zero either. Indeed, low but positive bond yields would more closely match a period of gradual reflation.
Fed: toward recognition of excesses in the markets?
The US labour market has firmed up nicely over the past 18 months, and wages are beginning to simmer, especially with skilled jobs. Amid the slowdown in productivity, this means rising unit wage costs, which are a decisive factor in core inflation. Thus, the rest of the cycle should end up materialising in a rise in core inflation. That said, the “Core PCE”1 has slowed significantly in recent months. And most importantly, the soft patch on activity, seen in the first half of the year, will push the Fed toward prudence.
Still, the debate over macro financial risks is certainly worth watching. A few days ago, Janet Yellen very openly expressed her concerns about the risk of an abrupt rise in long-term interest rates, specifically when the Fed decides to raise key interest rates. In normal times, the Fed’s objectives are macroeconomic only (inflation, unemployment) and it is the business of macroprudential policy to avoid “excesses,” specifically in leverage. That said, both Stanley Fischer and Janet Yellen have admitted in the past that a rise in key interest rates could sometimes be justified for reasons of financial stability. Therefore the Fed’s doctrine in the matter should be closely followed. The short portion of the interest-rate curve, traditionally very sensitive to economic data, could react if the Fed decided to include “extra-economic” factors in its reaction function. However, we are not yet at that point. Remember that Alan Greenspan had begun to worry about the equity markets overvaluation, four years before the IT bubble burst (his remarks about irrational exuberance go back to 1996).
What it means for the markets: unlike the eurozone, a bear flattening of the curve is still likely in the US in the months to come, with the start of monetary tightening that lies ahead. Long-term interest rates should remain contained.
An abrupt upward movement of long-term rates would be short-lived. The taper tantrum seen in 2013 is improbable. Given the lasting weakness of rates in Europe and the QE, many investors will be attracted by the rise in US bond yields. Ultimately, it is the dollar that should most certainly benefit from the reallocation of bond portfolios toward the Treasuries. And given the US economy’s sensitivity to the dollar, the more it appreciates, the longer the Fed will delay raising rates...
Greece: exiting the Economic and Monetary Union (Grexit)
Greece’s exit from the eurozone (Grexit) is highly unlikely, because the stakeholders are dead set against it. European authorities do not want to open the Pandora’s Box of an exit from the euro.
Relations between Greece and its creditors are certainly quite tense. But negotiations are ongoing. The risk of a technical default, the setup of capital monitoring, or more elections (even a referendum on Grexit) is considerably heightened. Public debt is unsustainable in the long term, and restructuring appears inevitable.
However, we still believe that the risk of an exit from the EMU or of a disorderly default is low: the surveys show that the Greek people are still quite attached to the euro, to the point that they will make some concessions. Stakeholders have an interest in continuing their negotiations. This year, the Greek economy may fall back into a recession, with the shock of confidence tied to political uncertainty. And the primary budget balance will probably fall into a deficit this year. The agreement, if there is one, will most likely be reached at the very last moment (end-June). Tensions may increase in the final negotiation phase.
What it means for the markets: even though the ECB’s purchasing should prevent contagion to the other bond markets, there may be unpredictable setbacks on peripheral sovereign spreads. Especially given the level of interest rates that have sunk very low (Spanish and Italian 10-year rates are lower than 10-year rates on Treasuries). In other words, the return of systemic risk related to the Greek situation is unlikely. But, we must prepare for a resurgence of volatility.
United Kingdom: toward an exit from the European Union (Brexit)?
The Conservative victory on May 7 caught all observers off guard who were not anticipating an absolute majority for either of the two major parties. In the wake of results, Prime Minister David Cameron, voted in for another term, confi rmed his intention to organise an In/Out referendum on the European Union “by end- 2017.” With regard to the legibility and credibility of economic policy, the removal of the fragile coalition is good news, because in that sense it is a vector for uncertainty that is disappearing. Furthermore, this explains the markets’ very favourable initial reaction (a rising currency, rebounding equity market and falling interest rates). Still, the referendum opens the door to uncertainty of another kind (whether or not to stay in the EU). In the polls – which we now know to be unreliable – there is no clear majority on the Brexit. Yet the economic consequences may materialise well before the referendum. They are mostly about confi dence (British businesses, foreign investors), and are thus hard to assess. It is the market variables that will crystallise investors’ fears first.
What will this mean for the markets?
Bond markets: the fiscal adjustment will continue, which is good news for government bond holders. The decline in the public deficit has already been spectacular (falling by more than half since its peak). The deficit, estimated at -4.1% of GDP by the European Commission over fiscal year 2015-16, is projected at -2.7% of GDP over 2016-2017 (the structural deficit would be scarcely higher, and it too would be down sharply). That said, if growth continues to soar, the labour market will tighten further, and inflationary pressures will end up intensifying (somewhat similar to in the US, due to wage pressures caused against a backdrop of weak productivity gains). The theme of a return to infl ation could come back to centre stage even faster if the pound should depreciate...
Foreign exchange market: the new uncertainty is likely to impact the pound in the medium run. Indeed, the current account deficit is 5% of GDP, and the income balance is ever worsening. The UK’s net foreign position has deteriorated quickly in recent years (from 0 in 2011 to -25% of GDP in 2014). In Q4 2014, the current defi cit (-5.5% of GDP) was funded to 2.6% of GDP by net FDI inflows. In terms of FDI stock, the UK came in second worldwide, after the US. The bulk of investments are from the other European Union countries. These investment fl ows are very directly tied to the UK’s membership in the EU. Nearly half of British goods exports and more than one-third of service exports are to the EU. That FDI has just weakened, and the pound could depreciate quickly...
In the months to come, Prime Minister Cameron will seek concessions from Brussels, especially in terms of controlling immigration or safeguarding the City’s interests. As things stand, it is unlikely he will achieve his ends. The consensus that now prevails in Brussels is that the UK has more to lose by leaving the EU than the EU has by letting the UK go. Most economic analyses corroborate the one done in Brussels. So “negotiations”promise to be difficult for Mr Cameron. But he has time before him to find a modus vivendi.
Ultimately, we believe that Conservatives should actively campaign to stay in the EU. It is thus clearly too soon to worry about the potential negative consequences of Brexit.
Central scenario and asset allocations
We have lowered our growth forecast in the US to 2.4% in 2015 and 2016. We continue to count on the US cycle to continue, though at a more moderate rate than the consensus.
We have adjusted our growth outlook upward for the eurozone, but there, too, our growth outlook is still lower than that of the consensus, for both 2015 and 2016.
Finally, although we are keeping our growth forecast for China unchanged, it is after adjusting it sharply downward since the start of the year, and substantially below the Consensus.
Ultimately, though we anticipate that global activity will continue to expand, it will be at a much more moderate rate than before the Great Recession.
Our scenario is not based solely on economic analysis. We have repeatedly said in these columns that it was global potential growth that was slowing down (weak gains in productivity, not enough investment spending to renew the capital stock, an aging population).
Yet on a global scale, public and private debts have continued to grow. Deleveraging of the world economy will have to continue over the next ten years, which – in a weakened growth phase – gives the topic of financial repression a bright future. If global inflation does not start back up, the central banks will have to maintain very accommodating monetary policies to facilitate deleveraging. Right now, no economy could withstand a sharp increase in real interest rates without going into a recession...
The combination of soft growth, controlled inflation (on average, in the major advanced countries), and surplus global liquidity will continue to reinforce the yield-seeking strategies.
From a strategic standpoint, we have no reason to question our asset allocation, which is very favourable overall to the equity markets and the credit market. This allocation, which has for many quarters been focused more precisely on the eurozone, spread products, and the short EUR, is not invalidated.
The signs of financial defragmentation are multiplying in the eurozone (the recovery of bank credit in the private sector and the decline in interest rates granted to SMEs are the most notable components). However, we see that this improvement is now priced-in GDP forecasts.
The economic surprise indice, which was in very positive territory since the start of the year, has become neutral in the Eurozone (see chart 2). Eurozone equity markets, which have had impressive performances since the year began (especially in comparison with the US equity market), may be subject to substantial profit taking if volatility increases.
Portfolios should be prepared for renewed volatility in the months ahead. In these conditions, we have decided, in the short term, to diminish the risk in portfolios, without compromising our allocation, which is favourable to the equity markets.
Before increasing exposure to risky assets, we must:
1 The core PCE deflator is the index of Personal Consumption Expenditure (excluding food and energy) in the national accounts; it is preferred over the traditional Consumer Price Index (CPI) for gauging inflationary pressures.
Unlike the equity markets, the bond markets cannot suffer a crash when the central banks are at work
In Germany, low but positive rates would more closely match a period of gradual reflation
Greece: toward a last minute (end-June) agreement…
United Kingdom: the prospect of a Brexit is too far away to worry the markets
Portfolios should be prepared for renewed volatility