In recent months, investors have been preoccupied with Greece and the negotiations between the Tsipras government and creditors. This is not because of the systemic importance of Greece, but rather because the European partners once again revealed their disagreement and their inability to quickly resolve their problems. In this they were not helped by the European Institutions, which, with the exception of the ECB, were largely unequipped to deal with the challenge. It was the ECB that helped buy time before a final agreement was reached among the members of the eurozone. But the ECB alone is not capable of "saving Europe". “Fascination with the ECB thrives in the political void” (interview with Benoît Coeuré, L'Economie politique no. 66, April 2015).
Nonetheless, the agreements of 13 and 16 August, followed by the conclusions to the negotiations which led on 11 August to the third bailout, have pushed the "Grexit" scenario out of the spotlight, and with it, the fear of contagion (essentially of a political nature) and the fear of a breakup of the eurozone.
Ultimately, things have returned to normal—or more fittingly, back to abnormal, with interest rates "artificially" kept very low by the ECB, low bond yields (largely administered by the Quantitative Easing programme), a weak euro and signs of excess in a number of areas, from the search for yields and spreads to the addition of risk into portfolios via duration and (lower) ratings and the introduction of leverage and illiquid assets (in overabundance?).
The focus on Greece has almost entirely obscured the real risks, as the global and systemic risks are to be found elsewhere. They are found in the Fed's looming interest rate hikes, the worrying situation in China—plus its impact on the "emerging world" and potential indirect consequences on the "developed world"—and political and economic risks facing the eurozone. Some of these risks have already materialised.
We will examine these different risks and assess their implications. To do so, we will briefly go over our central scenario and the various risk scenarios.
Central macroeconomic and financial scenario: key points
Our central scenario is based on eight key convictions:
The economic recovery is now a reality in the developed world, led in this regard by the United States. In the eurozone, the situation is improving, particularly in the "best" of the core countries (Germany) and the "best" of the periphery (Spain). And while the eurozone's potential (long-term) growth is lower (due to demographic decline, lack of investment and innovation, the impact of globalisation—particularly on wages—and the stifling effect of debt on recovery efforts, among other reasons), the improvement in the economic situation is clearly visible. It is true that global deflationary pressure has not gone away. One need only look at price trends in commodities and global trade in terms of volume (stagnation) and value (sharp decline), the stagnation of industrial prices and inflation in a number of countries like Japan and China. But for now, deflation has been limited to clearly defined areas. And the United States and the eurozone no longer figure among them.
China's economy is continuing to slow, a process that has been ongoing for several years. This is partly due to powerful factors such as the demographic decline and the drop in productivity gains, both of which drive down economic growth potential. But it also linked to a considerable decline in competitiveness (in wages, prices, exchange rates and quality) as well as excessive lending and debt. China's economic model seems to be running out of steam, the decrease in foreign exchange reserves (almost 300 $ bn in a year) and also the recent decision to allow the yuan to depreciate reveal the scale of the difficulties China faces in managing its transition toward a "new model". History shows that economic development is accompanied by a stage of decreased savings and slower economic growth, both real and potential, but this particular stage will experience particularly sharp downturns, as we are seeing today. We anticipate growth of around 6% in 2015 and 2016, though with a risk that growth could be even lower.
China's major contribution to demand for commodities has translated into an across-the-board drop in prices. This situation is compounded by recent supply-side developments, most notably in oil with the impacts of shale oil, Saudi Arabia's stance and the reopening of trade relations with Iran. All of this has a direct impact on the commodity-producing countries via their exchange rates, the sustainability of budget and/or current account surpluses of numerous countries (particularly those heavily reliant on commodities both for export and tax revenues), growth conditions and debt repayment abilities. This final impact is amplified for countries owing debt in foreign currencies and whose domestic currency is depreciating . Only the countries with strong domestic demand are immune.
Given these circumstances, monetary policies have remained accommodating overall. Admittedly, the Fed is expected to make its first move, as already announced by several members of its Board of Governors. But the question of when the first interest rate hike should take place is rekindling debate, including within the Fed itself. Will it occur before the end of the year as announced? Nothing could be less certain. For several quarters now, Eurodollar forward curves have evaded the Fed's projections by a wide margin. Thus, nobody thinks that urgent "normalisation" of US monetary policy is in order. Talking about normalisation is out of the question at this stage, as the pace of monetary tightening will undoubtedly be slower. The final interest rate target is moreover lower than in previous rate hike cycles. This "gradual" pace likely means one rate hike for every two FOMC meetings, at worst.
The ECB will carry on with its policy of keeping short- and long-term rates low through near-zero key rates and the continuation of its quantitative easing policy. This policy is expected to remain in place until September 2016.
In the absence of a crisis in Europe, the search for yields and spreads predominates. This strategy had been put on the back burner in the summer as the developments concerning Greece took centre stage.
Equity market valuation is a key concern. The prevailing conditions—the downward revision to growth potential (perpetual growth) and long-term interest rates (cost of capital)—have profoundly changed valuation models. This has favoured the rise in stock prices but also raised fears of bubble formation. Because growth has improved, the Greek crisis has dissipated and Chinese growth has not collapsed, the equity markets should continue to advance, and more so in Europe than in the United States, where valuations are more questionable and less attractive.
The forex markets offer greater investment opportunities now than in previous years. The commodities shock, the slowdown in China, the dissimilarity of growth drivers across different countries and the divergence of monetary policy are particularly divisive factors. The bulk of the euro's depreciation for 2015 is already over. Countries with weak domestic demand will have to face additional depreciation of their currencies, especially if they are also producers of commodities.
Like any scenario, our central scenario employs risk factors of varying severity for our asset allocation. Here are the questions we frequently ask ourselves and closely follow up on.
Risk scenario #1
What happens in the event of a new European crisis?
The divergences between European countries made evident during the Greek crisis of recent months will not disappear overnight. Even though an agreement was finally reached, fractures on both the political and conceptual level have appeared between European countries and even within certain countries.
The relationship between France and Germany took a hit during the crisis. Strong disagreement emerged with regard to the economic governance of the eurozone, the need for stimulus, the adoption of reforms as a response to the crisis, the management of Greece's debt and even the role of the ECB. The discussions on supporting Greek banks were intense, and QE was not implemented seamlessly the way it was in the United States or Japan due to differing interpretations of the ECB's statute.
The limitations of the European institutions were once again laid bare. One of the main reasons is that such crises—and their solutions—were simply never foreseen (or foreseeable) in the European treaties, and the "dogma of convergence" did not prepare the institutions for such risk scenarios. The task now is to respond to challenges like Europe's governance deficit, the lack of coordination in budgetary policies, the failure of supervision of budgetary imbalances, competitiveness gaps between countries, the unfinished nature of the mechanism meant to support countries facing difficulty and the failure to appreciate the interdependence of member states (while the ECB's anticontagion mechanism has evolved significantly, the same cannot be said on the budgetary front). In short, the illusion of convergence needs now to be addressed. It is highly likely that a new Greek (or European) crisis, if it were to occur, would be fatal, as the political consensus has taken a major hit over the past months. As for the negative impacts, these are all too well known as they have made the daily news of the financial markets over the past six years: widening of sovereign and credit spreads, rise of volatility—only this time it would certainly be accompanied by a severe weakening of the euro. A new European crisis would make a breakup of the eurozone highly likely. At the very least it would push the weaker countries out. The strongest country or countries could also be tempted to leave. Indeed, since 2010 the discussion has centred on the costs surrounding an exit by a vulnerable country—both for the country in question and for those that would remain in the eurozone—not on the costs of an exit by a strong country weary of economically and financially supporting countries facing difficulty.
Risk scenario #2
What if the Fed took the wrong turn?
The misinterpretation of the Fed's decisions remains a major risk factor. The Fed may well be cautious, but it already pre-announced its initial monetary tightening long ago. And if the Fed's own projections are to be believed, this tightening should occur before the end of the year. For several years now, central banks have made a practice of preparing financial markets and economies for changes in monetary policy. But the reversal of an ultra-accommodating monetary policy that has been in place for seven years carries particular importance. In our assessment, there is no pressing need for tightening or monetary policy normalisation at this point. This view is largely shared by the financial markets, if forward curves are any indication. William Dudley, the head of the New York branch of the Fed, recently stated that the arguments in favour of an interest rate hike had become "less compelling". While “international developments have increased the downside risk to US economic growth somewhat”, he nonetheless hopes that the Fed will hike interest rates by the end of 2015, explaining that in a context of generalised uncertainty on the markets, such a decision would be seen as reassuring and a sign of confidence in the country's economy.
Conditions in China and the "emerging world" also call for great caution on the part of the Fed, with fears that financial markets could react poorly if rates are increased prematurely or without a sound rationale. This would lead to a sharp downturn in the equity markets and contagion into the emerging markets, which have already been weakened by the situation in China, the economic slowdown, the drop in commodity prices, poorly managed inflation and downgrades to their credit ratings. The good news is that the ECB will maintain its QE programme for many quarters to come. This will contribute to the continued widening of spreads and interest rates between Europe and the United States and a further weakening of the euro—both of which favour European risky assets.
Risk scenario #3
What would happen if a major crisis occurred in China?
China's current difficulties are more serious than those in previous periods of stress on the emerging markets. This is for at least two reasons: China now accounts for 13% of global GDP, and its total debt is equivalent to 250% of GDP (before the financial crisis of 2008, it was 150%).
When talking about systemic risk, China is a much greater source of worry than Greece. China's economic model is running out of steam. Lending is excessive, debt is ballooning, the shadow banking system is poorly regulated, industrial competitiveness is eroding, productivity gains are falling and potential growth is down. Demographics and productivity gains in particular suggest that potential growth is about 50% lower than it was 10 years ago: it is estimated to have fallen from 10% to around 5%. Based on current trends, this same potential growth should reach 3% to 4% in 5 years. Indeed, China is experiencing a major demographic decline despite it still being a poor country, and it is also in this sense that the country is atypical. The question is not whether future growth will be lower. That is already a given. Rather, it is whether growth risks falling sharply below its potential— in other words, whether China will experience a large-scale economic crisis. Up to now, the Chinese government has shown that it has the means to counter the negative effects of such a situation, namely monetary, fiscal and budgetary stimulus, the non-convertibility of the yuan, the depreciation of the yuan, controls on capital outflows and stock market closures. However two questions arise today:
1. Is China still capable of stimulating its economy—i.e. its domestic demand?
The recent devaluation of the yuan suggests this may no longer be the case. China had promised the G20 it would not manipulate its exchange rate; it would help reduce global imbalances by allowing the yuan to appreciate gradually. But the sharp depreciation of the yuan shows this to be an untenable position. It also risks provoking a "currency war" with competitor countries (Japan, South Korea and all of the emerging countries). And a more severe contraction of Chinese growth would add to an already long list of deflationary pressures. It is in this sense that the sharp depreciation of the yuan is useful, namely high price elasticity on China's exports (good for the industrial sector, and consequently for the commodity markets, all other things being equal) and the necessity of restoring positive inflation.
2. Are the developed countries capable of adapting to the situation and to China's economic policies?
A more severe downturn in economic activity would have significant consequences: a continued decline in commodity prices, a further depreciation of commodity currencies (Canadian dollar, Norwegian krone, Brazilian real, New Zealand dollar, etc.)—particularly against safe haven currencies—and an additional downturn in the equity markets (particularly of emerging countries in relation to "advanced" countries). Accelerated QE by the ECB would help strengthen the European markets, at least in relative terms. The fixed-income markets (on both short- and long-term rates) would also be buoyed by such a scenario, as central banks would be forced to maintain accommodating monetary policy, with more expansionary policy pursued by countries in direct competition with China (South Korea, Japan and the emerging countries) and more cautious monetary policy used elsewhere, particularly in the United States. This would further weaken currencies of emerging countries against the euro and dollar.
Risk scenario #4
Are emerging markets due for another drop?
Falling commodity prices, the dip in Chinese growth, and the coming shift in US monetary policy are all factors that are raising fears of a repeat of the 1997-1998-crisis (when emerging markets collapsed across-the-board). Emerging markets have, in fact, been under stress since the US ended its QE programmes. Until now, only Asia had been able to withstand that stress, driven by the strength of the Chinese economy and its ability to address problems such as excess credit, shadow banking, the health of banks and companies, domestic demand, etc. Corporate defaults and leading activity indicators have occasionally put the markets on high alert, but the resources brought to bear by Chinese officials (cuts in interest rates
and in mandatory banking reserves, injection of liquidities, fiscal and tax measures, maintaining currency policy, etc.) ultimately put everything right. Now things are more complicated, and Asia has plummeted like Europe and Latin America before it. However, not all emerging markets are the same. In early 2014, we noted our shift from net-commodity-producing countries to net commodity consumers. Now two additional criteria are in order: those closely dependent on China (a negative criterion) and those that are still enjoying strong domestic demand (a positive criterion). To sum up: a net commodities consumer, low dependence on China, and solid domestic demand – that’s the winning trio.
Thus far, net commodity producers have been hit by falling prices, but some of them (Australia and Brazil in particular) were also held up by a major market: China. Both of these are now negative factors if Chinese growth continues to slacken. There remains the third criterion: domestic demand. Brazil and Russia are among those countries in which consumption and investment are making a negative contribution to growth. Countries where consumption and investment are making a positive contribution to growth are China (which is rather good news at this stage), India, South Korea and Poland. South Africa, Mexico, Chile, Thailand, Indonesia and Turkey are countries where consumption is making a positive contribution to growth and investment is making a negative contribution.
Risk scenario #5
Are the financial markets mistaken in their long-term rate outlook?
Long-term rate projections have consistently been overly pessimistic (too many projected increases) over the past three years, particularly when it comes to the United States. The end of the financial crisis, the recovery of economic activity and the anticipation of monetary policy normalisation—gradual or otherwise—are the three factors generally put forward in favour of such projections. We have remarked on the excessiveness of these long-term rate projections on numerous occasions; potential growth is lower, the economic recovery is less robust than in previous episodes (investment is insufficient, the labour market remains too weak, etc.) and it is still too early for monetary normalisation. Furthermore, the excess of global liquidity is not about to dry up. Japan and the eurozone have not completed their quantitative easing programmes. The conventional monetary policies of China, India and many other countries remain expansionary. The Fed will remain cautious and the Bank of England is not in favour of monetary tightening. And even if we assume that budgetary deficits are not closely tied to long-term rates, the widespread reduction of public deficits calls for maintaining long-term rates at low levels, all other things remaining equal. Finally, the deflationary pressures are real, with weaker global growth, a decline in global trade, a drop in commodity prices, lower inflation and industrial prices that are stagnant at best. In short, the factors in favour of keeping long-term rates low are powerful, and we could well see significant repricing on long-term rates, particularly in the United States, where rate hike anticipations seem to us to be excessive and rates are too high.
Risk scenario #6
Portfolio liquidity as an aggravating factor
Aside from the risk scenarios outlined above, which could lead to the liquidation of positions and/or portfolios, it is worth recalling once again that the prevailing liquidity constraints call for additional caution. Since the 2008 financial crisis, the decline in investment banks' inventories, the regulatory constraints that have led major players to buy and retain large volume of bonds, the reduction in market-making activities and the domination of central banks through QE programmes have all "drained" the fixed-income markets, and closing a position or portfolio now requires more time. This needs to be incorporated into investment decisions and should be taken into account in portfolio-building constraints and stress tests.
As for the financial markets, here are some key points to keep in mind:
Long sovereign yields: QE, statements by Fed officials, falling commodity prices, fears of a dip in global growth, stagnation in global growth, etc. – all these are keeping long-term yields low, and any resurgent crisis or risk of contagion could push the ECB into accelerating the pace of its QE (it has just decided to raise the ceiling of its bond purchases in the Eurosystem).
Peripheral sovereign spreads: We remain overweight, as any contagion has remained limited (Greece and China), and QE is likely to contain the risk.
Corporate bond spreads: Corporate bonds have been hit less hard than equities, despite (thanks to?) their lower liquidity. This would suggest that the disruption experienced during the yuan episode is not serious enough to reverse the prevailing quest for spreads and returns. True, this sector is not protected by QE, but it is also true that there is nothing keeping the ECB from stepping into this market, as well. It even very recently raised the possibility of doing so. However, lower liquidity on these markets should raise red fl ags and it is worth setting up macro-hedging strategies in the event that the aforementioned risk scenarios come to pass.
Equity markets: Anything that pushes yields down (both short and long ones) is another argument for investing in equities, especially as the economic upturn for the moment appears to be well entrenched, with a significant improvement in some peripheral countries, led by Spain. Moreover, given that most of the euro’s decline is behind us, that valuations are more attractive in Europe than in the US, and that there are fewer risks in Europe arising from monetary policy or long bond yields, we see no reason not to overweight Europe vs. the US.
Forex: Asian currencies have plummeted, and few of their scores (macro, momentum, risk, and carry) are favourable. Within this group, the Indian rupee nonetheless remains the most attractive. Prospects are now better for European currencies (especially the PLN and HUF) with the end of the Greek crisis, stronger momentum, more favourable macro data, etc. In the dollar zone, the outlook is bleaker for the CAD, as falling oil prices could force the Bank of Canada to cut rates further. The New Zealand dollar looks attractive, as rate cuts have been priced in excessively. Barring an unforeseen disruption (a new crisis in Europe, a Fed “error”, etc.), the euro is unlikely to give up further ground to the dollar, given a possible postponement in US rake hikes, the improved macro situation, and current account surpluses. As for the yen, which is now steeply undervalued (see chart below), it could get a slight boost from further weakness in other Asian currencies.
Fascination with the ECB thrives in the political void
Back to "abnormal"?
Is China running out of steam?
Fed: no urgency and no real normalisation in sight
Forex markets: volatility, divergence and investment opportunities
Will the next European crisis deal a fatal blow to the EMU?
If interest rates are increased prematurely or without a sound rationale, this would lead to a sharp downturn in the equity markets and contagion into the emerging markets
China is experiencing demographic problems despite it is not yet a rich country, and it is also in this sense that the country is atypical
The factors in favour of keeping long-term rates low are powerful, and we could well see significant repricing on long-term rate levels, in the US
Closing a position or portfolio now requires more time
A net commodities consumer, low dependence on China, and solid domestic demand – that’s the winning trio
No major changes in our asset allocation