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We still believe that the euro is going to appreciate versus the USD in the twelve coming months but this process is probably going to take a bit more time than expected.
The ECB statement reinforces our positive stance towards risky assets: high yield, credit and, especially, subordinated debt.
Longer term, the very low level of interest rate is not in favour of long duration view, also taking into account the risk associated to the US market.
In a multi-asset perspective, the decision of the ECB to recalibrate the QE program over a longer time span is consistent with our constructive view for risk assets.
What are the main messages coming from October ECB’s conference?
Andrea Brasili: The Asset Purchasing Programme (APP) will continue at €60 bln per month until December and then the size of purchases will be reduced to €30 bln per month starting from January, until September 2018. In its statement, the European Central Bank (ECB) once again expressed that the programme could go “…beyond if necessary” - indicating that the Council stands ready to increase the APP in terms of either size or duration, if needed (hence the program remains open-ended). In the press conference, President Draghi also stated that the ECB would not end the programme abruptly so there will likely be a phase-out period. Regarding forward guidance on rates, the ECB will remain at its present levels for an extended period of time, and well past the horizon of the net asset purchases.
Finally, speaking about its reinvestment policy, the ECB clarified that reinvestments will continue for an extended period of time (after the end of its APP). Even though there was probably an intense debate regarding the size of purchases/ the duration of the programme/its open-end nature, the ECB sent a dovish message and maintained quite a high degree of accommodation. The assessment given on the economy highlights that the recovery is getting stronger and more broad based (increasingly stronger corporate profits and hence investments) and its pace seems unabated in H2.
Is core inflation finally reaching a turning point due to the synchronized recovery and the closing output gap?
Andrea Brasili: No, not yet; and this is a good thing, we believe, because it allows the ECB to be patient (to use Draghi’s words). With the exception of the UK, in all the advanced economies we are seeing this very tame dynamic in prices. Actually, this sort of conundrum has to be split in two parts. First, the reduced sensitiveness of wages to labour market developments (a flatter Phillips curve). Second, the reduced transmission from producer prices to consumer prices (related to the notion of a global component of inflation, globalization, market pressures from abroad and the diffusion of price-to-market behaviour by firms). However, the Eurozone has been growing above potential for 12 quarters in a row, hence, even though the concept of output gap has become a bit elusive and difficult to be identified, it is closing. It is right then for the ECB to start reducing its accommodation.
How would you expect the ECB’s monetary policy to evolve, going forward?
Andrea Brasili: Our forecasts are pretty much in line with the ECB’s staff ones (as they published them in September), hence we think that the envisaged path for APP will be maintained. We foresee core inflation nearing headline in the course of next year but it is difficult to imagine both of them going higher than 1.5% towards the end of 2018. The ECB will hence continue to be present in the market for long, allowing financial conditions to remain very easy for a long time. The emphasis the ECB’s board members put on the forward guidance and on its importance for avoiding or minimizing market turbulence clearly highlights that the ECB wants to be “boringly” predictable. It is clear that things will change in the medium term: in 2019 we will likely see some movements in rates and a number of changes in the board, starting with President Draghi ending his mandate in October 2019.
How technical factors (supply/demand) of the APP may impact the bond market?
Bastien Drut: It seems that the market was expecting a larger reduction of asset purchases. On top of that, Mario Draghi has indicated that the Quantitative Easing (QE) will not stop ‘suddenly’, (the Eurosystem will purchase more than €270 bln 9 months at €30 bln- in 2018). Overall, the ECB’s net purchases of sovereign bonds will still represent around twice the amount of net issuance of long-term Euro government bonds. That being said, we maintain our view that German rates will increase next year, as the Bundesbank will continue to purchase on short-term maturities and as there will be some rebuilding of the term premium in the coming months. This announcement is generally positive for peripheral bonds and for corporate bonds as net purchases will continue to support these assets for almost one year at a relatively high pace. Mario Draghi confirmed that the ECB will continue to buy “sizeable amounts” of corporate bonds. However, Draghi says ECB didn’t discuss QE composition. In the corporate bond market, the ECB faces less supply constraints than in the sovereign bond market (no scarcity issue). We expect the ECB to taper corporate bond purchases by a half to €3.5bn a month. At end-September 2017 CSPP holdings were €114bn (13% of the CSPP-eligible bond universe). In this scenario, the ECB would hold €166bn at the end of September 2018 (19% of the current eligible universe). Therefore, we believe that ECB will continue to provide strong technical support to the credit markets in 2018.
Would you expect the ECB decision to have any impact on the currency?
Bastien Drut: The announcements led to some depreciation of the euro versus the US dollar. In the short-term, there are arguments which support the idea that the USD can appreciate versus the Euro. Since the end of September, the EUR/USD parity has remained stable while the 10-year rate differential between the US and Germany tightened by 15 to 20 bps, creating some downside potential for the Euro. Concerning the USD leg, we expect the Fed to hike the Fed funds in December and to reinforce the idea that it will hike several times next year. On top of that, there could also be upside surprises for the USD such as the tax reforms in the US. Overall, we still believe that the Euro is going to appreciate versus the USD in the coming 12 months. That said, this process is probably going to take a bit more time than expected.
Where do you see opportunities for fixed income investors going forward?
Eric Brard: The announcement by Mario Draghi to reduce QE purchases by half has successfully been seen by the market as a dovish move. The important part is the lengthening of the QE programme. Their willingness to raise rates only after asset purchases are completed, anchors the level of short rates to their current levels for longer. As a consequence we are heading for another year of negative net government issuances for the Euro Zone. The immediate effect is positive for the market, particularly for risky assets.
This said, the issue of QE exit will come back and duration will not be an ally at least for two reasons: the positive fundamental backdrop and technical limits to the amount Euro system can buy. The ECB statement reinforces our stance towards risky assets: high yield, credit and especially subordinated debt (financial hybrid solutions should perform particularly well). Longer term, the very low level of interest rate is not in favour of long duration views, nor the risk associated to the US market. Finally, there will be, in our view, a place for investment strategies with high flexibility because these movements are not linear and, as monetary cycles change, they will cause volatility.
Do you see any risk of bear market for bonds or for credit market in 2018?
Eric Brard: If bear market means at least 100bps rise 10-year Treasuries or Bunds then we do not share the view that this is a likely outcome. The main risk we see comes from a much healthier economic cycle. If we have significantly stronger growth in Europe and in the US, then Central Banks could appear “behind the curve”, and we could potentially see a sell-off in bond markets. Credit markets will suffer in absolute performance terms as spreads won’t be able to compensate the rise in government bonds. This may not be so impressive however, as stronger growth means better fundamentals for credit, which will be mitigated by higher M&A and little or no CSPP support. A bond bear market is not our central scenario given that we expect a gentle rise in yields, in combination with steady or even tighter spreads for 2018.
What are the investment implications of the ECB decision on your multi asset strategy?
Francesco Sandrini: From a multi-asset perspective, the ECB’s decision to recalibrate its QE program over a longer time span is consistent with our constructive view for risk assets. We are positive on equities, supported by stronger and more synchronized economic growth, in addition to good earnings momentum. Our base case is for asset reflation to continue over the next quarter, followed by a gradual move towards a late cycle scenario in 2018. This paradigm shift would imply a rotation of risk exposure towards equity, favoured versus credit. Within the equity markets, it would support a rotation towards stocks which benefit from higher inflation and higher interest rates. In the transition towards a late cycle phase, European (and Japanese) equity multiples exhibit the highest potential for rerating compared to US. In fixed income, the transition to a late cycle scenario could bring higher rates in both the US and the Eurozone, as we expect inflation to rise slowly and Central Banks to gradually reduce stimulus. So, while we don’t see value in nominal bonds, we think that inflation-protected securities continue to be interesting in this context. We still believe in the European credit markets which continue to benefit from the low rate environment, despite limited scope for spread tightening - and we remain aware of the risk of market complacency, particularly in some segments of the market. Geopolitical risks are also one of our top concerns. Therefore, we maintain our positive views regarding gold or specific currency strategies (particularly “safe haven” currencies”), in addition to equity option strategies to alleviate the risk of a potential market sell-off.
With the contribution of:
Silvia di Silvio,
Bastien DRUT, Eric BRARD, Matteo GERMANO
Fixed Income and FX Strategy