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Asset allocation: QE and oil prices are key factors for asset allocation and for the economic recovery in the eurozone

The essential

This month, the ECB is initiating purchases of government debt as part of its Quantitative Easing programme.

The programme’s credibility is ensured thanks to excellent communication on the part of the ECB and the programme’s alignment with the needs of the economy. The second phase, implementation, is a rather delicate affair, as €60 billion in securities will have to be purchased in a market where liquidity is not always available. The third phase, effectiveness, will depend on the activation of transmission channels for monetary policy which have mostly been obstructed until now. The exchange rate channel, interest rate and credit channel, wealth channel, infl ation anticipation channel and confi dence channel will have to become operational for economic activity to see a more robust recovery. The drop in oil prices, while contributing to defl ationary pressure (on prices), has a “refl ationary” impact (on economic activity) that should not be overlooked. Ultimately, the combined effect of QE and oil prices leads us to maintain an asset allocation centred on European assets (with a bearish stance on the euro, which may be amplified if the euro becomes increasingly seen as a carry currency), subject of course to the implementation of QE and its effectiveness on the real economy.









QE by the ECB: successful announcement, uncertain impact

This month, the ECB is initiating purchases of government debt as part of its Quantitative Easing programme. Three months ago in our January issue, we worked out our outlook and anticipated the impacts of a potential unconventional programme led by the European monetary institution. This programme is now a reality. But beyond the impacts on European asset classes, short rates, long rates, sovereign spreads, equities, corporate bonds and the euro’s exchange rate (on this point, see “What will be the impact of large-scale European QE?” on pp. 4-8 of January 2015’s Cross Asset Investment Strategy), what are the side effects of the ECB’s purchases? The past experience in the United States offers some instructive insight in this regard.

The graph (see next page) shows how the various rounds of QE by the Fed have accompanied the performance of the equity markets. The correlation is impressive, and it remains consistent over time; whether it is QE1, QE2 and QE3, the relationship is strong. It is also known that approximately 20% of the liquidity injected by the Fed was invested in the emerging markets, which were undervalued and attractive at the time. These investments gave the emerging markets a significant boost; indeed, these were the most afflicted regions when the Fed wound down its programme. Dependence on central banks has its cost!

The relationship of QE to commodities has proved more ambiguous. QE1 certainly pushed up prices across the board, affecting metals (both precious and non-precious) and agricultural products alike. But QE2 and QE3 did not have the same effect, as the steep downturn in growth ultimately dragged down commodity prices as a whole. The price of gold declined even more rapidly as a result of fewer systemic risks and lower risk aversion.

Overall, QE had a much stronger impact on US equities and interest rates, both long and short (the effect of QE on 10-year yields amounts to 130 - 150 bp, according to studies), than on commodities.

What can be expected of the ECB’s QE programme? In addition to its impacts, the credibility, implementation and effectiveness of the programme are also factors to consider.

On credibility, the announcement of QE was a resounding success. Its scale, comprehensiveness and suitability did not disappoint. The financial markets did not wait to show their approval, as reflected in the fall in short and long rates and the advance of asset classes such as eurozone equities.

Implementation seems like a simple matter, at least in principle. The ECB will nonetheless be faced with the challenge of purchasing €60 billion in securities each month in illiquid markets that are short on willing sellers. QE encourages market players to buy or hold on to assets rather than selling them. Meanwhile, the banks, which are major holders of government debt, retain these assets in portfolios for regulatory purposes or simply out of liquidity considerations, as the securities can be used as collateral. Given this backdrop, unless there is an explosion of issuances by governments, a rapid change in regulators’ policy or “forced” sales by public funds (is this not what Japan demanded of public pension funds?), the ECB’s drive to establish this programme will inevitably run into the realities of the market, which will undoubtedly push down short and long-term interest rates even further. There will be seven major impacts from this:

  • Short rates will remain in negative territory;
  • The euro will be under downward pressure, partially counterbalanced by current account surpluses;
  • The long-term rate spectrum will see heightened contagion. Like the two year and five-year yields before it, the German seven-year yield has fallen into negative territory. Long-term rates will inevitably stay very low;
  • Government bond spreads will tighten from already exceedingly low levels. While they can now offer little protection against a potential growth downturn or troubles in public debt or the political situation, they are in the hands of the ECB, which is reassuring, at least in the short term;
  • Corporate bond spreads will tighten;
  • European equities will continue to see gains;
  • US long rates will remain low, all other things remaining equal: the slope of the curve, rate levels and the attractiveness of the USD are convincing arguments in favour of the US bond market. Whereas the emerging markets were able to attract 20% of the liquidity from US QE, the US market should attract some of the flows from Europe’s QE programme.

Ultimately, if everything goes as anticipated, the eurozone can look forward to a more growth-friendly environment. The final step for Mario Draghi involves the matter of effectiveness. We have already alluded to the importance of transmitting QE to the real economy. Six transmission channels will have to be activated in order for growth to be revived:

  • An “exchange rate effect”: any currency depreciation would contribute to competitiveness and/or help restore business margins and/or lead to natural profit growth;
  • An “interest rate effect”: any additional drop in interest rates would improve the creditworthiness of indebted entities and offer (potential) support to bank lending;
  • A “spread effect”: the same impact as lower interest rates;
  • A “wealth effect”: growth in the equity and real estate markets would elevate the wealth of market players, both consumers and investors;
  • An “inflation anticipation effect”: the ECB’s intention is to stop the deflationary spiral, as lower prices mean lower consumption;
  • A “confidence effect”: without confidence, it will be difficult for growth to take off.

This would naturally also require a consistently low level of “financial stress”. The outlook for the peripheral countries is not completely certain in view of negotiations, solvency challenges and elections. QE must not be overshadowed by varying political situations.

Oil prices: deflationary impact on prices, reflationary impact on economic activity

The second factor that bodes well for growth is the persistence of low oil prices (on this topic, see our various articles in the January and February issues). In the United States, the fall in oil prices, while highly damaging to the country’s shale oil production, has revived confidence among consumers and business leaders. For consuming countries in general, lower oil prices have an immediate impact on prices and production. The more a country consumes, the more its production is energy intensive. The more sensitive its inflation rate to the price of energy, the greater its exporting capacity and the more favourable the impact on activity and growth. All other things being equal, China and Germany will derive significant benefits for growth, while countries like India will gain new leeway in monetary policy.

The question now is whether oil prices will rise, especially in light of the fact that they have increased by nearly 10% over the past month.

1. Low pressure on oil supply

The price of oil has slumped seven times since 1995. On every occasion, this has been accompanied closely by decreased production levels by OPEC members. Non-OPEC countries have rarely modelled their behaviour on the decisions of OPEC (there have been only two exceptions), resulting in confusion as to how oil prices are controlled. We will nonetheless consider the case of three significant episodes that were emblematic of concurrent drops in prices and OPEC supply levels: the 1994-1995 Asian crisis, the dot-com bubble in 2000 and the 2008 financial crisis.

  • New sources of production. Today these are biofuels, Canadian oil sands and North American shale oil (US oil production has grown by more than 65% in fi ve years); in 1985, it was the discoveries in Alaska, the North Sea and the Gulf of Mexico.
  • Surplus capacities: annual investments in exploration, development and production grew sevenfold between the 1990s and recent years. All of the periods of heavy investment invariably led to phases with lower prices. We are undoubtedly witnessing such a phase at the present time.
  • The abandonment of price controls: in 1985 as in 2014, OPEC gave up control over oil prices. Post-1985, the price of oil remained stable overall for more than 10 years before soaring in the 2000s, the price rising from $20-$30 per barrel to over $130 at its peak in 2008, prior to the financial crisis.

Crude stocks are also at a more than 30-year high (according to estimates by the US Energy Information Administration / EIA), which should help put into perspective OPEC’s recent more optimistic outlook, which assumes a revival of its production levels starting in 2015.

2. Little pressure on oil demand, at least for now

Unless there is a rapid acceleration of global growth, there is little likelihood that oil demand will grow sharply in the short term. The United States is now selfsufficient, while China’s demand is down, refl ecting an economic slowdown and/or less energy-intensive production. Oil import data reveal China has entered a “new regime”; its oil imports have fallen from an average growth rate of 12% until 2010 to just over 5% since.

A number of countries have entered recession (Russia, Brazil, Argentina, Ukraine, Venezuela) while others are directly impacted by the economic slowdown in China (Hong Kong and South Korea, but also Chile, Brazil and Peru). To revive demand for oil, there would have to be an acceleration in the United States (with increased consumption and stronger wage growth) and in Europe (effective QE for the real economy) coupled with improved growth in the other emerging countries.

Overall, it seems unlikely at this point that oil prices will see a sharp rise. A price of between $70 and $80 seems reasonable for 2015.

15 key points to keep in mind

  1. United States: even though wage growth has been disappointing and current momentum is weak, growth remains well above 2.5%, generally a good level for US equities, all other things being equal;
  2. Global growth should remain above 3% in 2015, generally a positive level for European equities;
  3. Global growth in both 2015 and 2016 should be below 4%, generally an unpromising level for commodities;
  4. While we recently revised German GDP growth upward, growth in the eurozone should not exceed 1.5%, which will not be enough to improve the labour market and public debt outside the countries that have primary surpluses and below-growth interest rates (Germany, essentially);
  5. QE and the drop in oil prices are two factors that have the potential to boost growth in the eurozone;
  6. Russia has entered a severe recession;
  7. Brazil has entered a recession, which has been moderate so far;
  8. Ukraine, Argentina and Venezuela are also now in recession;
  9. The slowdown in growth is continuing in China, impacting growth in Hong Kong, Chile, Brazil and Peru, which are commodity exporters;
  10. Inflation has been revised across the board: the US, the UK, the eurozone and elsewhere;
  11. Deflationary pressure should persist in 2015, particularly in the eurozone;
  12. Inflationary pressure persists in Venezuela, Argentina, Brazil, Chile, Turkey and Russia;
  13. Oil is the decisive factor for the emerging countries: producer countries vs. consumer countries, among producer countries, etc;
  14. In 2015, unless there is a major surprise on growth and from the Fed, the monetary policies of the largest countries should remain accommodating while long rates should stay extremely low;
  15. Public and private debt remain problematic in many countries. Few countries have been able to reverse the trend, due to insuffi cient growth, a lack of discipline, poor budgetary performance or the excessive use of debt as financing.


Without a doubt, the price oil and QE are the key factors when it comes to reviving growth in the eurozone. The former is a simpler matter than the latter, however. While a lot is expected of QE, the effectiveness of its implementation remains to be seen. The ECB’s drive to carry out its programme goes beyond the difficulties it will encounter, which will push down rates and spreads. In other words, we are preserving our asset allocation, which incorporates:

  • The expectation that the euro will depreciate: QE should work in favour of the euro’s weakness. What occurred in the United States and Japan will be put to the test in the eurozone. It should be borne in mind, however, that the eurozone’s current account surpluses are an obstacle to a weaker euro. We nonetheless remain bearish, as the QE effect should prevail, at least initially. On top of this, the euro, like the yen, is gradually becoming a carry currency and a borrowing currency, which makes it even weaker. The Japanese and European yield curves are also very similar.
  • Overweighting eurozone equities. These markets seem bound for growth. QE should provide liquidity, which will in turn fl ow into risky assets;
  • Overweighting the eurozone corporate bond segment, including HY;
  • Overweighting the eurozone’s government bond spreads;
  • A long-term strategy.

Our allocation is quite aggressive, due to QE, oil, the search for yield, the search for spreads and dependence on central banks. Portfolio liquidity must be managed carefully because the positions referred to above have become extremely “common” on the market. Reducing risk and taking some profit as the difficulties mentioned approach also seems to us a reasonable course of action in light of positive past performance.


What are the side effects
of the ECB’s purchases?
The past experience in the
United States offers some
instructive insight in this






Credibility, implementation, effectiveness: the two final steps are crucial



Market liquidity: a constraint
for the ECB




If everything goes “normally”,
the eurozone can look forward
to a more growth-friendly



Falling oil prices have positive
impacts on economic growth




Should we expect a sharp rise
in oil prices in 2015?




The current situation is
strangely reminiscent of
that of 1985-1986



A new regime for China?


Deflationary pressure in some
countries and inflationary
pressure in others











Equity portfolios

Bond portfolios

Diversified portfolios

  • Prefer Eurozone equities
  • Stay neutral to underweight US
  • Stay neutral Japan
  • Beta of portfolio maintained to neutral
  • Emerging markets: country selection is key
  • Within emerging markets

- overweight Mexico, Peru, India, and Thailand
- neutral China, Brazil, Turkey, South Africa and GCC
- underweight Malaysia, South Korea, Greece, Taiwan and Chili

  • Maintain long USD, short JPY and EUR
  • Maintain overweight position especially on European HY
  • Opportunities on US HY
  • Overweight TIPS
  • Maintain overweight position on Italy and Spain
  • Emerging debt:

- overweight emerging debt of commodities consuming countries

- prefer hard currencies debt (long USD)

- prefer local debt of countries benefitting from the lower oil price

  • Maintain Long USD, short JPY and EUR
  • Prefer Eurozone (now) and Japanese equities (midterm)
  • Stay neutral US equities
  • Caution on EMG equities, prefer commodities consuming countries
  • Prefer equities to corporate bonds, including for liquidity reasons
  • Maintain long position on Eurozone corporate bonds (mainly HY) for carry purposes
  • Reinforce diversification into US credit
  • Keep overweight position on sovereign bonds of peripheral Eurozone countries
  • Positive on emerging debt in hard currencies, USD and EUR
  • Maintain Long USD, short EUR and JPY


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ITHURBIDE Philippe , Senior Economic Advisor
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Asset allocation: QE and oil prices are key factors for asset allocation and for the economic recovery in the eurozone
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