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Asset allocation: Financial repression: misery for savers, but a boon for long-term investors

The essential

With the return of tensions on the bond markets and volatility, investors are once again wondering about the possibility of a bond crash.

In most advanced countries, the combination of growing debt and dwindling growth potential has changed the game for economic policies and the markets. On one hand, measures must be adopted that contribute to increasing potential growth, which requires structural reforms and investment in order to stimulate innovation and productivity. On the other, the cost of debt must be contained to avoid debtors (households, corporates and governments) being overcome by interest charges.

The threat of secular stagnation primarily concerns the eurozone. This threat will require the ECB to intervene if bond yields rise to the point of undermining the current recovery. It is a financial repression policy by another name. This policy, which comes down to a tax on savers, would be a boon for long-term investors, who will be able to rebalance their portfolios in favour of risky assets, led by equities.

Despite the volatility, the soft-growth and-low rate environment remains conducive to searching for yield and moderate risk-taking: (1) we prefer equities to bonds, especially in the eurozone and in Japan. We are more neutral in the United States; (2) as to credit, we are maintaining our diversified positions with no particular geographical preference; (3) regarding sovereign debt in the Eurozone, we prefer peripheral debt to core country debt. We are maintaining our positions on dollar-denominated emerging debt. Lastly (4), we remain positioned on the dollar, in particular against the euro.

 

 

 

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Bond markets tensions have returned to the fore. After an initial “warning” a few weeks ago, the bond yields of core eurozone countries moved upward, pulling peripheral countries’ interest rates in their wake. After bottoming out at 0.07% on 20 April, the 10-year Bund yield surged by more than 90 bp!

Many factors played into this trend: the increasing price of oil, a rebound in inflation expectations and an improved economic climate in the eurozone. This is added to the fact that liquidity is no longer provided by investment banks as it has been in the past. Against this backdrop, the unwinding of “uni-directional bets”—all market participants had been simultaneously positioned for the purchase of eurozone bonds with the ECB’s QE announcement—may lead to a sharp correction similar to that seen over recent weeks.

The rise in volatility that accompanied this correction was not unwelcome for the ECB, for which the rise in bond yields means greater liquidity for the bond market.

The trends on other markets (credit markets and equity markets) were in large part due to the correction the on bond markets; we saw this in the US as well, but to a lesser extent.

Before getting back to the consequences for our asset allocation of the recent market trends, it is worth taking a detour via the threat of “secular stagnation”, without which it would be impossible to understand the current policy mix. That was one of the themes discussed at our International Forum.Held in Paris on 4-5 June, the forum included prestigious guests Larry Summers (former US Secretary of the Treasury), Jean Tirole (2014 Nobel laureate in economics), Robert Schiller (2013 Nobel laureate in economics), Otmar Issing (former chief economist of the ECB) and Lord Stern (former advisor to the UK government).

Secular stagnation?The eurozone is the most threatened region

In its most basic form, secular stagnation is understood as the period in which economies are unable, under certain conditions, to “spontaneously” (or through policies) return to their level of potential activity. There is neither a consensus on the reality of this threat, nor on the reforms and measures necessary to return to sustainable growth.

However, there is a near consensus that major advanced economies are collectively facing the same types of challenges: unfavourable demographics (population ageing), growing inequalities in the sharing of wealth, growing debt stocks and deteriorating productivity gains (gradual depletion of the effects related to past technological advances). And this does not take into account the challenges related to climate change, the economic consequences of which could prove to be disastrous.

Among the major advanced economies, those of the eurozone are clearly the most threatened by a long period of stagnation: indeed, we estimate that potential growth has slowed significantly with the crisis (barely over 1%) and that will not necessarily be enough to resolve the problem of public and private debt. Total indebtedness in the eurozone (households, non-financial corporates and governments) grew between 2008 and 2014 by nearly as much as it did between 2000 and 2008 (at 178% of GDP in 2000, 201% of GDP in 2008 and 220% of GDP in 2014).

The eurozone must complete its institutional framework (banking union and capital markets union), but also accelerate the pace of structural reforms by adopting, as needed, policies aiming to reboot investment.

In a climate characterised by excess global savings and historically low interest rates, there is something fundamentally abnormal in that companies are not rolling out productive investment projects.

Should we worry about a continued rise in eurozone bond yields?

Given the economic climate described above, interest rates cannot sustainably increase. The eurozone recovery is a cyclical recovery driven by factors whose effects will be temporary: the decline in the euro, of interest rates and in the price of oil. The continued rise in bond yields would quickly stifle the current recovery, from which private investment is still conspicuously absent.

The medium-term risk is not price deflation, but a process of balance-sheet deflation, which sees a drop in asset prices push debtors into insolvency and worsen the crisis. The combination of growing debt and dwindling potential growth has changed the game. On one hand, there is a need for a policy that contributes to increasing potential growth, which requires structural reforms and investment in order to stimulate innovation and productivity. On the other, the cost of debt must be contained to avoid debtors (households, businesses and governments) being overcome by interest charges.

That is why the ECB programme – which is only just getting started (less than 20% of planned asset purchases have been completed) – may be enhanced if necessary. The ECB’s goals do not only involve price stability. Its policy aims to maintain sustainably very low real interest rates to set the conditions for “orderly deleveraging”. It is up to governments to implement the necessary reforms to increase potential growth (through reforms on the labour market, retirement, competition policy, etc.).

In other words, the threat of secular stagnation will require the ECB to intervene if long-term bond yields rise to the point of undermining the current recovery. It is a financial repression policy by another name. It is a tax on saving, but a boon for long-term investors—those who are able to ignore the rise in short-term volatility and who have been (or will be) able to rebalance their portfolios in favour of risky assets, starting with equities.

What are the consequences for our asset allocation?

In this somewhat troubled market environment, the good news is found among (1) spreads (credit, peripheral European sovereigns, emerging) which have not expanded that much despite the rise in long-term bond yields, (2) European small caps that have outperformed large caps, and (3) cyclicals that have performed well compared to global defensive securities. These segments reinforce the idea that this consolidation is only temporary.

Meanwhile, the key role played by exchange rates in assets’ performances demonstrates that we are seeing more of a redistribution of global wealth (from the US to the rest of the world and from oil exporting countries to oil consuming countries) than an acceleration of global growth. The impact of exchange rates also reflects global regions’ different positions in the cycle, which should be taken advantage of when modelling portfolios.

US market: a sufficiently balanced position between equities and fixed income

While the Fed’s balance sheet now seems to be evolving along a plateau, the equity market is barely outperforming bonds, notwithstanding the recent correction in T-bonds and the fact that the S&P 500 has been setting new record highs. The 10-year breakeven inflation rates are coinciding with the target inflation rate of 2% established by the Fed, which will be increasingly focusing its attention. Usually, this maturity phase of the cycle, which has lasted for six years now, ends either with a recession (or a pronounced slowdown) or a bubble (or a substantial overvaluation of assets).

And the Fed is increasingly acting as the arbiter of this duality. Although the soft patch seen in the first quarter argue for postponing tightening perhaps until 2016 (favourable for equities), the Fed may act sooner to “maintain long-run financial stability”, hoping that it will not cause too much short-term financial instability itself (favourable for bonds). In fact, the level of the neutral rate is a subject of debate (see Article 2 in our May issue of Cross Asset Investment Strategy: “US: the equilibrium real interest rate is lower than in the past”) and it cannot be ruled out that the Fed may be overestimating it.

So it seems that now is the right time to have a fairly balanced position between equities and bonds on the US markets, with a preference for credit within the fixed-income universe. For international investors, maintaining a position on the US dollar makes more sense as insurance rather than counting on substantial gains. Most of the increase is now behind us. We are expecting a euro-dollar exchange rate of about 1.00 - 1.10 within 12 months.

Allocate the risk to the European and Japanese equity markets instead

The eurozone is the furthest behind in the cycle. It is now taking full advantage of a proactive ECB, which will not allow the factors (very low interest rates and a weak euro) responsible for restoring confidence and improving growth during the first quarter to melt away. In a way, the reaction of the bond market also suggests being further ahead in the investment cycle, rather like Ben Bernanke’s announcement of tapering in May 2013 served as a marker in the United States. This phase is being driven by an actual improvement in the economy and remains a favourable environment for the riskiest assets.

We are therefore maintaining our preference for peripheral sovereigns over core country sovereigns and for credit and equities. After the market went through a re-rating phase that fuelled the bull market early in the year, the next upswing will mainly rely on improving earnings, which is finally beginning to take shape. The lower euro is clearly playing an important role in the recovery of earnings. It is estimated that an average euro/dollar exchange rate of 1.05 for the year will have a 14% positive impact on earnings for Eurostoxx 50 companies. If it fluctuates within the range we predict, earnings will deliver a number of pleasant surprises.

As to Japanese equities, they recently moved beyond their previous highs (2007). Currently they are delivering outstanding performance, even if adjusted to a common currency (the US dollar). This trend is due to the combined effects of the central bank, which is purchasing locally-issued bonds, allowing pension funds to diversify internationally (which is weakening the yen and boosting corporate earnings) and the growing percentage of equities in their portfolios (which is supporting the market). The impetus is being orchestrated by a government determined to improve corporate governance and encourage businesses to seek higher profitability and better shareholder returns. We still hold a favourable view of the Japanese market.

Emerging assets: still too soon to get excited

Despite an effort by the Chinese authorities to stimulate the economy, the policy seems to be aiming only at accompanying a downturn. At this stage, the reboot of the money supply does not appear sufficient to influence a price recovery in industrial commodities in any meaningful way: this is further weakening a broad swath of emerging countries.

For now, we are maintaining positions on dollar-denominated emerging debt but we think it is still too soon to add to our emerging equities positions.

Conclusion: we are broadly maintaining our strategies

Despite the strong rebound of bond yields in May/June, overall the environment remains one of soft growth and low rates, conducive to searching for yield and moderate risk-taking.

  • We prefer equities to bonds, especially in the eurozone and in Japan. We are more neutral in the United States.
  • As to credit, we are maintaining our diversified positions with no particular geographical preference.
  • Regarding sovereign debt, we prefer peripheral debt to core country debt in the Eurozone. We are maintaining our positions on dollar-denominated emerging debt.

 

 

 

2015-06-00-01

 

 

The ECB will not remain on the sidelines if bond yields continue to rise

 

 

 

2015-06-00-02

 

 

 

 

2015-06-00-03

 

 

 

The eurozone and Japanese equity markets still have good potential

 

 

 

2015-06-00-04

 

 

 

 

 

 

 

2015-06-00-05

PORTFOLIO TYPE

Equity portfolios

Bond portfolios

Diversified portfolios

  • Beta of portfolio slightly above 1 
  • Prefer Eurozone and Japan
  • Neutral on the US
  • Emerging markets: country selection is key:
    - overweight Mexico, Peru, India, GCC, Russia, South Africa, Indonesia and Thailand
    - neutral Brazil, Turkey and China
    - underweight Malaysia, Colombia, South Korea, Greece, Taiwan and Chile
  • No currency bias on the short term
  • Neutral duration with a short bias
  • Short duration on core Eurozone but long on peripheral countries
  • Preference for US vs. core Eurozone
  • Maintain overweight position in credit
  • Positive bias on ILB
  • Emerging debt:
    - prefer hard currencies debt (long USD)
    - prefer local debt only on a case to case basis
  • Maintain long USD and GBP, short JPY and EUR
  • Risk budget stable
  • Prefer Eurozone, then Japanese and US equities
  • Neutral on emerging market equities
  • Neutral duration with a short bias
  • Maintain long position on corporate bonds. Refocus on the belly of the curve
  • Keep overweight position on sovereign bonds of peripheral Eurozone countries vs. core (i.e. Germany)
  • Maintain the flattening position on US yield curve
  • Positive on emerging debt in hard currencies
  • Long USD vs. EUR

 

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Article in English

Article en Français

Cross Asset of June 2015 in English

Cross Asset de Juin 2015 en Français

 

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BOROWSKI Didier , Head of Global Views
MIJOT Eric , Head of Equity Strategy, Deputy Head of Strategy Research
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Asset allocation: Financial repression: misery for savers, but a boon for long-term investors
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