The year got off to a complicated start, with equity markets falling, volatility surging, credit spreads widening and bank stocks tumbling. These trends fuelled a resurgence of major fears (global recession, a “hard landing” for China's economy, a devaluation of the yuan, etc.), which were priced into equities, fixed income and corporate bonds. Since then, the markets—and emotions—have calmed down. Repeating a common pattern in recent years, central banks played a key role in the periods of both calm and stress.
Central banks at the helm, again
The ECB got the ball rolling on 10 March. It had already announced its intention to reconsider its monetary policy several months prior (presumably, to take on new easing measures), and did not miss its opportunity when the market fell into a slump. It would have been hard for it to do more, or to pull off a more surprising move. The interest rate cut, the expansion (+33%) of its asset purchasing programme, the adoption of an investment grade corporate bond purchasing programme and a new series of TLTROs were the ECB's response to the deterioration of the global economic environment. Central banks obviously cannot solve all of the current problems on their own, but the ECB's large-scale response nonetheless provided some support.
The ECB continued to lower interest rates, but thankfully combined this decision with a whole arsenal of other measures. What is the ECB actually seeking to achieve? Negative interest rates are meant to dissuade banks from depositing their extra cash with the ECB. The TLTROs are supposed to direct liquidity to loans to the economy and maintain country selectivity. Expanding asset purchases to corporate bonds is meant to keep spreads low to boost solvency and facilitate financing on the fixed-income markets. What more can it do? At this stage, the only possibility would be to maintain QE longer than planned. Mario Draghi has suggested that the ECB was unlikely to pursue further cuts to interest rates, which are already deep in negative territory. It’s a wise decision, as we were never enthusiastic about continuing the negative interest rate policy. Such a policy would limit the growth potential for short-term securities, and make their risk exposure even more asymmetrical.
In any event, the breadth and variety of measures taken reflect serious concerns about the economic environment, a message also conveyed by the Fed through Janet Yellen.
According to the US central bank, the environment is less favourable than it was in December, meaning greater caution is in order. While Yellen confirmed the Fed's expectation of two rate hikes by the end of 2016, she also reiterated that the Fed could, if needed, resort to the measures employed in the aftermath of the financial crisis—in other words, quantitative easing. We have long said that, without any interest rate leeway, the Fed would have no other solution but to put in place a QE4 programme. This prediction was confirmed last week by the Chair of the Federal Reserve. When speaking about interest rate hikes and QE, Yellen nonetheless confirmed that she had not given up on the goal of re-establishing some leeway, and that QE could be used to compensate for it. Should this reassure us, or concern us? Whatever the case may be, any interest rate hikes will be limited, all the more so since Yellen believes that the natural rate of interest (one compatible with a monetary policy that is neither expansionary nor restrictive) is currently close to zero. This contrasts significantly with studies conducted by the Fed since the financial crisis which have argued that the rate has remained at 2%. Janet Yellen's comments suggest that the simultaneous drop in inflation and potential growth have had an influence. The paradox is that the Fed talked about hiking interest rates when the markets were concerned about growth, only to adopt a more dovish stance and hint at QE when the fears of a recession subsided. This is not an error in communication, but simply a strategy, albeit a more pleasant one in current circumstances, with recent economic indicators pushing away expectations of recession.
In any case, traditional methods of communication are hard enough during a monetary policy shift, and all the more so when the central bank is behind the curve as is the case today.
The Bank of Japan has entered a phase of very low—or rather, negative—interest rates, undoubtedly for the long haul. By lowering its short-term rates below zero, the Bank of Japan dragged the entire yield curve into negative territory, and it is “killing off” what remains of its money market funds.
Macro and market fears: same story
Our central scenario remains broadly the same. It incorporates the following considerations, which justify our asset allocation strategy:
A number of developments caught our attention in recent weeks:
The preceding discussion is significant for us because these are exactly the same factors that were outlined in previous publications in support of maintaining our asset allocation. Of course, these trends are not yet strong enough to justify taking on more exposure to the emerging markets, commodities, undervalued currencies and “shunned” assets. Nonetheless, we believe they validate our approach, which is on the constructive side on these assets and asset subclasses. We continue to favour long-term and corporate exposures (and other spread instruments like peripheral country securities). The USD’s potential for appreciation has fallen somewhat, and we are steering clear of UK exposures (currency and equities) due to the risk of Brexit. In our assessment, European equities remain the most attractive, despite the slowdown of some performance drivers (for example, the weak euro and its impact on profits). This is shown in the tables below.
The ECB adopted an arsenal of measures on 10 March
On 29 March, the Fed said rate hikes and QE would be on the table if necessary
The BoJ is ‘killing off’ money market funds
Our central scenario remains the same
Europe à la carte, the real danger of the EU
Asset allocation unchanged, higher risk budget