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ASSET ALLOCATION - The central banks are still at the helm - A welcome respite



The financial markets are still very reliant on central banks, far too reliant, in fact, given that today's major problems (weak growth and investment, weak consumer spending, low productivity gains, etc.) clearly call for a response based more on structural reforms and changes in the direction of budgetary and fiscal policies.

This reliance on central banks reflects the absence of genuine growth policies, particularly in Europe. Despite the damage to their credibility, the Fed and ECB are doing what they can. The Fed is stepping back from monetary tightening (which reinforces our view that the rise of the USD will be limited), while the ECB has deployed a whole arsenal of measures including interest rate cuts, TLTROs, expanded QE and purchases of investment grade corporate bonds. While these measures cannot revive growth on their own, they are welcome news in the current environment. Meanwhile, the price of oil has seen a strong recovery, fears of a recession in the United States have receded somewhat and China is doing its best to provide reassurance: the economic indicators are decent, and the change in the currency policy (managing the yuan's stability) has been effective thus far. A massive, brutal depreciation no longer looms on the horizon. The market environment is improving. The risks have not disappeared, but the future is looking brighter. Appropriately, we have scaled back protective positions in the portfolios and added some more risk on hitherto stressed asset classes.






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:

  • We expect global growth to be lower than the consensus forecast, at 3% in 2016 and 2017;
  • The gap between the emerging and developing countries is narrowing, thanks to improved performance in the latter;
  • The developed countries, and commodity-importing countries more generally, are benefiting from the current oil “counter-shock”;
  • The pressure on oil-producing countries has not disappeared, despite the recent rebound in crude prices;
  • China's economy is still in its "slowdown" phase, but its manufacturing industry is in recession;
  • A “hard landing” by China's economy should be avoided;
  • In the advanced economies, growth remains driven by domestic demand (more so by consumer spending than investment or public spending);
  • The slowdown in the emerging economies is not without consequences for the advanced economies;
  • The US economy will converge toward its growth potential in 2017 (under 2%);
  • Europe is growing at a pace similar to that of 2015: no more, no less;
  • Core inflation continues to decline in China;
  • Inflation is rising slightly in the developed countries;
  • Global trade is contributing negatively to global growth, and economic cycles are becoming more domestic in nature. As a result, country risk is becoming more important.
  • In the United States, the decoupling between the service and manufacturing sectors is a key factor. So is consumer spending, which is currently slowing but still strong enough to avoid the worst;
  • Monetary policies remain accommodating overall;
  • Inflation remains under control. Base effects are certainly a factor, especially in the United States, but base effects are not the same as inflation. Inflation is an overall cumulative increase in prices, or any price increase that impacts patterns of consumption, saving or inflation. This is still a distant prospect;
  • Deflationary risk has not disappeared, but it is now more external (global trade, China, commodity prices, etc.) than internal, unlike the post-financial crisis period in the US and Europe or the aftermath of the debt crisis in Europe.

Click here to see an overview of the risk factors

A number of developments caught our attention in recent weeks:

  • First and foremost, the expansion of the ECB's asset purchasing programme to include corporate bonds. Clearly, the ECB will not be buying enormous volumes. This would be difficult to do in any case. Nonetheless, having a major player like the European Central Bank in the market will contribute to tightening credit spreads;
  • Second, fears of recession have receded in the United States, with indicators stabilising (manufacturing sector, etc.) or coming out favourably (particularly business confidence, jobs and consumer spending). Statements by the Fed Chair also contributed to this calming trend;
  • China, another major topic of concern, remains on track for its “managed” slowdown. The stabilisation of its foreign exchange reserve and national currency have also provided some respite;
  • The rebound in oil prices (more than 50% from their low point) has reinvigorated the emerging economies, which were in urgent need of good news like the rise in crude prices, the cautious stance taken by the Fed and the stabilisation of a number of indicators in China. Admittedly, rating agencies continue to downgrade commodity-producing countries (Saudi Arabia, Oman, Bahrain and Kazakhstan just to name the most recent ones), but that's not something new.

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


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Cross Asset of April 2016 in English

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ITHURBIDE Philippe , Senior Economic Advisor
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ASSET ALLOCATION - The central banks are still at the helm - A welcome respite
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