The increased stimulus is consistent with a scenario of low rates for longer and search for yield in the Eurozone. |
ECB: strong support to Euro fixed income in 2021Very much in line with consensus and market expectations, the package delivered by the ECB at its December meeting combined additional measures of quantitative easing (QE) with further support to the financial system. The pandemic programme (PEPP) was extended in time and increased by EUR 500bn while the APP (Asset Purchasing Programme) was confirmed to proceed at the current path of EUR 20bn in purchases per month, meaning additional firepower of EUR 300bn over 15 months. Measures in support of the financial system came through the TLTRO tool, extended, enlarged in its scope and confirmed in terms of very favourable conditions attached to ECB lending operations. A nine-month extension of the PEPP into 1Q22 is longer than the six-month (end 2021) extension generally expected by consensus, but the decision appears to be consistent with recent messages from many ECB members on the importance of both the size and duration of the stimulus. The extension of the reinvestments horizon of maturing bonds is very much in the same direction as well. The ECB’s emphasis has turned mostly on providing and keeping favourable funding conditions for as long as needed to support economic growth in recovering from the pandemic crisis. In the Q&A following the meeting, President Lagarde underlined that the strategy of the ECB aims at “preserving favourable financing conditions over the pandemic period”, defining them “in a very holistic way”, namely “for all sectors of the economy.” Therefore, the ECB made it clear that lending rates to households and corporates, and at sovereign levels are all within the scope of the support, together with credit flows to the economy. In order to reach this target, the ECB calibrated a very strong increase in its QE, securing a “significant constant market presence” which will provide the central bank with the necessary flexibility for managing its QE. In this respect, the ECB president also underlined the symmetry of the eventual pace of adjustment as on one side, the envelope represents a ceiling and “does not have to be spent in a pre-defined way, or even in full”, but “equally, the envelope can be increased if it is necessary.” We assess that the increased stimulus looks consistent with the objective of keeping up support for technicals regarding fixed income markets into 2021 and thus supporting the current low rates for longer scenario as well as the yield search. Between the now larger PEPP and APP, the ECB will in fact have more than €1.4tn of remaining net purchasing capacity by end-March 2022. ECB QE also looks more than sufficient to cover eventual additional Euro government bond net funding that may be needed to finance new support measures to counteract negative impacts from current restrictions and to increase its presence in supranational segment as well in sight stronger EU issuance. On the TLTRO side as well, our guess is that the new measures will be effective in keeping a high level of liquidity available in the financial system, indirectly supporting bond technicals. Ultra-cheap credit for banks, even with strong conditionality, will not be enough to avoid a tightening in banks’ lending conditions for companies. This crisis has been characterized by contra-cyclical credit conditions, thanks to the coordinated actions of CBs and governments. In recent months, banks’ credit conditions have remained accommodative, thanks to (1) strong liquidity injections via TLTROs and (2) government loan guarantees. The massive supply of credit for all businesses has limited corporate defaults and the long-term economic damage from this crisis. We remain concerned about a significant tightening in bank lending conditions once government guaranteed loans expire. Banks had already curtailed access to corporate credit in Q3 and expected to tighten further in the coming three months. “Banks referred to the deterioration of the general economic outlook, increased credit risk of borrowers and a lower risk tolerance as relevant factors for the tightening of their credit standards for loans to firms and households”.
The duration of the monetary support is as key as the degree of accommodation. A lot of monetary and fiscal support is currently justified by the pandemic. However, very accommodative monetary policy will still be needed after March 2022. In the coming years, (1) inflation is expected to remain well below the 2% target and (2) economic fragmentation among Eurozone countries will continue to be a challenge. TLTRO= targeted longer-term refinancing operations. |
We maintain a pro-cyclical tilt and believe the reflation trade can continue, but investors must protect their equity and credit exposure through robust hedges. |
Reinforce cyclicality with relative value and hedgesWe continue to see support for risky assets as we move into 2021, backed by the shift from a contraction phase to a recovery. Importantly, a Democrats majority in both Houses of the US Congress supports the reflation trade narrative and creates a positive backdrop for cyclical segments. In this environment, equity remains more attractive than bonds and we see some upside over a one- year horizon. We are mindful that this recovery is different from those in the past in the sense that equity valuations are already high as we enter this phase and it is dependent on an effective, large-scale rollout of vaccines. As a result, we recommend that investors be very selective and valuation-conscious across the asset spectrum. High conviction ideas
Overall constructive on DM equities due to positive momentum on PMIs and strong fundamentals, we have upgraded our view on the UK amid the current ‘Brexit discount’ and improving earnings revisions, but stay vigilant. On the other hand, we continue to believe that Japanese and Pacific-ex-Japan (Australia) equities should benefit from an economic rebound. Their high operating leverage means profit margins could grow in proportion to the higher sales we expect in 2021. On EM, we remain optimistic overall, with a positive view on Asia. In particular, with an eye for relative value, we now believe the Chinese A-share market (largely financials, conventional consumption) should do well vs MSCI China (ie, internet, e-commerce and telecoms) while financials should benefit from the improving economic momentum supporting the factor-rotation towards Value and Laggards; internet-related segments may be weighed on by a regulatory overhang. Financials will also benefit from favourable technicals, sentiment (potential inclusion in MSCI indices) and earnings. Risks and hedgingAdditional waves of coronavirus infections and accompanying lockdowns, a premature withdrawal of stimulus and geopolitical tensions represent credible risks to an economic recovery. As a result, investors should maintain robust hedging structures in the form of derivatives, JPY, USD and USTs to safeguard credit and equities exposure. We also believe gold continues to act as a strong hedge in the current environment. |
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Economic reopening could raise inflation expectations in the US, affecting real yields. Investors should use credit research as a means to strike a balance between higher yields and high quality. |
"Great discrimination” in creditThe Q3 rebound in GDP numbers was stronger than expected, but renewed lockdowns due to the second wave of Covid-19 infections could affect economic activity in 4Q20 and 1Q21. On the vaccine front, a large-scale rollout and accommodative policies, as put in place by the ECB at its latest policy review meeting, should drive a recovery in global GDP in 2H21, providing a supportive environment for risky assets. However, in credit, there is a wide gap between valuations and fundamentals. So, we recommend investors balance their search for yield with quality credit through strong research and selection. Global and European fixed incomeWith an overall cautious view on duration, we marginally downgraded our US stance to move close to neutral and maintain our defensive position on core Europe. We remain constructive on peripheral debt mainly through Italy (ECB support, strong EU policy response) even though the likelihood of spread tightening going forward is now lower. On the US curve, we stay vigilant on the 2Y, 10Y and 30Y segments. Finally, we upgraded our US break-even view, favouring 5Y over 10Y, and believe valuations are attractive in the EZ. The upside potential in break-even is not currently priced-in by the markets. We remain constructive on credit, particularly cyclicals, and see the recent rally as an opportunity to lock in some gains without altering our stance. The scope for further spread compression is higher in HY vs IG, in BBB vs A-rated, and in subordinated vs senior debt. However, markets are not far from a situation where spreads do not appropriately reward for the risk. Hence, we stay very active. At a sector level, we are positive on financials and telecommunications, but cautious on basic utilities, healthcare and transportation. US fixed incomeAs we move out of the pandemic and see large-scale vaccine distribution, we believe, the pent-up demand for goods and services from US consumers (supported by savings), coupled with the Fed’s lower-for-longer stance, should push up inflation. Accordingly, we believe TIPS are a good way to diversify portfolios and protect from inflation. On the other hand, deficit spending and increased UST issuance may put upward pressure on yields, leading to some steepening. Hence, we remain defensive, but believe UST futures offer strong liquidity. On credit, active selection and research are crucial in allowing investors to de-risk portfolios. We think investors should avoid sectors that have completely normalised. In fact, current conditions are ripe for idiosyncratic aspects rather than a complete market beta exposure. In particular, consumer (esoteric ABS) and residential mortgage markets (agency mortgages) remain attractive in light of strong aggregate consumer earnings, savings and debt repayments. EM bondsOverall positive on EM FI, we believe there is still room for spread compression in HY. Local FX is supported by low yields globally, benign inflation, stable US policy, and an early-cycle growth environment. Asian growth could outperform other regions in 1H21, offering selective opportunities. In Turkey, we acknowledge risks related to the BoP and lira, but believe there are opportunities amid credible normalisation of economic policies and cheap valuations. FXWe are cautious on USD/JPY and USD/CNY given improving environment for cyclical FX. Our constructive view on NOK/EUR is also maintained. 
GFI= Global Fixed Income, GEMs/EM FX = Global emerging markets foreign exchange, HY = High yield, IG = Investment grade, EUR = Euro, UST = US Treasuries, RMBS = Residential mortgage-backed securities, ABS = Asset-backed securities, HC = Hard currency, LC = Local currency, CRE = Commercial real estate, CEE = Central and Eastern Europe, JBGs = Japanese government bonds, EZ = Eurozone. BoP = Balance of Payments. |
Despite the recent outperformance of Value vs Growth, the catch-up potential for Value is significant and depends on earnings growth and economic normalization. |
Still room for Value to catch upOverall assessmentThe progress on vaccines globally and the approval of one in the UK and two in the US seem to have put a time limit on the pandemic, which is encouraging markets to look into the future. On the corporate front, earnings growth is expected to be significant in 2021, driven by continued stimulus and an economic recovery. However, stretched valuations in some segments, risks of multiple Covid-19 waves, and worries over corporate solvency require a selective approach. We believe that a fundamental, bottom-up analysis of businesses with quality balance sheets will be crucial for sustainable returns. European equitiesGiven that reopening of the economy is very much dependent on a large-scale vaccine rollout, we maintain a balanced stance, with a bias towards normalization and recovery. This supports our barbell stance regarding defensive sectors such as healthcare and telecommunication services, on the one hand, and quality cyclical stocks in the industrials and material sectors, on the other. While we are optimistic on the last two, we became marginally positive on financials, which should benefit from a shift towards Value. Interestingly, the last month saw Value investing coming back in favour vs Growth. However, on a longer historical perspective, the Growth vs Value premium is still high. We believe the potential for Value to outperform is still significant, but depends on the aforementioned vaccine rollout, economic recovery, improving PMIs, and direction of rates. Therefore, we prioritize process discipline and stock selection, all the while managing market and style risks. In contrast, we are more cautious on consumer discretionary, but have maintained our negative view on tech. In all cases, though, we focus on resilient businesses. US equitiesWe believe equities are more attractive than credit from an income perspective, but, however, this doesn’t eliminate the need to stay active. In fact, selection is even more important today because there are pockets of extreme valuations in the market. However, digging deeper, investors should avoid hyper-growth stocks and see if continuous fiscal stimulus, a recovery in 2021, and improvement in corporate earnings drive a rotation from the mega-cap growth stocks towards more cyclical growth and cyclical value stocks. The last should benefit from lower interest rate sensitivity. Growth names are more rate-sensitive because they have a higher dependency on future earnings and would be more negatively affected by rising discount rates. Conversely, financials, heavily represented in the Value universe, would benefit from a steeper yield curve. As a result, investors should: (1) consider shifting away from hyper-growth and high momentum stocks and move to reasonably priced, stable growth names (ie, medical devices); (2) aim to benefit from a rotation favouring high-quality Value stocks (ie, industrial automation, parcel delivery); and (3) explore opportunities in the ESG space. EM equitiesWhile geopolitical risks remain on our radar for EM assets, we continue to be constructive about exploring names in countries where economic activity has rebounded. At a sector level, we are selectively positive on tech and internet, consumer discretionary and industrials, but are mindful of extreme valuations in these areas. We don’t like sectors where profitability may be restrained by government action. Stylistically speaking, our tendency is to look for value with sufficient cyclical growth and quality characteristics. 
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