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Asset allocation: debt, political environment and liquidity remain the biggest threats

The essential

Asset allocation that gives priority to the eurozone and risky asset classes and is short on the euro has been highly effective since the ECB announced its QE programme.

The programme is driving down rates, spreads and the euro, and the outlook for earnings growth is invigorating the equity markets. On balance, there is nothing substantially different from when the US and Japanese central banks expanded their balance sheets. Do not underestimate the risk factors, notably i) the deteriorating political backdrop (with the rise of anti-European political parties and the upcoming elections in some European countries); ii) the debt burden, which remains a serious obstacle to growth acceleration; iii) the slowdown in growth in emerging countries, with China in the lead, and, above all, iv) lower portfolio liquidity since the financial crisis. There are undoubtedly a few risk factors to keep close watch on although at present the global backdrop leads us to maintain a fairly aggressive asset allocation.







Thanks largely to the activation of the ECB’s Quantitative Easing programme, last month confirmed past trends: for the month, the MSCI Europe rose 2% (the MSCI World lost 1%, the MSCI Emerging Markets Index fell 1.8% and the S&P 500 gave up 2.4%), and the EUR/USD exchange rate fell 1.5% (-9% since the beginning of the year). True, there was not much of a correction to 10-year sovereign spreads (+9bp for Italy compared to German 10-year rates, +10bp for Spain and +4bp for Portugal), but buy and hold continues to deliver good performance. The same goes for credit indices: +7bp for the iTraxx Main (57bp) and the iTraxx Crossover index (now at 267bp).
The strong improvement in European stock markets is the result of three major factors:

  • First, the prospect of rising corporate earnings resulting from a weakened euro, a factor whose importance is exacerbated by the fact that Europe’s earnings lag behind those of the United States by approximately 40%;
  • Second, renewed growth, which should also boost sales;
  • Finally, the maintenance of extremely low long- and short-term interest rates for an extended period of time.

These three factors alone justify the continued repricing of European stocks, without leading to overvaluation (see “2015 outlook” in our November 2014 issue).

In short, all this supports our decision not to change our asset allocation strategy, which has been focused for several quarters on the eurozone, risky asset classes, spread products and going short on the euro. We have repeatedly stated that low growth is not viewed as incompatible with our allocation but that the risks of a further deceleration in economic activity do pose a major risk to our portfolios. We are maintaining this approach.

But the good news is that economic activity is gradually recovering in the eurozone. Admittedly, investment is still conspicuously missing from the recovery but there have been several comforting positive developments:

  • The interest rate level;
  • The credit spread level;
  • The equity market boom;
  • The weakness of the euro;
  • The recovery in bank lending;
  • The introduction of a massive QE programme, whose impact on the real economy we are monitoring, is crucial (On this score, see our new monthly publication “ECB QE Monitor”);
  • A lack of financial market stress.

What are the threats that could hamper this asset allocation strategy? Portfolio liquidity, the political backdrop, the downturn in emerging market economies and the debt burden

1. Firstly, liquidity is once again a core concern.

The central banks have purchased assets time after time in recent years, often in vast quantities, and their expanded balance sheets resulted in massive injections of liquidity. After the Fed, it is now the turn of the Bank of Japan and the ECB to supply the capital markets. However, this excess liquidity must not camouflage true liquidity: the flows of liquidity into the real economy on the one hand and portfolio liquidity on the other.

  • As to the real economy, it should be recognised that, thus far, this channel has not really worked. There was more incentive (risk-reward, regulation, etc.) to buy government bonds than to increase bank lending.
  • As to portfolio liquidity, investor demand for risky assets, which are frequently less liquid, must be carefully weighed against the diminishing number of market-making investment banks and less risk-taking. In fact, there are now fewer market practitioners, hedge funds are less eager to supply liquidity than in the past and banks’ inventories have been reduced by nearly 80% since the financial crisis. At the same time, the volume of investment in asset classes like corporate bonds or alternative asset classes has been steadily climbing. Overall, the liquidity supplied by central banks (abundant) and portfolio liquidity (falling) should not be confused. Ignoring this distinction would certainly be a big mistake.

2. Next, there is the issue of debt burden, as deleveraging in the private sector and the need to stabilise public debt are cutting into disposable income and consumer spending.

The return of public debt to a sustainable path is unavoidably having a negative impact on GDP growth: how do you justify pursuing growth policies when excessive public and/or private debt is setting the stage for a financial crisis and pushing countries toward budgetary and fiscal austerity? What’s worse is that countries are unable to reduce their debt relative to GDP (a ratio that is supposed to represent their ability to pay back their debt).

Only five countries (Argentina, Romania, Saudi Arabia, Israel and Egypt) have been successful in reducing their total debt-to-GDP (private + public debt) ratio since the 2007-2008 financial crisis. For others, admittedly to varying extents, this ratio has increased, often alarmingly so. Japan is now at 400%, Ireland at 390%, Portugal at 360%, Belgium at 330%, the Netherlands at 325%, Spain at 315%, France at 280%, to mention only a few. To put an end to the spiral, the following is obviously needed: very low interest rates, strong growth, budget austerity leading to primary surpluses, continued private sector deleveraging...or debt restructuring/cancellation. Reducing public debt whilst ensuring growth above the interest rate (debt service) has become almost impossible. The balance sheet recession affecting banks and all economic players will only reduce the rate of economic growth for the foreseeable future. Furthermore, investment is conspicuously absent from the economic recovery in the eurozone, which is raising doubts about the pace of economic recovery.

It is possible to calculate the level of growth required to reverse the trend of important economic indicators, such as employment or public debt. In a very recent study, McKinsey Global Institute demonstrated that to begin reducing the public debt-to-GDP ratio, real GDP growth rates far higher than currently projected would be needed (Debt and (not much) Deleveraging”, McKinsey Institute, February 2015).

According to McKinsey, a real GDP growth rate of 5.5% for Spain, 4.7% for the United Kingdom, 4% for France, 3.9% for Portugal, 3.6% for Finland, etc. would be needed. In other words, there is now a growth deficit along the lines of 2.5% in France and Portugal and 3.8% in Spain. However, Germany and the United States are among the few countries that do not require any additional growth to roll back the public debt-to-GDP ratio.

3. The political and social landscape is becoming complex.

We are seeing a major reshuffling of the cards in several countries. We cite just a few examples. In Greece, the long-time governing party in power (PASOK) has virtually disappeared, replaced by a young party (Syriza). In Spain, a new political party, Podemos, created in January 2014, has traditional parties shaking. Podemos aspires to replace the Socialist Party, the PSOE. It now claims that it is a social democratic party and is turning away from the extremist label frequently attached to it. The planks of its party platform now include a 35-hour work week, retirement at age 65, a rise in public expenditure, eligibility for loans, a higher national minimum wage and debt restructuring, especially for households. So great is the threat that the conservative Partido Popular (PP) recently raised the possibility of a grand coalition government with the socialists if an absolute majority is not reached in the upcoming general elections (scheduled for this year). The PSOE rejected this idea, which business and financial circles want. In France, the Front National has made major strides in the past few years. But two things are worth noting:

  • Extreme left parties are making inroads in the peripheral countries of the eurozone while extreme right parties are gaining adherents at the core of the eurozone.
  • The parties enjoying growth, whether right-wing or leftist, have adopted platforms very critical of European bodies and the economic policies theypursue, including the European monetary union itself.

4. The slowdown of emerging market economies, particularly China.

It is clear that both the rate and the composition of growth have changed considerably in recent years: demographics, wage growth, productivity gains and the revision of potential growth to the downside are common themes. An added complicating factor stems from exchange rates. The strength of the dollar has caused the yuan to appreciate against all other currencies, particularly emerging currencies, and this has undermined China’s positioning. The current strength of the dollar or, to be more exact, the relative weakness of the yen, the euro and a good number of emerging currencies creates problems for China... but not really for the United States. We should remember that over the past 15 years, the strength of the yen and, for that matter, the euro, has been steadily eroding against the effective exchange rate of the US dollar. But this is not the case for the yuan, which has strengthened tenfold. In other words, if we assume China’s exchange rate policy is crucial and if the Chinese authorities are forced to react (pursuing growth through competitive devaluation), then a full-scale currency war would ensue with major financial instability along with it.

5. The question of Greek solvency has not been settled.

There is no doubt that 2015 is one of the toughest years for Greek finances. Indeed, Athens will have to repay €15bn in total, primarily to the International Monetary Fund and the European Central Bank (repayment of the €240bn bailout package). According to the Greek prime minister, Greece does not have the resources to pay such amounts. Alexis Tsipras claims the government’s coffers will be empty as of this April. There is a lot at stake, because Athens is due to receive the next tranche of international aid (slightly more than €7bn) next June, but only if the government can present a specific plan for reform, complete with figures. However, we should not forget that even if Athens actually receives that amount, the problem will still not be completely solved: Athens still has to pay back another €6.5bn in July and August.

Consequently, on 27 March Tsipras presented approximately 20 measures that include stepping up the fight against tax fraud, curbing fuel and alcohol smuggling, checks on bank accounts opened in foreign countries by Greek citizens, changes to the tax code, etc. He also offered to limit early retirement and to create a resolution structure (or “bad bank”) to deal with the banks’ accumulated doubtful loan. This year’s income from privatisation is expected to be €1.5bn, instead of the €2.2bn provided for by the Greek bailout package, but the Greek plan expects more than €3bn in new income for 2015. The plan is based on a primary surplus (budget deficit – debt service) of 1.5% of GDP (versus 3% previously), and GDP growth of 1.4%. European creditors are certainly ready to compromise, but the basis for their calculations is still the list of reforms to which the previous Samaras government committed (especially retirement reform and more rapid liberalisation of the labour market), which the Greeks are disputing.

The partial early release of the last tranche (€7.2bn) of the Greek bailout plan is still under negotiation. The good news is that on 9 April the Greek government managed to meet the deadline to repay a €460 million loan instalment to the IMF. In addition, it is expected to have enough cash to meet its commitments until the next Eurogroup meeting on 24 April. Another positive development is the slight easing of relations between the Greek government and its creditors.

That said, nothing has been resolved at a substantive level and the risks remain. The Greek government’s commitments are not enough: the governmental coalition is unstable and national politics remain extremely tense.

But for the moment, we believe the Fed’s renewed caution regarding tightening its monetary policy, the breadth and duration of the ECB’s QE, the maintenance of extremely low interest rates and the repricing of European assets will remain the dominant factors. We are therefore maintaining our asset allocation, while nevertheless making sure, as we have previously mentioned in these columns, to take profits and closely monitor the liquidity of these portfolios.


The beginning of the year
was positive for European
asset classes but not for
the euro regard




Real threats



The liquidity supplied by
central banks (abundant)
and portfolio liquidity (falling)
should not be confused




Few countries have
successfully reduced
their total debt



The growth rate required
to roll back soaring debt
has not been reached




The rise anti-European parties
are should not be ignored




Yuan exchange rate policy,
a critical element for global
fi nancial stability



The question of Greek
solvency has not yet
been settled


















Equity portfolios

Bond portfolios

Diversified portfolios

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

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

  • Maintain long USD, short JPY and EUR
  • Long duration on core Eurozone (and US)
  • Curve flattening trades
  • 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: debt, political environment and liquidity remain the biggest threats
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