Yields through the looking glass
According to Laurent Clavel, Head of Research at AXA Investment Managers: “In the Eurozone, we believe the ECB has very thin margins for further rate cuts, and that it is high time for fiscal policy to take over, especially in Germany. Yet, despite whispers of off-budget public investment spending, we remain sceptical of an imminent, meaningful fiscal stimulus there.”
- For a euro-based investor, 70 % of global fixed income is now negative-yielding – unprecedented for institutional investors
- We continue to expect a narrowly-avoided US recession in the next 12 months thanks to the US Federal Reserve’s pre-emptive action, in absence of an external shock
- Some risks remain contained despite regular flare-ups: US/China trade war, no-deal Brexit, Italy
- Whilst it would be much appreciated, we are skeptical of a Northern European fiscal stimulus in the short run
The last couple of months have led us to a truly unchartered wonderland where about 70 % of the global fixed income space is negative-yielding once hedged back to euros. Our computation includes all developed government bonds, investment grade and high yield corporate debt on both sides of the Atlantic, and emerging market debt in hard currencies.
How did we get here? First, we continue a now 30-year global trend of decreasing interest rates. Ageing, the rise of income and net wealth inequalities – with the marginal saving rate increasing with income and wealth – and globalisation have all contributed to feed a global saving glut, boosting demand for debt. Second, the 2008-2009 global financial crisis left deep scars in households’ and corporates’ minds and behaviours. On balance the crisis elevated debt, reducing aggregate demand and strengthening the excess of savings over investments. Third, financial regulations were tightened in the wake of the crisis, from banks to insurers and other institutional investors. More recently these structural factors have been amplified by cyclical ones, namely markets’ fears of an economic downturn and additional monetary easing.
The US/China trade conflict escalation has been another concern, for us – and for the bond market. Recent developments have eased some of this tension. Moreover, there is some speculation that the White House is becoming increasingly wary of the economic impact of further trade escalation on the US economy during the forthcoming election year. Meanwhile, China is walking a tightrope. After slowing to 6.2 % year-on-year in the second quarter (Q2) – its slowest in 27 years – the Chinese economy demonstrated renewed signs of weakness, with August’s activity disappointing. After targeting China, the next flare of US trade tariffs is set to impact Europe with a salve worth 7.5bn$ announced in early October.
Among other risks looms yet another Brexit deadline. The UK Parliament has voted against a no-deal exit and legal actions are underway. Still, preventing a ‘no deal by accident’ is no certainty.
The Eurozone continues to walk its own tightrope. With the deleterious side-effects of negative interest rates in mind, September’s ECB meeting introduced a tiering system, exonerating about 40 % of banks’ excess reserves from the new -0.5 % deposit rate. Even with this mechanism in place – which offers only a partial compensation – we believe the ECB has very thin margins for further rate cuts. As President Mario Draghi kept repeating in his penultimate press conference, “it is high time that fiscal [policy] takes charge”. Despite whispers of off-budget public investment spending, we remain sceptical of an imminent, meaningful fiscal stimulus in Germany.
Serge Pizem, Global Head of Multi-Asset Investments at AXA IM exposes his asset allocation views for October: “In the low rate environment and with all the uncertainties about the US/China trade war, we believe performance can be found in riskier assets such as the US High Yield and emerging market debt. Yet, we prefer to maintain our slightly cautious stance on US equities for the moment.”
- We keep a slight cyclical tilt in our Euro equity exposure as market pessimism on Eurozone growth is still extreme. We remain prudent on US equities as prices are close to all-time highs while the underlying macro momentum is weakening.
- We remain positive on US High Yield and Emerging Market debt as a more dovish Fed is supportive for carry positions
- We remain constructive on Eurozone inflation breakeven as market pricing remains too pessimistic
“September witnessed interesting price action with a sharp rotation into pro-cyclical assets, indicating a potential repricing of global growth expectations. Global yields have risen, rates curves have bear-steepened, inflation break-evens widened, commodity indices rallied, whilst in equities value and cyclical stocks strongly outperformed growth and defensive stocks.
Most of these market moves were primarily driven by rates. In our last views, we argued that market pricing of Fed fund rates was extremely aggressive which, coupled with extreme long duration positioning caused a strong reversal since the beginning of the month. Developments over the past few weeks catalysed this repricing, particularly following hints from Trump that trade negotiations are continuing with a possibility for trade detente. Positive data surprises - e.g. retail sales, industrial production and a solid rebound in non-manufacturing ISM in the US, more loosening signals in China in the form of RRR cuts and a lower probability of ‘No-deal Brexit’ in October also supported the rotation.
Market pricing is now consistent with our forecast of two more Fed cuts this year, but remain more dovish versus our forecast beyond 2019 as some recession risks continue to be priced into front-end rates. As a knock on, this re-pricing has channeled into positions within the equity market, causing a large rotation between equity factors from momentum and growth towards value and cyclicals. This movement can continue for a while until positioning is cleaner. This is why we maintain our slight cyclical tilt in our Euro equity exposure. We also remain constructive on Eurozone inflation break-evens as market pricing remains too pessimistic.
Lastly, there is a lot of good news in S&P500 prices which are close to all-time highs. However, the underlying macro momentum remains weak. In this context, the 10 % consensus 2020 earnings growth expectation looks optimistic. Therefore, we prefer to wait and see how trade negotiations proceed and maintain our slightly cautious stance on US equities for the moment.
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