Although it is difficult to get excited about the economic cycle, we believe that global growth will continue. Equities should thus be supported, but our exposure remains non-cyclical. At the same time, a tentative stabilization of oil prices and USD, as well as further stimulus from the European Central Bank (ECB) should help support risk appetite and the search for yield. These elements should principally benefit credit and emerging markets bonds, and we add to our EM bond exposure.
- Our additions to credit, inflation linked bonds and select commodity-related currencies made last month, proved effective. A bounce in oil prices, inflation expectations and ECB action led risk appetite to bounce from very low levels.
- Following the bounce, positive momentum may slow down. In particular, economic data alone is unlikely to drive equities much higher, and we thus maintain a defensive sector positioning, while maintaining our small equity overweight.
- However, the ECB package should further reinforce the search for yield. The measures should boost M&A activity and share buybacks, in our view. Investment grade credit remains well supported and should also benefit from the ECB announcement. We see value in European and US senior bank bonds.
- We increase our exposure to EM debt, using some cash from the model portfolio. We no longer prefer hard currency over local currency debt. EM bond flows have started to benefit from the search for yield and improving fundamentals. Attractive valuations, relative resilience in recent weeks, a stabilizing USD, a slower Fed and improving oil prices all contribute to the investment case.
- We see continued risks in the UK as the ‘Brexit’ referendum of 23 June approaches. We maintain an underweight on UK stocks and believe CHF can be a good hedge against the ‘Brexit’ risk. We prefer Eurozone credit over UK credit.
- The Federal Reserve did not surprise on 16 March, and it left interest rates unchanged, while signaling slower rate hikes going forward. We believe they will wait till June 2016 for the next interest rate hike.
Analyzing the market rebound
Markets had dropped sharply at the start of the year, only to rebound from the middle of February. The fear of a US recession has been put into question by recent data, which has generally been more positive than expected. Fears of a new credit crisis have not led to any tightening in interbank lending conditions. And finally, fears of ever lower inflation have started to be contradicted by improvement in some wage growth data, continued job gains in many countries, and, of course, the rising oil price.
The meeting of the European Central Bank on 10th March 2016 importantly also illustrated that central banks have not run out of tools to stimulate the economy. We expect that, with time, the measures taken by the ECB should lead to some increased lending growth. Even if this is not the case, the signaling effect of a major central bank going ‘all in’ should, in our view, support the risk appetite.
Skeptical on cyclicality, but bullish on the search for yield
Markets may remain skeptical on any ‘quick recovery’ of global growth and we therefore think it is too early to position for this. We think Chinese growth will stabilize in H2 2016, and believe that a stabilization of oil prices should remove one of the headwinds for investment spending activity in the US and some emerging market countries in coming months. In the meantime, however, the uncertainty created by the Brexit referendum may weigh on investment spending and consumption in the UK. It may also cause some collateral damage to the otherwise resilient Eurozone economy.
For now, the support coming from central banks is more tangible than the support coming from the economic recovery. Therefore, we remain focused on the search for yield in our portfolios.
The many implications of the search for yield
Developed market credit: The ECB’s decision to increase the size of its bond buying program and the broadening of the scope to include investment grade bonds issued by non-banks should have a positive effect on credit. The decision should principally benefit EUR investment grade credit, but should also have positive contagion effects on BBB/BB (crossover) credit and USD corporates.
- We upgrade Eurozone senior bank debt to neutral with a positive bias, as we think that the targeted longer-term refinancing operations (TLTROs, where banks can borrow for 4 years at a zero rate, or even lower) should address any fears of limitations on access to liquidity. Bank spreads had widened on fears of a renewed credit crisis, which we think are overdone, even if profitability may remain challenged.
- As a consequence of the upgrade, we hold a relatively positive view on senior and Tier II bank bonds in the Eurozone core, the periphery and the US. We hold a more cautious view on UK bank bonds (and an underweight on Tier I UK bank bonds) as there could be significant volatility in the run-up to the Brexit vote, in our view.
Emerging market credit: We think that the search for yield will extend to emerging markets, and we put 2% of the cash in our model portfolio to work in EM hard and local currency debt.
- As shown in the graph on the front page, EM bond yields look attractive relative to developed market debt, even after adjusting for inflation and rating differences. Although they are lower than for high yield bonds, they have been much less volatile in recent weeks.
- In addition, the three principal drivers of local currency debt – namely, the outlook for China, commodity prices and the risk of Federal Reserve rate hikes, have all eased somewhat. The March meeting of the Federal Reserve signaled a slower patch for US interest rate hikes, which should also help cap USD – both positive factors for EM debt.
- EM currencies have been more stable lately, and with global currency wars easing (as illustrated by the ECB and Bank of Japan meetings), we believe that the currency risk associated with EM local currency has decreased. Investor positioning is generally long USD against EM currencies and some positions may thus need to be adjusted.
- As a result, we no longer hold a preference for hard currency EM debt over local currency EM debt, and add to EM exposure in both categories. We particularly like Mexico and have upgraded Russia from an underweight to a neutral position. We think valuations look attractive in India and Indonesia as well, although these two markets are more difficult to invest into (funds can provide access).
In equities, we remain defensively positioned due to the economic cycle, but we believe that the search for yield can significantly add to the performance.
- The high dividend yields in the Eurozone compared to the US is one of the reasons for our continued mild preference for the former.
- We think that the ECB’s TLTRO (Targeted Longer-term refinancing operations) program will incentivize banks to finance M&A activity, or allow firms to borrow to help finance share buybacks. Globally, we continue to like companies that create shareholder value through M&A, buybacks or dividends, as this is an alternative way for investors to boost portfolio yield.
Managing Brexit risk
The polls on voting intentions in the UK referendum remain tight. Given the uncertainty, it is important to manage risks, in our view.
- We remain underweight in the UK stock market as we believe that there is little evidence of any material risk premium embedded in current pricing. Investors are generally still overweight and earnings expectations are too high, in our view.
- GBP is currently trading at 1.40, in the middle of the 1.20 we expect in the case of an exit and the 1.60 we expect in case of continued membership. With the polls indicating roughly a 50/50 chance for both scenarios, there does not seem to be any clear trade. However, it is important for investors to consider if they are comfortable with the risk they are exposed to, through their investments or liabilities.
- We believe that CHF could benefit from safe-haven flows in case of a UK vote to leave the EU. Conversely, given that there is currently little risk premium embedded in CHF valuations, we do not think that CHF would weaken much in case of a UK vote to stay in the EU. We therefore think that the risk profile of CHF is much more attractive than that of GBP.
In summary, we hold a small overweight position in equities, investment grade credit and emerging market debt. This makes our portfolio pro-risk in nature. However, this stance is motivated mainly by continued central bank support, the recent ECB measures, a slow Fed and the exaggeration of some perceived market fears.
We maintain a defensive exposure to the economic cycle and manage some short term risks. In particular, we believe diversification and careful management of currency exposure remain paramount.