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February 2015 – Battle Against Deflation Heats Up



The first month of the year saw a wave of easing across global central banks as the spectre of deflation has forced the hand of monetary policy. Thirteen central banks eased monetary policy in January 2015, which drove yields on fixed income assets down across the globe as the search for yield intensifies and the battle against deflation heats up.


The fight against deflation is fiercest in Europe where prices fell for the second consecutive month in January. On January 22, the European Central Bank (ECB) announced an Expanded Asset Purchase Programme (EAPP) whereby it will purchase sovereign debt at monthly rate of 60 billion euro until at least September 2016. The size and open-ended nature of the program exceeded the market’s expectations and should be supportive for European equities and credit.


The ECB was not the only central bank to make waves. A week earlier, the Swiss National Bank (SNB) announced that it was abandoning the 1.20 Swiss franc (CHF) to euro floor it had imposed and slashed the deposit rate by 50 basis points to -0.75%. This led to a near-20 standard-deviation appreciation in the CHF, which is up 15.75% on the year against the euro.


These actions led to further declines in yields across Europe and provided a boost for U.S. fixed income assets. As a result, U.S 10-year Treasuries posted their biggest monthly gains since 2011, rising 4.6% in January to yield 1.64%. According to Bloomberg, U.S. 10-year yields are around 76 basis points higher than the average for their developed market peers.


It is notable that U.S. yields continued to fall even as the Federal Reserve indicated it was still on track to raise interest rates this year. The Federal Reserve reiterated its pledge to remain “patient ” before raising interest rates and noted an improvement in labor market conditions and rise in household spending as lower energy prices have boosted purchasing power. GDP data for the fourth quarter of 2014 confirmed this; while the print of 2.6% was below expectations, consumer spending rose to its highest level in nine years. Despite a stronger U.S. economy, the market continues to expect that the Federal Reserve will raise rates at a slower pace than it has communicated to the market given global growth concerns. This fact, along with easing across central banks has further fuelled U.S. Dollar (USD) strength which finished the month up 5%.


A stronger USD was partly responsible for the underperformance of U.S. equities in January as the exports of U.S. companies were less competitive. While the S&P 500 fell 3.10%, the Eurostoxx 50 was up 6.52%, in local currency terms. Indeed, earnings growth in the U.S. has come in on the softer side. For the 45% of S&P 500 companies to report thus far, fourth quarter earnings are up around 2.1% and have been weighed down by a stronger currency and the energy sector, whose earnings are down 22.6%. In Europe, earnings are surprising more to the upside, though only 16% of companies have reported. In Japan, around 40% of companies have reported with earnings growth up around 10%.


The high-yield market fared relatively well in January, gaining 1.24% in the U.S. and 0.98% in Europe. This is partly due to the decline in government yields though an increase in retail flows, as well as a supportive policy backdrop is providing further support to the asset class.


Emerging market equities rose 0.5% with major divergences across regions. The MSCI India Index continued to perform well, up 5.88% while the more commodity dependent countries of Brazil and Russia are down 6.62% and 0.77% respectively. We expect these divergences will persist across the EM as the end of the commodity super-cycle creates winners and losers.


We continue to have a constructive view on equities as still abundant liquidity and a continued expansion in the U.S. economy should benefit risky assets. At the same time, we also expect a higher degree of volatility given divergences across monetary policy and the uncertainty associated with the timing and pace of Federal Reserve rate hikes. On this basis, we advise looking through the shorter-term spikes in volatility and positioning for additional gains in risky assets.


Markets are growing increasingly vulnerable to the spectre of deflation. At the same time, divergences in monetary policy are creating opportunities across asset classes. In that context, risk-management combined with rigorous sector and geographical selection will remain key factors for investment performance. As usual, don’t hesitate to contact us to discuss our investment views or financial markets more generally.

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