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June 2014 - ECB’s Bazooka is loaded, but will they use it ?



Contrary to most expectations, the month of May saw a further rally in global interest rates as G7 growth remains sluggish and CPI inflation is lower than where most central banks would like to see it. The 10-year US Treasury yield has plummeted to its lowest level in a year, marking a whopping 0,55% drop since the start of the year. Five years after the worst economic contraction since the 1930s, market participants still appear reluctant to express optimism about global growth. Most investors were not positioned at the start of the year for such a Japanese-like scenario for interest rates, coupled with a multi-year low in financial markets volatility and continued asset price inflation.


The bond market rally has kept investors uneasy, as it continues to defy expectations that yields would drift higher this year with monetary policy in the US being less accommodative. According to J.P. Morgan data, world growth (ex. Japan) is rebounding to the 3% pace last seen in Q4 2013, but is not making up for the particularly weak growth witnessed around the world in Q1 2014, especially in the US. The jury is still not out on what has caused this setback in Q1. Most analysts point to extreme weather conditions in the US. Investors however seem to have dismissed this weak data and expect further recovery, starting in Q2. After all, major asset classes (bonds, equities and commodities) are up 3-4% year-to-date and equity market volatility (as measured by the VIX index) has dropped to a 7-year low.


Our view is that global central banks are still very much dictating the direction of financial markets. The next central bank to embark on a new round of monetary stimulus is no doubt the European Central Bank (ECB), as indicated by its President Mario Draghi during his last ECB meeting when admitting that ‘pre-emptive action may be warranted’ to head off deflation threats. With inflation at just 0.7% in April, far below the 2% official target, it seems evident that the ECB will act at its next meeting on June 5th. The question is whether the traditionally gun-shy ECB is ready to deploy the bazooka or will it hold back from using its firepower?


The ECB may choose to put a few measures in place. First of such moves could be to cut the refinancing and deposit rates (estimates stand at a 10-15bp cuts in both). Such actions are already priced into financial markets. The second move by the ECB could be a new Long-Term Refinancing Operation (LTRO) by which the central bank would provide unlimited long-term (3-4 years) funding to Eurozone banks at very low levels. The objective of this new LTRO would be to condition it upon fresh lending by the borrowing banks and to limit their incentive to use this funding to implement carry trades by purchasing sovereign bonds. Other measures to boost lending in the Eurozone may include a purchase program of Asset Backed Securities issued by Small and Medium Sized Enterprises (SME’s) and changes to the regulatory capital requirement rules for holding such securities. The market for such securities remains relatively small and illiquid and there is some uncertainty on how such purchases would effectively be conducted. Nevertheless, an attempt to change the ABS regulatory requirement seems within reach.


Our base case for this week’s ECB meeting is for a multi policy rate cut combined with a renewed ‘conditional’ LTRO. The ECB would want to wait a few months before acting again as it will measure the impact of its latest easing measures. Judging by the recent drop in the Euro currency and the repricing of the short-dated Euro interest rate markets, such actions seem to be largely priced into the markets.


In the US, we continue to think that the Fed is on ‘auto-pilot’ as it is gradually tapering its QE-program by $10bn every month. Q1 GDP may have been the weakest quarter in nominal terms since 2009, yet recent data from the housing market, labor market, consumption and durable good orders are pointing towards a recovery in Q2. We don’t see the Fed diverging from its current policy and still expect a first rate hike around the middle of 2015.


In Japan, consensus has shifted and the baseline view is that the Bank of Japan (BOJ) will remain on the sidelines throughout 2014, instead of the previously anticipated easing in July. The BOJ appears confident that it will achieve its ‘2% in two years’ price stability target for CPI. It also feels confident that the economy has weathered last month’s sales tax increase.


Our general view on financial markets is still very constructive. We think that the current scenario of below-trend growth, but not too weak, combined with low inflation and low financial markets volatility, is going to remain supportive for risk assets. Despite tapering in the US and no new action in Japan, central banks are still very accommodative with their monetary policies. A more activist ECB is likely to provide further support, in particular for European equities. Cash levels on corporate balance sheets are still at record high levels, M&A activity is booming, investors remain under-allocated in global equities and over-allocated in fixed income. All of which comfort us in our view that the 5-year old bull market in risk assets has not run its course yet.


Our asset allocation and geographical choices remain unchanged: preference for equity over bonds and cash, preference for high yield over investment grade and government bonds, preference for shortdated bonds over long-dated. Our equity allocation remains skewed towards US large-cap industrials. About 1/3 of our equity book is invested in European names to express our view of stronger growth supported by accomodative European monetary policies. In the credit space, our allocation is centered around B / BB-rated bonds with 3-5 years till maturity, from US and European corporates.


Market accidents might happen, especially when implied volatility is trading at historically low levels. Markets may at some point become vulnerable to an increased focus on an earlier than expected first hike by the Fed. 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.