When writing the previous Global Strategic Outlook three months ago, we were quite optimistic on the future development of risky assets in the subsequent months. At the time, global cyclical data were strong, central banks globally pursued an expansionary monetary policy and, as a consequence, spreads in the European Monetary Union (EMU) sovereign bond market were tightening. This relaxation of tensions in the financial markets also led to a better outlook for the banking sector, which is crucial for an improvement in the credit cycle.
So what went wrong? Why did equity prices start to fall at the end of March in Europe and one month later in the U.S.? Could this risk-off mode in markets have been anticipated? With the benefit of hindsight, we can identify various explanations for the decline in risky assets. First, capital markets have become addicted to ever more liquidity injections from the European Central Bank (ECB) after the second long-term refinancing operation (LTRO) in February. Even though the ECB has continued to provide unlimited liquidity to the market—albeit at shorter maturities than three years, as under the LTRO—market participants seemed to have disliked this. Artificial demand was generated, which was probably caused by the LTRO in conjunction with “soft pressure” from national treasuries in the EMU periphery. National treasuries would have wanted to use ECB liquidity to buy sovereign bonds which were issued by the respective government. As there has been no follow-up LTRO, demand for sovereign bonds has dried up. We did not really expect this market reaction, as central bank policy has been and still is extremely loose globally.
Second, global cyclical data have started to weaken. Initially, only surprise indicators, measuring the actual reading of economic data relative to market expectations, have disappointed. This was followed by a rollover in various high-frequency data globally. Against our expectations from one quarter ago, data now points to an ongoing recession in the euro zone. In the U.S. and Asia, though, we are not anticipating a hard landing; data are still consistent with a normal cyclical moderation in activity and may be explained by weather effects (in the U.S.) and lagged effects of last year’s policy tightening (in Asia). However, in contrast to our expectations, data continue to surprise on the downside. In addition, the renewed spread widening in the euro zone is surely also having negative ramifications on U.S. and Asian growth via an increased stress in the financial system.
Third, the election outcome in Greece has added to additional political uncertainty. While three-fourths of Greek voters are still in favor of holding on to the euro, the vast majority has voted in favor of parties opposing fiscal austerity. The risk of a Greek disorderly exit from the euro zone has increased. In case Greece is not ready to implement austerity measures, it is quite likely that the Troika (ECB, EU, IMF) would cut the lines. Even the mere risk of this happening could already lead to a further escalation of the situation. Why? If the Greeks anticipated the risk of an EMU exit, the withdrawal of bank deposits could ultimately turn into a real bank run and increase the liabilities of the Bank of Greece vis-à-vis the ECB. Hence, Target 2 imbalances would increase further. It is difficult to predict how Greece or the rest of the EMU would react in this environment. The outcome of the June 17 elections, which resulted in a new government of austerity supporting parties, has brought some short-term relief. However, the fundamental problem still prevails: low growth and continuing high public sector debt. Such uncertainty is likely to continue, as, based on our estimates, Greek public debts are still on an explosive path, even after the haircut in March. Fourth, the Spanish banking system continues to remain fragile. Even after the recent €100 billion recapitalization, investors remain skeptical if the amount is sufficient. It potentially is, but we cannot be sure either. In our stress scenario, we came to the conclusion that a figure of around €150 billion would probably have been more appropriate, and we anticipate a further decline in house prices and an ongoing weakness in economic activity. Spanish bank clients seem not to trust the banking system either. Deposits have started to shrink, albeit still at a much lower pace than in Greece.
Containment How could the crisis be contained, and how likely is this? Since May 2010, European politicians have tried relentlessly to fight the debt crisis by addressing its symptoms—high debt and a weak banking sector—rather than the underlying fundamental problems such as an imperfect monetary union and diverging economic trends. It is only since late 2011 that the real problems are being addressed: structural reforms are being implemented in the periphery to improve international competitiveness, and economic policy is increasingly being harmonized.
However, measures being taken so far are anything but sufficient. In addition, one flaw in the EMU financial architecture has not yet been really addressed: as history shows, a currency union without a fiscal and political union is usually quite unstable. The lack of any real fiscal integration has not been a problem in boom times. Now it is. Given the speed at which bank deposits are eroding in Greece—and increasingly elsewhere in the periphery—and the contagion risk in other countries in the EMU periphery, the market would need a signal soon, pointing toward a tighter European integration. This could include pan-European bank deposit insurance and a Europe-wide bank supervisor, at least for the banks operating across Europe, as well as a sort of burden sharing of existing government debts—or even a transfer system. Several proposals are currently being discussed. The one that could gain traction is the debt redemption pact, proposed by the German Council of Economic Experts.
Given that the council is limited both in terms of size— maximum debt burden sharing limited to all debt in excess of 60% of GDP on the day the plan starts—and time, as it also requires a credible debt-reduction plan for every country to bring debt-to-GDP levels back to 60% within a 25-year period, it could get the support from politicians in the core EMU much more easily than the conventional euro-bond or euro-bill proposals. In addition, the ECB needs to remain an active lender of last resort and potentially has to increase its scope of liquidity provisioning. One could think of lending to the European Stability Mechanism, in case this institution gets a banking license.
Tighter Fiscal Integration
Do we think that Europe will actually implement these measures? Clearly, there is no guarantee. However, we do think that all EMU member countries would face costs in case of an EMU breakup which exceed the costs of keeping the currency union alive. This is the reason why we as a house think that it is increasingly likely to see more steps toward a tighter fiscal integration. Admittedly, any decisions toward a tighter fiscal and political union would need a long time to be implemented. Nevertheless, we would expect the market to react positively to any credible roadmap in that direction.
In any case, we think that central bank interest rates will have to remain very low in the euro zone—and not only there. The U.S., too, is unlikely to see a rate hike any time soon. For U.S. treasuries and German bunds, this implies that the outlook is rather cautious. Even though the price risk is moderate, as central banks are unlikely to hike rates anytime soon, thereby anchoring the long end of the yield curve, total return expectations in inflation-adjusted terms are very meager. We think we will have to live with a low (real) rate environment for longer, which is typical for a deleveraging period. Governments have an incentive to keep nominal and real yields low in such an environment. Central banks, too, will need to keep rates at very low levels and also distort the prices of government bonds by intervening in the bond market. This mechanism, called financial repression, has been applied in the past in various economies and is being applied again today.
In the fixed-income space, we have therefore warmed up to corporate bonds, which offer a higher yield than government bonds in the U.S., Germany and the UK. Valuations are quite attractive on our numbers. In our view implied default rates are still very high, too high actually, despite the recent outperformance. To give an example: BBB-rated bonds with a five-year maturity in Europe are priced for a default probability of around 20%. This is close to the actual default rates of all bonds, including non-investment-grade bonds, during the Great Depression in the 1930s in the U.S. Clearly, the implied default rates today look way too high. For long-term investors, we think there is value. We also like to have a long position in emerging-market bonds. With government debt levels being lower than in developed markets and continuing to trend down, we think that this market segment should deserve tighter spreads than what we are seeing today. On our numbers, the market is still pricing in a default probability of around 10%–20% for Brazil and China and 20%–40% for Russia and India, depending on varying assumptions on the recovery rate.
We reduced our equity exposure in April back to neutral. Having added to the position in January, we have locked in profits from our risk-on position, which we had for three months. The headwinds mentioned at the beginning of this article have become too strong to justify an ongoing long position in equities. Given that valuations, on average, are rather moderate for global equities, we are inclined to increase our exposure at a later point in time, provided that economic data are troughing. So far, this is not yet happening. However, surprise indicators have fallen to very low levels already and therefore could start to rebound soon. If and once this happens, this would be a positive equity market backdrop tactically. For sure, in case we get a break-up of the euro zone—currently the biggest risk case for capital markets—we would review our position and potentially reduce equities further.
Regionally, we are currently underweight U.S. equities against a global equity benchmark. U.S. equity valuations are not overly attractive based on our preferred valuation metric, the Graham-Dodd price-to-earnings ratio, relative to other markets. However, this position is under review, as the U.S. market usually performs well in a risk-off mode and in times of growth moderation.
In line with our reduction of equities in our global tactical asset allocation portfolio, we also trimmed our European equities exposure. It is only when we see first signs of a credible solution to the EMU debt crisis and, consequently, a tightening of credit spreads that European stocks are likely to outperform again. Low valuations prevented us from going underweight. Japan is a market on which we have a neutral weighting. Admittedly, we should have trimmed our Japan weighting to underweight, as Japan is highly cyclical—not the best place to be in times of growth moderation. However, the Bank of Japan (BoJ) decided to provide much more liquidity to the financial system. If this actually happens, the yen should weaken and support the equity market.
We are holding on to our constructive view on emerging-market equities, which tend to outperform in times of low real interest rates—likely the case for the foreseeable future. In addition, early indicators for growth in emerging markets are showing signs of improvements: the yield curve in most markets has started to steepen, consistent with a view of a better economic momentum towards the end of this year. Equity valuations are not particularly low in Asia, albeit justified by high corporate profitability.
Our currency views reflect our constructive views on emerging markets. We have reintroduced our secular constructive view on emerging markets in general. After the announcement by the BoJ to increase its total asset purchase program, we have implemented a short of the yen versus the U.S. dollar. This view is being reinforced by our assessment of the high valuation of the yen against most developed market currencies. Due to the ongoing divergence in growth dynamics between the U.S. and Europe, we will stick to our tactical short of the euro against the U.S dollar.