Draghi’s last act likely to disappoint

9 minute read

On September 12 the Governing Council of the ECB announced an extensive package of the monetary stimulus. It includes a deposit rate cut to -0.5%, the asset purchases program restarting November 1, two-tier system for banks and easing of the TLTROs conditions. Although the rate cut of only 10 basis points and EUR 20 bln per month of APP looked like the lower limit for the market estimates, the overall tone of the ECB’s statements perceived as more dovish than expected. After the initial announcement, the bond market rallied, notably in the periphery countries. However, the following press conference and released details caused a selloff, especially in the front-end of the curve.

The ECB has decided to use a package of the familiar tools like rate cut, QE, and TLTRO, but also to introduce a new measure: a tiering system for banks.

Draghi has mentioned three main reasons which prompted the significant monetary stimulus: (1) the global economic slowdown which increases the risk of the recession in Eurozone, (2) persistent geopolitical risks and trade tensions, and (3) downward revision of the inflation forecast. New measures were introduced to support banks as they are seen as the main transmission mechanism of the monetary policy to the real economy through lending.

Given the mixed market movements, investors still need time to digest what the new stimulus means for their portfolios and future asset prices. The ECB has delivered what Draghi was pushing through, and now it is up to Lagarde to take over the responsibility for the results. On a tactical horizon, we have set fixed income to overweight from neutral. Equity investments have been set to underweight versus an overweight position last month. We are neutral on alternative assets this month.

Overview

Within Fixed Income:

  • Our previous neutral position in fixed income has been increased to an overweight.
  • Within fixed income, we are maintaining an underweight in government bonds and are overweighting the different spread categories, particularly high yield.
  • Central banks have expressed their willingness to support the economy through (extraordinary) monetary policy. This is regarded as a positive for fixed-income categories.
  • Spread categories offer a spread pickup versus (low-yielding) government bonds, which has led to this relative positioning.

Within Equities:

  • We have reduced our overweight in equities to an underweight.
  • Within equities, we have an overweight in listed real estate and an underweight in Chinese equities.

Figure 1: Our asset class overweights/underweights in our model portfolio as of September 1, 2019 on a 3-month horizon. Each percentage reflects the relative weighting of the different asset classes within our model portfolio.

Fixed income – Government bonds

US: Neutral. Fundamentals are close to neutral. US/global economic growth is slowing and will likely be exacerbated by the ongoing China-US trade war, which remains the most significant source of uncertainty in the near term for this asset class. Developed foreign central banks have tilted toward accommodation, with the FOMC having the most firepower. We believe the Fed will cut rates two more times by the end of 2019, but there is a possibility of three cuts this year in connection with Brexit. Valuations are still negative. 10Y Treasuries remain rich to other currency-hedged developed sovereigns, but are very cheap if unhedged. Despite lower yields, on a relative basis the US has not become more expensive compared to the rest of the world. This continues to drive demand from other sovereigns on a non-hedged basis. Sentiment has deteriorated from neutral to negative. Bullish sentiment in the 10s and 30s has increased dramatically and is now at extreme levels. Technicals remain positive. The sizable rally is threatening to test the 2016 lows in yield and re-establish the ultra-long-term downtrend in 10Y Treasury rates going back to the early 1980s. Momentum clearly favors lower rates, although the market is also extremely overbought.

Europe: Negative. Fundamentals have become more positive. Core inflation is below 1% and expected to remain low in the coming months. Underspending by Germany and the Netherlands exacerbates this problem. Markets are pricing in a rate cut by the ECB. As usual, the ECB is keeping all other options open, including a new round of quantitative easing (QE), which is expected to start this month. Meanwhile, the new TLTRO is mildly supportive for peripheral banks. The dovish stance of the ECB gives comfort to European sovereign markets in general, keeping spreads low (with the exception of the volatile Italian market) and buying more time for companies and countries to get their houses in order. Valuations and sentiment are negative. Volatility indicators have increased for highly rated sovereigns due to the flight to quality. Technicals are neutral. The ultra-long down trend in yields is yet unbroken. Yields have reached new historical lows of -0.70%. Technical studies indicate there's very limited room left for yields to move even lower.

UK: Positive. Fundamentals are neutral. The latest round of PMIs was better than expected. Wages are rising at their fastest level since 2008 and inflation, currently 2.1%, exceeds the BoE's target. Brexit will continue to weigh on the current business environment. Valuations are negative, but sentiment has turned positive. The chances of a no-deal have been rising and the market has adjusted to this. Chances of a new deal are low. Technicals are neutral. Gilts have broken through the all-time lows of 50 bps.

Japan: Positive. Fundamentals remain positive. With the 10-year rate trading below the specified range of +/-0.20%, we expect the Bank of Japan to reassess its standpoint once the dovishness of the ECB and Fed are confirmed. Valuations remain very negative. Sentiment is positive. Global sentiment has taken a hit due to the trade tensions, and further action is expected by most central banks in the world, which would dampen potential volatility. Technicals are positive. The 10-year point of the curve is on the lowest end of the range defined by the Bank of Japan; it is possible that the BoJ will widen the range.

Fixed income – Investment-grade

US investment-grade: Positive. Fundamentals are neutral. The US economy is still growing at acceptable pace for corporate credit, but at a micro level there is increased scrutiny about leverage. Valuations are negative. Credit spreads widened by 11 bps over the past month to an OAS of 117. The YTD range has been 102-147. Spreads remain fairly rich versus their long-term average, and when adjusting for leverage and duration, the asset class looks even less attractive. Sentiment is neutral. Constant trade-war-related headlines, deteriorating global economic data and a significant rise in volatility have caused investors to sit on the sidelines. Investors have turned sharply bearish (61%) according to the JPM August Investor Survey. Technicals are strong. The primary calendar is behind last year's pace but net numbers are 18% lower than last year. Inflows into the asset class are very robust and the yield advantage in the US should drive demand, but hedging costs still remain high, even after the rate cut by the Fed.

European investment-grade: Neutral. Fundamentals have slipped from neutral to negative. We now acknowledge that a recession in Europe is inescapable. PMIs in Europe are under 50. The number of profit warnings has increased and credit ratings are deteriorating. Valuations are neutral. European IG spreads have tightened significantly. Currently, 60-65% of the benchmark is negative-yielding. Sentiment has dropped slightly, according to several surveys, and is therefore neutral. Technicals are very strong due to the expectation of a new asset purchase program by the ECB that would also include corporate bonds. The first wave of supply after the calm summer months will be met by plenty of money seeking a home.

Fixed income – High yield

US high yield: Neutral. Fundamentals are neutral. The US economy continues to provide a supportive backdrop for US high-yield companies, but macro/geopolitical headlines are causing near-term uncertainty. Commodity prices remain volatile, which has led to underperformance of the energy sector. We are especially cautious on the gas sector. Valuations are negative. Spreads have widened since the last House View. Spreads are now inside 400 OAS (within long-term averages). BB is trading extremely tight, while there are not a lot of incremental buyers of CCC. Sentiment remains balanced. Technicals are positive. Although there have been outflows, the market continues to be well bid, and issuance has been above average.

European high yield: Negative. Fundamentals are neutral. European economic indicators continue to deteriorate, the fear of a recession is rising, and inflation remains (very) low. Company results are deteriorating in general (low /no sales growth). Levered companies with no or limited free cash flow and short maturities are having a tough time. Valuations are neutral. Spreads are a lot tighter than they were at the beginning of the year, but relative to other asset classes this asset class still feels attractive, especially if defaults do not rise. Overall sentiment still seems bearish. The market is cautious of recession risk, but there is a lack of yielding alternatives. Investors want to buy this asset class, but it doesn't feel that convincing. Technicals are neutral. Flows are muted with low to no supply. We don't expect actions by the ECB to have same effect on high-yield debt as they would on investment-grade bonds.

US leveraged loans: Neutral. Little has changed in this asset class. The US economy keeps chugging along but we're seeing higher secured leverage, which is a bad sign. Fundamentals are neutral. Valuations are positive. Secondary prices are still down from their 2018 high due to retail outflows and a more discerning buyer base in CLO accounts. Due to the price decline, value remains in single Bs and there is some value left in distressed/CCC loans too if you pick cleverly. Sentiment is negative. There have been 40 straight weeks of retail outflows, and this asset class is no longer being sold as protection against rising interest rates. Technicals are neutral. CLO creation remains a pillar of the market and remains the largest buyer of loans.

Fixed income – Emerging market (EM) debt

Emerging markets: Positive. Fundamentals are negative. The European Central Bank (ECB) and US Federal Reserve (Fed) continue to add to the easing-bias tone in monetary policy. This should counter the impact of weaker growth for emerging markets. Valuations are positive. While the overall backdrop remains supportive, EM sovereign credit spreads have widened 40 bps since the last House View. Hard-currency sovereign debt is up 12.36% YTD and EM corporate debt has risen 9.72% YTD. EM fixed income looks attractive relative to other credit markets. Sentiment is positive. Investors in emerging markets expect monetary policy easing to reverse the rising probability of a recession risk. Technicals are positive. The last month included two consecutive weeks of bond outflows (-$3.1bn), mainly out of local-currency funds, while outflows from hard-currency funds have been contained. ETFs are bearing the brunt of redemptions. Overall, EM sovereign financing looks manageable.

Fixed income – Securitized

US securitized: Positive. Fundamentals are supportive. Consumer balance sheets are healthy and house prices are still rising. Valuations have improved from neutral to positive. Agency MBS nominal and option-adjusted spreads have widened significantly and appear somewhat attractive. Implied volatility has risen significantly over the last few months, which is positive for this sector, but convexity remains very negative. Sentiment is neutral. The volatility caused by constant flow of trade-related headlines, coupled with underwhelming global economic data, have kept many investors on the sidelines. Technicals are still positive, but less so than last month. The supply/demand picture is positive. The FOMC has hit their Agency MBS runoff cap of $20 billion per month. This runoff will continue until the position is eliminated, and proceeds will be reinvested in Treasuries.

European securitized: Positive. Fundamentals are neutral. On the one hand, arrears are stable to improving and conditional prepayment rates (CPRs) are still high. But EU growth is fading and consumer confidence is waning. Valuations are positive. Spreads are broadly stable and the move in rates is generating positive returns. CLO spreads are broadly stable, with some widening in BBB and lower quality. Primary issuance is still strong. The relative value of ABS is still very attractive versus covereds and corporates. Sentiment is neutral. Technicals are moderately positive due to a lack of EUR-denominated issuance in several of the more plain-vanilla sectors. Supply is being met with strong demand. Technicals in (ECB eligible) sectors are very strong.

Equities

US: Neutral. Fundamentals for US equity are positive, but less so than last month. US and global economic growth are slowing and the trade risks have increased, with more potential downside risk to economy. Valuations are positive. EPS forecasts are roughly unchanged; therefore, 2019 multiples are about a point lower. Absolute metrics are, on balance, cheaper than last month. Relative value metrics make this asset class more favourable than Treasuries. Trade remains a wildcard for the direction of valuations. The worsening of global PMIs could also put a lid on valuation. Sentiment is negative. The Leuthold Major Trend Index (MTI) is worsening and the weekly NDR sentiment indicator has retreated from extreme optimism to neutral. Technicals are positive. Buybacks are down but still elevated. Companies are becoming more tactical in how they apply their buyback dollars, which is supportive for technicals.

Europe ex-UK: Negative. The fundamental picture is negative and has worsened since last month. Earnings revisions are still negative, especially in Germany and Italy, and the negative momentum of earnings growth persists. The economic effect of monetary easing by the ECB remains questionable and the ECB's toolkit seems limited. At the same time, we see the possibility for fiscal stimulus. GDP downgrades are likely to have an impact on EPS growth. Valuations are neutral. Sentiment improved from negative to neutral. The Citi Surprise Index used to be flat and now is in deep negative territory. Hedge-fund net exposure is the lowest since 2012. Implied volatility, at around 20, is less resilient. Technicals are neutral. The index has been range-trading since 2015.

UK: Negative. Brexit continues to dominate this asset class. Fundamentals are neutral. The risk of a hard Brexit on October 31 has increased significantly. The current thinking is that a hard Brexit would be swiftly followed by meaningful fiscal easing and potentially QE, perhaps making UK assets more attractive. Economic data has deteriorated quite markedly in the last several months. Brexit aside, the domestic economy looks challenged. Valuations remain attractive, particularly from a dividend yield perspective. Sentiment is negative, as reflected by weakening in the GBP and UK domestic companies. Technicals are still positive, but less so than last month.

Japan: Neutral. Fundamentals remain negative. Japan is a slow-growth economy, burdened by high debt and an aging population. Valuations are slightly positive. Sentiment is negative. That said, the view on Japan is no more bearish than it is on UK or EU, according to the Bank of America Merrill Lynch (BAML) survey. The opportunity for a contrarian bounce is real on any fiscal or monetary stimulus or good economic data. Technicals are neutral.
Emerging markets: Positive. Fundamentals are neutral. The economic backdrop is tough, but some policy response is expected. Valuations are negative. The blended forward emerging market P/E of 11.40x) is now trading below long-term averages. The EM/DM discount has widened to 25%. YTD earnings have reaccelerated downwards: YTD: 12%, which is word year after 2015 so far. Expected earnings growth for 2019 is -7.7%. Sentiment is neutral. Positioning is still rather bearish, but EM sentiment is far from contrarian. Emerging markets equities suffer from permanent outflows (YTD the outflows are negative.) Technicals have improved from neutral to positive, mainly because markets look a bit oversold.

China: Positive. Fundamentals are neutral. Chinese PMI has improved slightly (but still under 50), and growth of Chinese industrial production growth is the weakest since 1990. Valuations are negative. Chinese equities are trading slightly below historical averages. While EPS growth for 2019 is still positive (+1.6%), growth has almost disappeared. Earnings downgrades are starting to follow the trend in emerging markets. Sentiment is neutral. Technicals have moved from neutral to positive as a rebound is expected from current levels based on oversold conditions.

Alternative Assets

REITs: Positive. Fundamentals are positive. This asset class still benefits from defensive income qualities versus general equities. Listed real-estate markets are down -1.7% since the last House View versus -5.7% for global equity markets. In China, developers of residential properties still outperform overall markets on volume due to better access to capital. Valuations are strong. The sector looks cheap versus credits, but is firm versus equity on earnings. The dividend yield for real estate versus credits (a more stable sector) is positive. US REITS' Implied Cap Rate Spread to Baa is currently trading at 195bps vs the historical average of 75bps (95% percentile from 84%), which is very positive for valuations. Sentiment is also positive. Sentiment for this asset class is determined by how the market behaves towards equities given the changes in rates. On a three-month basis, REITs still have upside versus equity markets when the rate movement is taken into account. Technicals remain positive, and have improved from last month.

Distressed credit: Negative. Our opinion of this asset class has deteriorated. We have therefore positioned our book more conservatively. Fundamentals have gone from neutral to negative because the risks to the downside (Chinese tariffs, global trade, European slowdown, Brexit, etc.) outweigh those to upside. Moreover, the market is now pricing in the possibility of a recession and the companies we follow have weakened. Valuations have also turned negative. CCCs, which are the best indicator of lower credit quality, have vastly underperformed recently. Sentiment also dropped from neutral to negative. Investors' patience with non-performers is dissipating. Even names that have had very strong earnings have traded down due to negative investor sentiment. Spread and equity volatility has returned to heightened levels. Technicals are neutral. Net flows in high yield are positive YTD in 2019 as the rate move drives the search for incremental spread. New issue supply is still constrained and the forward calendar among lower-quality issuers looks light as well.

Commodities – oil: Neutral. Fundamentals remain quite mixed. On the one hand, inventory levels are above normal. On the other hand, OPEC is balancing the market and there is high compliance among all members to extend production cuts of 1.2 mbd until the end of Q1 2020. Valuations are modestly supportive: the trade-weighted dollar is a headwind for the oil price but on the oil futures curve there is a decent positive carry (currently around 7.5% annualized carry). Techincals are mixed, so neutral this month.

Currencies

EUR/USD: Negative, close to neutral. Fundamentals are positive, valuations and technicals negative, and sentiment is neutral. Recent US data has been good, while European data continues to be poor. Germany's economy shrank in Q2. We expect the USD to weaken over the medium term, but the currency's status as a safe haven is a challenge to this assumption. A combination of softening in global data and trade tensions will keep the US dollar supported. Based on our aggregate valuation of PPP, BEER and FEER, the euro remains cheap. The euro tends to weaken when investors are looking for investors are looking for attractive funding currencies to finance higher-carry asset positions. If trade tensions continue to escalate and risk-off trading continues, these carry trades will unwind. Italian political risk, auto tariffs and poor macroeconomic landscape are keeping the euro in a tight range. Positioning for the USD remains long (but has been reduced), while the market position is still short EUR.

USD/JPY: Negative. Fundamentals, sentiment and technicals are negative. Valuations are positive. Our analysis concludes that the yen is one of the world's cheapest currencies. After range-trading through June and July (107-109), USD/JPY broke lower in early August as markets turned sharply risk averse on a further blow-up in US-China trade tensions. Continued rhetoric from the Fed suggests that the Fed's policy will remain reactive, not proactive. Coupled with slowing global growth and continued trade escalation, this suggests USD/JPY will continue to trade lower. Positioning on the yen is neutral after being underweight earlier in the year, but this could shift to long, as it has in the past when bond yields have dropped.

GBP/USD: Negative, close to neutral. Fundamentals and technicals are neutral, valuations positive and sentiment negative. GBP price action has become so focused on the prospects for Brexit that economic data are completely overshadowed at the moment. The risk of a no-deal Brexit has risen. Positioning has moved sharply but is not at extreme levels. As a result, sterling remains vulnerable to negative news. Valuations continue to point to sterling being undervalued and we expect this to persist until the twin uncertainties of politics and the economy have been removed. If a deal is reached before Oct. 31, subsequent fiscal loosening should generate additional upside to GBP. If the UK leaves the EU without a deal on 31 October, sterling will fall sharply due to expectations of sharp economic contraction and easier monetary policy. We estimate the downside to the exchange rate to be nearer 10% against the USD, against European currencies it is likely to be less.

About the House View

Aegon Asset Management operates from centers of expertise in North America, the UK, Continental Europe and Asia. The Aegon Asset Management House View is updated on a monthly basis, and is an excellent example of how we leverage our international expertise. First, we collate a global set of asset class views from our international teams. The asset class views are subsequently reviewed from macro, rates and asset allocation angles and an overarching committee then establishes the global House View. The outcome of this disciplined global process provides portfolio managers with latitude while at the same time ensuring that our products and solutions remain aligned.

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